A well-designed employee share scheme (ESS) can give employees more financial incentives than they could get through a salary or bonus. These schemes can also provide substantial discounts on capital gains tax for businesses. However, tax rules for ESSs in Australia are complex. To maximize the potential incentive you’re providing, you should engage a specialist tax advisor to help design your scheme. Here we provide some general advice on ESSs and tax in Australia. Be aware that it may not apply to you, so get professional advice about your own situation.
Upfront Tax Liability Under ESS’S
If an employee receives an interest (such as a share) under an ESS, they will owe tax on any difference between the price and the market value (the ‘discount’) when they do their income tax return. However, they may not receive cash from the company to pay this tax. Here are some strategies to help you avoid this problem. All of them will affect how you design your scheme, so you should get tax planning advice before using any of these.
Strategies To Deal With Upfront Tax:
Some companies offer employees a ‘non-recourse’ loan to help them pay the upfront tax. You have recourse to the shares if necessary to repay the loan, but can’t take other action against the employee if the loan isn’t repaid. Employees usually repay the loan from dividends declared on the shares and any sale proceeds. They will receive future dividends and/or a capital return if the company is listed or sold. If an employee leaves the company with an unpaid loan, you can sell their shares or buy them back. As employees own the shares outright, they should get CGT relief on any capital gain they make when they sell the shares. Also, any type of share can be issued under this scheme. However, if the loan is interest-free and not on ‘arm’s length’ terms, fringe benefits tax may apply. And if you issue different tranches of shares to the same employee over time, other issues could apply. Under this arrangement, shares are usually issued at market value, so employees don’t have a tax liability when the shares are issued.
An option gives the holder the right to buy a share at a specified exercise price. This price must be at least equal to the share’s market value when issued. Usually, employees pay nothing or little for the option itself. Employees can’t usually ‘vest’ (exercise) their options until a certain time or they’ve met performance targets. This discourages employees from leaving and improves performance. Often, employees also can’t exercise options until the company is sold or listed. However, they can receive a capital return at this time. They participate in a sale or listing basically as shareholders, but can’t become shareholders or have voting rights before that time.
If your company is a start-up for tax purposes, employees may receive CGT concessions on any capital gain on their shares.
For ESS tax rules, a company is a start-up if it:
- is an Australian company
- is not listed
- has been incorporated for less than 10 years
- has an aggregated turnover of less than $50 million.
If your company is part of a corporate group, the ATO applies the ‘10 year’ and ‘$50 million’ rules at a group, not individual, company level. If your company intends to issue options (rather than shares) under the scheme, it must meet a range of conditions to qualify for start-up concessions. One benefit of these start-up concessions is that, when an employee sells their interests, they may get discounts on the CGT that the ATO would usually apply. Start-up concessions can also apply to schemes that issue shares, but different rules and eligibility criteria apply.
Another way to deal with the upfront tax problem is a ‘tax-deferred’ scheme, where the employee’s tax liability on the discount is deferred for a period. To do this, your ESS must be structured very specifically. Different rules apply depending on whether employees will receive options or shares and, if they’ll receive shares, whether employees acquire them under certain salary sacrifice arrangements. For example, if options are issued, an employee must meet specific criteria to defer the tax on any discount for these options.
If eligible, the employee can defer the tax for their options until the earliest of these:
- the employee ceases employment
- there is no risk of forfeiting the option and the scheme no longer genuinely restricts disposal of the option
- the employee exercises the option, and there is no real risk of forfeiting the underlying share and the scheme no longer genuinely restricts the disposal of the resulting share
- 15 years after the employee acquired the option.
If employees receive shares rather than options, some of these above principles apply with some additional requirements. Be aware that, although tax-deferred schemes do give employees an upfront cashflow benefit, the employee can’t access the more favorable CGT regime until after their options or shares are first assessed for tax. So if they ultimately dispose of these interests, they may end up paying a lot more tax than if they had paid the tax on the discount upfront.
Need Professional Help?
As you can see, tax rules for employee share schemes are very complex and tax legislation changes all the time. You need an income tax and tax planning professional to guide you through the design of your ESS.