In brief: Dust off your old employee option plans, as options look set to make a comeback. In consultations with Treasury earlier this year, we were informed that the Federal Government was considering introducing a special tax regime for 'start-ups' but that there was limited appetite to reverse any of the 2009 tax changes that largely resulted in the death of options for Australian employees. So, it was to our pleasant surprise that, on 14 October 2014, the Government announced that, from 1 July 2015, Australia will be moving back to the global norm of employee options granted by all companies generally being taxed on exercise. Special concessions for start-up companies are also proposed. Partner Sarah Bernhardt (view CV) and Senior Associate Shaun Cartoon, members of Allens' Head Office & Governance team, report.
HOW DOES IT AFFECT YOU?
- For all companies:
- reverting back to tax on exercise of options (rather than on grant or vesting) should mean that, from 1 July 2015, tax will be less of an impediment to granting options to Australian employees; but
- some options will continue to be taxed prior to exercise. In particular, it is not yet clear whether tax on exercise will be subject to an exercise price condition. Further, a taxing point prior to exercise will still arise if employment ceases before exercise (an illogical outcome in need of urgent reform) or if the options are not exercised within seven years of grant.
- For eligible start-up companies:
- it is proposed that tax concessions will be provided for awards granted from 1 July 2015 in the form of either shares (where a 'small' discount on grant may be tax exempt) or options (provided the exercise price is not less than the market value of the shares on grant); and
- if the tax concessions apply, tax will not apply on grant of the awards. Instead, the taxing point will generally be on sale of the shares and the gain on sale will generally be taxed as a capital gain (and therefore may be eligible for the Capital Gains Tax (CGT) 50 per cent discount).
Before the 2009 changes to the taxation of employee share schemes (ESS), employees could choose to have qualifying ESS shares or options taxed on grant or at a deferred taxing point (subject to certain conditions). Tax deferred options were usually taxed on exercise.
The 2009 changes introduced the concept of a 'real risk of forfeiture' as one of the gateways to deferred taxation of shares and options. Under these changes, if shares or options are granted without a 'real risk of forfeiture', the shares or options are generally taxed on grant (even though there may be restrictions on the employee's ability to sell the award to fund the tax). If there is a 'real risk of forfeiture' on grant, then the taxing point is generally deferred to a later time. For tax deferred options, the taxing point is usually when the options are first able to be exercised (rather than when the employee decides to exercise, as was previously the case).
Having tax payable on grant or vesting of options on an imputed taxable value of the options which can be significantly greater than the difference between the market value of the share at that time and the exercise price (including tax on under-water options) was, not surprisingly, seen as an unacceptable outcome for employees. As a result, the 2009 changes largely resulted in the death of options for Australian employees.
OPTIONS GRANTED BY ALL COMPANIES
The Government has announced that employees who are granted 'options' under 'tax deferred schemes' from 1 July 2015 will generally be able to defer income tax until they exercise the options.
This is a long overdue change and a victory for common sense. In practice, this should mean that tax will be less of an impediment to employers granting options to Australian employees. Not only will employees now generally be able to fund the tax bill on their options by selling the resulting shares, but there is also a good chance more taxes will be collected as a result of this change. This is because, as a result of this change, capital growth in the share price between vesting and exercise will no longer get the benefit of the CGT 50 per cent discount. Further, options generally provide an employee with more leverage into any increase in a company's share price than do free shares. This means that, in a rising share market, both the employee and the Tax Office are likely to ultimately benefit more from options than from free shares.
At this stage it is unclear what is meant by an 'option'. For example, will 'options' include performance rights without an exercise mechanism? What if there is an exercise mechanism, but a zero or nominal exercise price? It is also unclear what is meant by 'tax deferred scheme'. For example, will tax on exercise also be available where the real risk of forfeiture test is not satisfied on grant (that would seem to be implied in the available documents)? If so, will that be subject to an exercise price condition? These issues should become more clear during the consultation stage.
Tax on cessation of employment to remain?
It is disappointing that the Government has not indicated an intention to remove cessation of employment as a taxing point. Taxing participants who cease employment on unvested awards at that time is entirely inappropriate and Australia would be one of the few countries in the world to do so. The ESS reporting and 'No TFN' withholding rules (which are set to stay) should deal with any concerns that the Government may have about reporting and disclosure for former employees.
Update of valuation tables
The Government has announced that it will update the safe harbour valuation tables used to value unlisted rights, to ensure they reflect 'current market conditions'. One of the purposes of the tables is to offer employees who are granted options a simpler and less costly alternative to obtaining a real market valuation. As the valuation tables are not relevant for options taxed on exercise, the tables may become less relevant over time. However, we can expect that they will still be used to value options that are taxed on grant, on cessation of employment or on reaching the maximum deferral period of seven years.
The valuation tables, which are based on a Black Scholes valuation method, were designed, having regard to their 'one size fits all' purpose, to be generally concessional when determining a market value for options. For example, while Black Scholes usually requires company specific inputs (dividend yield and volatility) and time specific inputs (time to expiry and risk free rate of return), the tables assume a 'constant' for dividend yield (4 per cent pa – the higher the yield, the lower the value of the option), volatility (10 per cent - the higher the volatility rate, the higher the value of the options) and risk-free rate of return (7.6 per cent pa – the higher the rate, the higher the value of the option). With the exception of the risk-free rate of return (which may be lower in the current market conditions), those assumed constants may be considered (both when designed and in the current environment) to be potentially concessional. Whether the update to the tables to reflect 'current market conditions' will make the taxable value under those tables more or less than what it is currently will depend on how the Government chooses to tinker with these 'constants'. If, for example, the Government were to adopt The Board of Taxation's recommendations in its 2010 paper, the tables might result in higher taxable values. However, we would hope that if the Government refuses to remove cessation of employment as a taxing time, it would not further compound the problem by increasing the taxable values under the valuation tables.
Commencement from 1 July 2015
The Government has stated that the legislation is intended to come into effect for shares or options 'provided' from 1 July 2015. It is unclear whether there will be any transitional rules for options granted before 1 July 2015. If there are to be transitional rules, we would assume, consistent with the 2009 transitional rules, that might only be relevant to options which have not yet had a taxing point before 1 July 2015 (ie generally unvested options held by current employees on 1 July 2015).
In this intermediate period, companies should be careful not to create rights in employees to be granted options from 1 July 2015 (in case the indeterminate right rule might apply to treat the date of grant of such options as the date on which the promise to grant was made, which may prevent the application of the new rules).
OPTIONS AND SHARES AWARDED BY START-UP COMPANIES
It is proposed that new tax concessions for options and shares in start-up companies will be available from 1 July 2015. To be eligible to access the start-up concession a company will need to have an aggregate turnover of not more than $50 million, be unlisted and have been incorporated for less than 10 years. Other qualifying conditions that the Government might consider include a qualifying trade requirement, an independence requirement and a maximum number of employees requirement. These are some of the qualifying conditions for the UK's Enterprise Management Incentive scheme, on which the Government's proposal for the start-up concession would seem to be based.
In relation to a grant of start-up options, the key features of the tax concession seem to be:
- Options will potentially qualify for the concessional treatment if the exercise price is not less than the market value of the shares at the date of grant.
- Such options will not be taxed on grant, vesting or exercise. Instead, the taxing point will generally be deferred until the eventual sale of the shares (subject to a possible 15-year limit).
- The whole gain made on the sale of the shares will generally be taxed as a capital gain (and therefore the CGT 50 per cent discount is likely to apply, provided the shares are held for more than 12 months from exercise). However, if the shares are sold within three years of grant of the options, it is possible the gain may be taxed as employment income.
- It is not clear whether there will be a cap on the number of options granted to an employee that are eligible for this concession. This could be a cap based on the taxable value of the options on grant (in which case the proposal to update the option valuation tables will be relevant) or, instead, might be based on the sum of the exercise price of the options.
In relation to an award of start-up shares, the key features of the tax concession seem to be:
- Shares will potentially qualify for the concessional treatment if the shares are acquired at a discount of no more than 15 per cent to the market value of the shares at the date of purchase.
- The discount on the acquisition of the shares may be tax exempt. Consistent with the current $1000 tax exemption, this new concession will be a 'real' exemption as, for CGT purposes, this discount will be included in the cost base of the shares (so is never taxed).
- The taxing point on such shares will generally be deferred until sale.
- The gain made on the sale of the shares will generally be taxed as a capital gain (and therefore the CGT 50 per cent discount will generally apply). However, if the shares are sold within three years of purchase, it is possible that some or all of the gain on sale of the shares (including the discount on grant) may be taxed as employment income.
- Given the reference to 'small discount' in the available documents, we expect the Government will place a cap on the maximum dollar value of exempt 'discount' that can be provided to employees in respect of an award of shares. If so, we hope that any proposed cap will be more than the existing $1000 cap, which has not been increased since 1996.
Other than a possible 15-year maximum deferral period (the relevance of which is not clear to us – perhaps this is instead to apply to options granted by start-ups that do not satisfy the proposed exercise price condition?), the available documents make no mention of an earlier taxable event arising in event one or more of the start-up qualification criteria are no longer satisfied (eg in the event of an IPO).
The changes announced by the Government are encouraging. We intend to be actively involved in the consultation stage to assist in achieving sensible and workable outcomes for industry.