Employee Share Schemes: Pros, Cons and Tax Implications

Employee Share Schemes can be a powerful tool for aligning incentives and supporting growth. They can also create tax exposure and governance complexity if not structured correctly.

In this episode of Explain That by Velocity Legal, Andrew Henshaw is joined by Edward Hart and Archana Manapakkam to examine the commercial and tax realities of Employee Share Schemes.

This article summarises the key commercial and tax considerations discussed in the episode. The central message is clear: Employee Share Schemes are not plug and play.

Why Businesses Use Employee Share Schemes

• Alignment of Interests

Employee Share Schemes can align staff with the long-term performance of the company. When employees become shareholders, their incentives shift toward enterprise value rather than short-term remuneration.
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• ‍Cash Flow Preservation for Growth Businesses

For startups and growth-stage companies, equity can reduce immediate cash outflow compared to bonuses or profit share arrangements.
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• ‍Retention Through Vesting

Vesting conditions, service-based hurdles and performance milestones can promote retention. Time-based vesting is commonly used to encourage employees to remain with the business.
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How Employee Share Schemes Are Taxed in Australia

Employee Share Schemes are governed by Division 83A of the Income Tax Assessment Act 1997.
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• ‍Default Position: Upfront Taxation

If shares or options are issued at a discount, that discount is generally taxed upfront as income in the hands of the employee
This can create a tax liability without a corresponding cash benefit.
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• ‍Deferred Taxation and the Real Risk of Forfeiture

Deferred taxation may apply where specific conditions are satisfied, including the existence of a genuine real risk of forfeiture. This requires a meaningful risk that the employee may lose the equity, typically linked to performance or service conditions.

• ‍The Startup Concession

The start up concession is often viewed as the preferred outcome.

Where eligible:

·      The company and relevant group entities must meet strict conditions, including incorporation within the last 10 years

·      Market value requirements must be satisfied

·      Valuation may rely on net tangible assets rather than goodwill

If the startup concession applies, the discount is not taxed upfront under the ESS rules. Tax is instead dealt with on disposal under the CGT regime, with the potential availability of the CGT discount

‍Commercial and Governance Risks in Employee Share Schemes

Tax is only one side of the equation.
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• ‍Dilution of Existing Shareholders

Issuing new shares under an Employee Share Scheme dilutes existing shareholdings

• ‍Voting Rights and Minority Protections

If documentation is not carefully drafted, employees may acquire voting rights and minority protections. Share classes without voting rights are often used to manage this risk

• ‍Shareholder Agreement Alignment

Employee Share Schemes must align with the constitution and shareholder agreement.

Key considerations discussed include:

·      Drag along rights

·      Good leaver and bad leaver provisions

·      Decision-making thresholds

·      Restraints of trade

Even very small shareholdings carry legal rights

Loan-Funded Employee Share Schemes

Some Employee Share Schemes are loan-funded.

This raises additional considerations, including:

·      Division 7A risk

·      Potential Fringe Benefits Tax exposure

·      Shareholder approval requirements

·      Proper loan documentation

Misalignment between tax structuring and corporate documentation can undermine the intended outcome.

Strategic Questions Before Implementing an Employee Share Scheme

Before issuing equity, businesses should consider:

·      Are we willing to issue voting equity?

·      Do we qualify for the startup concession?

·      When was the company incorporated?

·      How will dilution affect control?

·      Are our constitution and shareholder agreement aligned?

·      Should restructuring occur before implementation?

The answers to these questions inform the appropriate Employee Share Scheme structure

The Takeaway

Employee Share Schemes can:

·      Align incentives

·      Support retention

·      Preserve cash in growth businesses

They can also:

·      Trigger upfront tax

·      Dilute control

·      Create governance complexity

The appropriate structure depends on the company’s stage of growth, tax eligibility and ownership objectives.

Employee equity should be engineered deliberately, with coordinated commercial and tax advice, rather than implemented as a standard incentive template
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🎧Listen to the full podcast episode to hear the detailed discussion on the commercial and tax considerations of Employee Share Schemes.

For tailored advice on structuring and implementing an Employee Share Scheme, contact our Commercial and Tax teams.