Despite industry hopes that this year’s Federal Budget would include announcements on the Abbott Government’s plans for the overhaul of taxation on employee share schemes (ESS) in Australia the Government has delayed any announcement until later this year.

It is widely considered across the industry that existing barriers to the use of employee share schemes to reward employees (particularly in Australia’s technology and innovation sector) place companies operating in Australia at a competitive disadvantage to their overseas counterparts and that removing those barriers is critical to development of the industry in Australia.  

An effective employee share scheme regime allows start-ups to attract and retain talent at a time when they are cash poor.  Usually for these types of companies it is simply not possible to reward staff with salary commensurate with that offered by established businesses or industries and offering any salary shortfall in equity both rewards the employee (allowing them to share in the future success) and fosters a sense of ownership and participation.  

The intricacy surrounding the existing employee share scheme regime in Australia is not just a barrier to the use of such schemes for companies in the technology and innovation industries.  Companies in a range of industries all across Australia are hampered by the inherent complexity in the rules.  

Overview of the current rules

The default position under the current rules is that each employee who is issued a share or a right to acquire a share (ESS interest) at a discount to market value must include that discount in their ordinary assessable income and pay tax on this amount at their marginal tax rate.

The time at which the ESS interest is taxed may, however, be deferred in certain circumstances – most commonly, where there is a real risk that the employee may forfeit or lose the interest. 

The advantage of having a small amount taxed upfront upon the grant of the options is that once this occurs, the ESS tax provisions will no longer apply.  Instead, the capital gains tax (CGT) provisions will operate from that point forward.  This has two benefits:

  • where the taxpayer is an individual or individual beneficiary of a trust, the CGT discount can be accessed for future increases in value (i.e. beyond that already taxed upfront under the ESS rules) subject to meeting the normal discount conditions, and
  • any future taxing point will only arise when a CGT event occurs (normally when there is a disposal or other ‘cash-out’ event) and if this does not occur, deferral can be indefinite.

This may be contrasted with the deferral position.  When deferral ends (and the discount is potentially much higher, due to growth of the business) the discount is included in the employee’s assessable income and subject to tax at their marginal rate.

Importantly, the current regime does not allow the employee to choose upfront taxation in circumstances where the conditions for the deferral concession are satisfied (although it is possible to structure schemes that take advantage of the benefits of upfront taxation at a time when the value is low).  

Barriers to implementation

The current complexity and regulation of the rules is the most significant barrier to the wide adoption of employee share schemes in Australia.  While there are some alternatives that can allow effective remuneration of key employees for start-ups or companies with high growth potential, due to their complexity (and cost) such plans are not effective to encourage broad participation by employees.

Although the rules provide valuation mechanisms, these cannot always be used.  In circumstances where the employer is not listed, the company needs to obtain a business valuation each time it wishes to issue shares to employees.  Obviously obtaining valuations of many start-ups is problematic or, at the very least, expensive.  Further, where incentive arrangements satisfy the conditions for the deferral concession to apply, there can be multiple valuation points, meaning significant compliance costs in obtaining valuations of the relevant interests at each time a deferral period ends for an employee. 

The fact that employees are likely to be taxed upfront on the value of their shares, of itself, provides significant disincentive.  Where there is no market for those shares, the employee is stuck with an upfront tax liability in respect of an unrealised (and potentially unrealisable) investment.  Particularly relevant to start-ups is the risk that an employee will be left with an upfront tax liability in respect of a venture that may fail and shares that are ultimately worthless.  

Even in circumstances where the employee is able to sell shares to meet any upfront tax liability the result is equivalent to paying a cash bonus or salary and the executive using the after cash amount to fund an acquisition of shares at market price.  While this may well be the economic goal of the provisions, it is hardly a means to encourage share ownership.

Whilst this scenario is problematic for a listed company, it is even worse for a private company or entity in which there is no liquidity or available market to dispose of the shares.  In either case, the use of employee share schemes to provide significant benefits to employees that do not qualify for the deferral concession are rare.

Although it is possible to structure an employee share scheme around the obvious complexity in the existing regime, this of itself can produce a scheme that is both costly, complex and in certain industries, may not provide employees with the incentive sought by implementation of the scheme in the first place.  

Where to from here?

Treasury released a discussion paper in August 2013 seeking input in respect of the application of the employee share schemes for ‘start-up companies’.  While the paper originally had a closing date for submissions of 30 August 2013, the consultation process was put on hold due to the Federal election and there has been no further announcement from the Government as to the proposed time line for reform of the employee share scheme regime.

Arguably, the proposals in the paper remain highly restrictive when compared to international comparisons (with which the measures are designed to compete for attraction and retention of talent).  In any event, the paper focuses only on the use of employee share schemes by start-ups with the concessions proposed restricted to businesses with a turnover of less than $5 million and 15 or fewer employees meaning that concessions are effectively restricted to ‘small businesses’.

If the Government did proceed with the arrangement and sought to implement some or all of the proposals in full, there would still remain a substantive competitive disadvantage of Australia compared to other overseas incentives, such as those in the UK, US and Singapore:  

  • in Singapore a 75% exemption is provided for up to SGD$10 million in value received by an employee over a 10 year period
  • in the UK, the concession allows up to £120,000 per employee and £3 million per employer to be granted without tax and without National Insurance Contributions paid on exercise, and 
  • the US employee share arrangements (which are not limited to start up or speculative companies) provide for options of up to $100,000 a year per employee to be issued and stock purchase plans of $25,000 per year per employee, which are not taxed when granted or exercised.  Taxation only occurs when the stock is sold and, if held for one year from the date of purchase and two years from the date of granting in respect of options, CGT rates are available.

It goes without saying that both the current and proposed employee share scheme tax incentives in Australia are substantially more restrictive and less generous than a number of our overseas peers and a full review of the regime is warranted.

It is envisaged that the Government will announce proposed changes to the rules later this year.  For companies that do not have the luxury of waiting this long, there are still structures available to optimise the effectiveness of an employee share scheme and tailored advice should be sought prior to implementation.