Business owners and managers are constantly looking at the most effective ways to remunerate their employees. There is a long list of alternatives, ranging from cash to equity (and lots in-between).
We’ve put together a list of the key considerations when designing and implementing an arrangement that will attract, reward and retain key employees and non-employees, such as contractors, consultants and directors.
Tax will often be a key driver in structuring incentive arrangements, but other legal and commercial considerations will also come into play.
The comments below are general, and many will require some planning to navigate the interaction between tax, company law and the commercial drivers for the arrangement. You should consult your legal adviser on these matters.
1. Equity or cash
Cash is a simple way of rewarding employees, but it isn’t particularly tax effective; nor does it specifically assist in retaining key employees once the cash is paid. Equity can be more tax effective than salary, provide greater financial upside, but it does require a consideration of a broader range of issues than cash.
2. The problem with cash incentives
Whether by way of salary or bonus, cash is taxed on receipt at an employee’s marginal tax rate, so your employees may lose half of what they’ve earned to tax. But there’s no doubt, cash is a simple strategy that can be made subject to the meeting of KPIs and company law compliance obligations are typically not a factor that needs to be considered.
3. Not quite equity? Shadow (or phantom) equity
Shadow equity is a means of paying an employee a cash incentive calculated as if the employee owned equity in the company. While these arrangements offer the benefit of greater upside in reward – as equity will often increase in value over time – the tax outcome for employees is no different than being paid cash. However, unlike cash, the company will need to consider whether company law imposes obligations that require disclosure documents to be prepared and impose licensing requirements.
Be it in the form of shares or options, equity is usually structured to give a tax deferral benefit under the ‘Employee Share Scheme’ (ESS) tax rules. Tax is deferred until the employee can realise the benefit in the equity (‘deferred tax time’), such as when options are exercised or shares are no longer subject to forfeiture. The trade-off is that the employee pays tax at their marginal rate on the value of the equity at the deferred tax time.
5. Don’t forget there may be tax to pay on sale
Employees who receive employee equity will usually be subject to a tax event when they sell their shares (or options), even after paying tax at the deferred tax time. The gain on sale will typically be taxed as a capital gain, so the 50% CGT discount may be available.
6. Start-up tax concessions
The ESS tax rules have recently changed to make equity far more tax effective for employees of ‘start-ups’. Employees are only subject to tax on the sale of their equity and any gain is only subject to CGT. However, there are strict rules that define which companies can qualify as a ‘start-up’, some of which require a consideration of the start-up’s investor base and other entities in its corporate group.
7. The non-tax legal considerations
The company needs to consider whether the issue of equity (or even shadow equity) triggers company law requirements to prepare some form of disclosure document or if the company needs to be licensed for AFSL purposes. An exemption from these requirements will often apply in the case of an employee share scheme, but the exemptions only apply if specific conditions can be met.
8. Company tax deduction
The employer may be able to obtain a tax deduction for the full value of the equity that is provided to its employees. The deduction requires some planning and typically requires a trust to be established to manage the equity plan. This can add to the complexity of the arrangements. Remuneration arrangements can also have other tax risks for the employer, such as payroll tax and fringe benefits tax that need to be considered.
9. Employee benefit trusts
These types of arrangements are increasingly common and are often used when the ESS rules cannot apply or when a business owner doesn’t want to offer equity in the company to its employees but wants them to share in the increase in company value. These arrangements have come under the close scrutiny of the ATO and must be carefully planned and implemented to avoid adverse tax outcomes.
10. Drafting the incentive arrangement – don’t forget employee leaver arrangements
A well-drafted plan should set out the terms of the incentive arrangement and deal with future events as completely as possible so everyone knows where they stand, say if the company is listed in the future. In particular, the incentive documents need to set out what happens if an employee leaves. Many owners of private companies don’t want ex-employees to hold equity, so the incentive documents need to address how equity is handed back. Different tax outcomes can arise for the employee depending on how the equity is returned and some are more tax effective than others.