Prior to the recent election, the then Assistant Treasurer released a discussion paper proposing and inviting submissions on possible changes to relax the administrative and tax arrangements for employee share schemes (ESS) for start-up companies. Partner, Craig Yeung and Associate, Jarrod Wilksch review the proposals.
The discussion paper was part of the now former Labor Government’s proposed measures aimed at encouraging high growth start-up companies as outlined in its A Plan for Australian Jobs: The Australian Government’s Industry and Innovation Statement paper released earlier this year. It describes the importance of innovative and entrepreneurial companies to Australia’s economic growth while also outlining the difficulties faced by start-ups in attracting and retaining skilled and experienced staff.
The discussion paper recognises that although ESS can be a valuable tool for start-ups in attracting and retaining talented people, while ensuring sufficient capital is conserved to grow their business, improvements could be made to the administrative and taxation arrangements of ESS for start-ups to reduce their costs and complexities for these companies.
The key focuses of the discussion paper relate to:
- the definition of "start-up" companies
- tax treatment for ESS interests offered by start-ups
- valuation options for ESS interests offered by start-ups
- simplifying the creation of ESS.
Current ESS arrangements
Under the current taxation arrangements, any discount in the market value of an interest in a share or right provided under an ESS is taxed upfront in the tax year it is granted, unless certain other conditions apply, in which case it may be deferred until a later point in time. If it was taxed up front and certain conditions are met, then a $1,000 "tax-free" concession may apply.
In order to determine the market value of the ESS interest, a valuation is usually required.
In addition to the income tax payable, if the shares or rights are sold, the employee is required to pay capital gains tax (CGT) on any gain from the value of the shares or rights from when they were acquired.
Overall, many have complained that the current system is complex, costly and creates a disincentive for start-ups to adopt an ESS.
Drawing upon perceived "common features" of start-ups, the Government proposes a definition of "start-up company" to be used in determining whether a business is eligible for the concessions, as a business that:
- has 15 or fewer employees
- has an aggregated turnover of less than $5m and is not a subsidiary, owned or controlled by another company
- has been in existence for less than a certain period (the discussion paper proposes five or seven years or less)
- is not undertaking an "excluded activity" or is providing new products, processes or services based on the development and commercialisation of intellectual property
- is unlisted, and
- has the majority of its employees and assets in Australia.
The discussion paper also suggests that a process could be introduced where companies may apply to a regulatory body to determine whether it meets the above definition. However, this would appear to be inconsistent with the objective of reducing compliance obligations and costs to these companies.
Proposed taxation reform options for treatment of ESS interests
The discussion paper proposes the following four potential reform options to the taxation of ESS interests that apply to start-ups:
- Deferring the taxing point for the interests to the earlier of when the employee exercises the options, their employment ceases or seven years after the shares or rights were acquired. This option removes the need for the start-up to value the securities at the time they are granted. The $1,000 tax-free concession would not apply under this option.
- Calculating the tax liability upfront but deferring payment of that liability until the share or option is sold or exercised. The $1,000 tax-free concession would not apply under this option.
- Taxing the ESS interests at the time they are granted but at a lower tax rate (rather than the employee’s marginal rate). The Discussion Paper proposes a rate of 15% for this purpose. The $1,000 tax free concession would apply under this option.
- Increasing the upfront concession on the discount between value and the amount paid at the time of the acquisition from $1,000 to $5,000.
Under all of the above options, CGT would continue to apply to any gains where the shares or rights are sold. However, under option 1 the 50% CGT discount would only apply 12 months after the date that the taxing point is deferred to (although no CGT would be payable if the securities are sold within 30 days of the taxing point).
Proposed valuation options for ESS interests
The discussion paper notes that the requirement to ascertain the market value of the ESS interests at the time they are granted increases the costs of ESS’s to start-ups. It acknowledges that in many cases an independent or formal valuation is required, which must be paid for by the company.
Accordingly, it proposes the following three additional valuation options as alternatives to reduce these costs and complexities:
- A net asset backing method. Under this method the start-up’s net asset amount (calculated by reference to its balance sheet) is divided by the issued shares that have access to its capital upon wind up. The value of each shareholder is then calculated according to the number of shares held.
- Using the mechanisms provided under AASB 2 (share based payments).
- Alternative formula-based valuation methodologies, such as the Monte Carlo option pricing model and the Binominal option pricing model.
Simplifying the creation of ESS’s
The discussion paper also acknowledges concerns regarding the costs of professional advisors required in establishing ESS’s and puts forward the possibility of developing standard/template documents that could be used for basic ESS’s. However, it acknowledges that the uptake of these documents may depend upon the guidance, promotion and support offered to start-ups in relation to the documents.
The paper also recognises the impact of the fundraising regulations and disclosure requirements under the Corporations Act in relation to the offering of interests under ESS’s. To this end it notes that ASIC is currently reviewing the relief it has provided in Regulatory Guide 49: Employee Share Schemes, with a view to possibly broadening the ambit of the relief offered under this guidance.
Submissions on the discussion paper closed on 31 August 2013 and it was expected that Treasury was to report back to the Government on the outcome of the submissions and review by December 2013. However, with the recent change in Government, at this stage it is unclear whether the new Abbott Government will proceed with the review in its current form and whether the previously stated timelines will be met.