Employee share schemes (ESS) have been around for some time now but have become more prevalent of late in Australia, especially with the introduction of the “start-up concessions” and other improvements from 1 July 2015. The tax implications of issuing ESS interests are complex and details analysis of these tax issues is outside the scope of this article. Rather, this article aims to:
- Provide examples of common employee share schemes;
- Provide practical tips hen dealing with these schemes; and
- Discuss, at a high level, how the ESS provisions interact with some of the other tax provisions.
Why use an employee share scheme
As a starting point, an employee share scheme is an arrangement whereby an employee or a part related to the employee is provided shares or other equity interests in a company in respect of their employment. These arrangements can be an effective tool for the employer to:
- Attract talent;
- Retain and incentivise key staff;
- Align the interest of employees and the business;
- Provide flexible remuneration packages; and
- Encourage increased productivity.
A recent study by the Department of Innovation found that compared with their non-ESS counterparts, companies which implemented employee share schemes had lower employee churn, higher sales, higher value added, higher labour productivity and higher value-added growth. Evidently, when set up correctly, an employee share scheme can be mutually beneficial to the employer and employee.
Why is tax relevant?
Division 83A is the starting point for identifying the tax implications of employee share schemes. The general principle of this division (subject to various adjustments) is that the employee is taxed (at their individual marginal tax rates) on any discount to market value received on ESS interests.
Depending on which provisions of Division 83A apply (i.e. taxed upfront, tax deferred or the start-up concessions), the “taxing point” of the ESS interests is on key consideration employers and employees should be aware of. Although unintended, issuing ESS interests could impose a cash flow burden on employees as the tax liability could arise on issue of the interests, leaving the employee unable to fund the liability due to the generally illiquid nature of unlisted company shares.
This is but one example highlighting the importance of finding the right balance between the commercial and tax attributes of the scheme.
Over the years, employee share schemes have taken many forms. The table below summaries some of the more common types of employee share schemes and similar remuneration packages we have seen in practice, along with the key tax issues to consider.
As previously stated, it is important to find the right balance between the ideal commercial parameters and tax attributes of the scheme. Commercially, there can be a natural tension or trad-off between “what’s best” for all parties. Finding the “sweet spot” can be difficult. However, if the right balance is found, the employee share scheme can be beneficial to all parties – the employees, the business and ultimately the business owners.
|Plan Type||General attributes and tax issues|
|Shares||– Employees become shareholders, which can maximise alignment and encourage long-term commitment
– Possible shareholder management issues
– Generally more difficult than options to obtain tax deferral
|Options||– A right to acquire shares in the future
– Generally better prospects of deferred taxation than shares
– Employee perception of having no present dividend or voting rights
|– Employee acquires shares at market value, and is protected from the downside risk if the value of the shares falls below the loan balance (i.e. there cannot be any downside to employee)
– Replicate the economic substance of an option (i.e. employees participate on future upside in capital value)
– Provides actual share ownership
– Provides shareholder management issues
– Division 7A issues if loans are provided to existing shareholders
– FBT issues if shares held by associates of employees, as “otherwise deductible rule” does not extend to associates
|Flowering Shares||– Shares initially have minimal rights but subsequently “flower” with more rights
– Potential for deferred taxation
– Valuation should be obtained, which can be complex and costly
– Navigation the anti-avoidance provision can be complex (Direct Value Shifting, Part IVA, Section 45B)
|Indeterminate Rights||– A right to receive an unspecified number of shares or options; or
– A right to receive either shares/options or cash
– If settled in equity, need to go back and amend tax return for year of issue once number of shares/options is known
– If settle in cash, ordinary PAYG provisions apply
|Phantom Shares||– A right to receive a cash payment, calculated by reference to the value of the company shares at some future point in time (i.e. effectively a bonus scheme)
– Simple to administer as no equity is issued
– Marginal tax rates apply on entire amount (i.e. no CGT discount or other concessions available)
– Superannuation obligations generally arise to employer on bonus payments
– Potential large contingent liability for accounting purposes
|Employee Share Trusts||– A trust whose sole activity is to provide ESS interests to employees of a company
– Generally more suited for listed companies as they can set aside a pool of unallocated shares and navigate strict trading windows
– Company may be entitled to tax deduction for contributions made to the trust
– Need to navigate complex deductibility and CGT issues
– Set up and ongoing administration are complex
Practical issues and other considerations
Implementing an employee share scheme is generally a three-way conversation between the company board, the tax advisor and the lawyer:
- Company communicates its ideal commercial parameters (e.g. vesting conditions, exercise/acquisition prices, exercise window, disposal restrictions, good and bad leaver provisions, tag along and drag along rights, right to voting, dividends and capital);
- Tax advisor structures the scheme having regard to commercial and tax considerations, and reviews legal documents; and
- Lawyer prepares the legal documents (usually the Plan Rules, Offer Letter and accession to Shareholders Agreement) and advised on any Corporations Act disclosures and reporting obligations.
The above roles are not fixed or done in a particular order. Rather, this is a fluid conversation between all parties.
Finally, there are various other issues that require consideration before implementing an employee share scheme. A detailed analysis of these issues is outside the scope of this article, but some of these are summarised below:
- Choosing an appropriate valuation methodology (e.g. professional valuation, ATO tabular method, recent capital raise, Black-Scholes models, net tangible assets calculation);
- Annual reporting requirement for the employer (i.e. ESS statement must be provided to employees by 14 July and to the ATO by 14 August);
- Payroll tax reporting requirements (ESS interests are generally considered “taxable wages”);
- Workers compensation reporting requirements (ESS interest may be considered “wages”)
- Accounting for the scheme, especially if preparing General Purpose Financial Statements; and
- Corporation Act reporting and disclosure obligations
Employee share schemes require time and effort to plan and implement, and often tax attributes are a key determinant of the success or failure of the scheme. If set up correctly, an employee share scheme provides a compelling argument for a fast-growing company.
If you require any further information, please contact one of our tax accountants on 1300 QUINNS (1300 784 667) or on +61 2 9223 9166 to arrange an appointment or teleconference. Alternatively, please click here to submit an online enquiry form.