In the absence of a tax concession, the starting point is that if a share or option is issued to an employee at a discount to market value, the discount is assessable to the employee.
ESOPs are not the only way to incentivise staff. There are other ways to reward and incentivise staff (e.g. ‘phantom equity’ / profit share arrangements).
ESOP rules are complex and should not be overlooked when designing and implementing an incentive scheme.
In the current age of disruption, new ideas are giving rise to new businesses which hope to transform the way we do everything in our lives. However, it takes time to get a new idea off the ground and without revenue, attracting and retaining the individuals who can make the idea a reality can be a major challenge.
When money is not available, employee share and option plans (ESOPs) are an invaluable tool to incentivise key staff without draining cashflow and give key staff a real stake in the business going forward.
From a tax perspective, ESOPs raise a number of challenges and opportunities. Here are some things you should know if you are thinking of implementing or participating in an ESOP:
In the absence of a tax concession, the starting point is that if a share or option is issued to an employee at a discount to market value, the discount on that share or option is assessable to the employee in the year of grant (i.e. upfront).
So, for example, if $500 worth of company shares are given to an employee for free (i.e. a 100% discount), $500 will be included in the employee’s assessable income and subject to tax.
This is the starting point. The tax rules contain concessions which might improve this position.
If the ESOP and employee meet certain conditions, the employee can knock off up to $1,000 of the amount included in their assessable income if they are taxed upfront.
This essentially means that the employer can give up to $1,000 worth of shares in the company to an individual for free without any tax consequences for the individual.
It is important to note that this concession is subject to various requirements. One of those requirements is that the ESOP must be ‘non-discriminatory’. That is, the ESOP must be broadly available on the same terms to at least 75% of the company’s permanent employees with at least three years of service.
If upfront taxation is undesirable, or the $1,000 concession is not enough, it may be possible to structure the ESOP in such a way as to qualify for deferred tax treatment. However, there are several conditions which must be met to unlock this concession, one of which is that there must be a real risk that the individual will forfeit or lose their share or option under the terms of the scheme.
Under the deferral concession, the taxation of any discount on the grant of the shares or options is deferred until the earlier of (Deferral Point):
While the deferral concession can be useful for those wanting to postpone their tax bill, there is a trade off. Selecting the deferral concession will mean paying tax at the Deferral Point on the market value of the share or option (less any amount paid by the individual) without access to any CGT concessions (for example, the 50% CGT discount or the small business CGT concessions). In contrast, if the discount on the share or option is taxed upfront, any subsequent growth is taxed as a capital gain and therefore may be eligible for CGT concessions.
Accordingly, in circumstances where the shares are expected to increase significantly in value, upfront taxation may result in a much lower overall tax bill for the individual.
The ESOP tax concessions contain ‘non-discrimination’ requirements, meaning that any shares issued must be broadly available on the same terms to at least 75% of the company’s permanent employees with at least three years of service.
These non-discrimination rules do not apply when options to acquire shares are granted. Accordingly, if a company wants to incentivise certain key employees (but not all employees) but still get the benefit of the tax concessions described above, an option plan will be the way to go.
In addition to the concessions described above, there are more generous concessions available for ‘start ups’. Start ups are those entities which have been incorporated for less than 10 years, are unlisted and have turnover below $50 million.
There are numerous requirements to be met to be eligible for the start up concessions. If those concessions are available:
While they are referred to as ‘employee’ share and option plans, the definition of ‘employee‘ for the purposes of these rules is quite broad. It not only includes traditional employees, but also company directors and independent contractors.
ESOPs are not the only way to incentivise staff. There are other ways to reward and incentivise staff, including:
Each alternative option has its drawbacks, but in an appropriate circumstance an alternative to an ESOP may prove to be a better choice.
As you can tell from the above, the ESOP rules are complex. Expert advice will almost always be required when structuring an ESOP to ensure that they work commercially and from a tax perspective for both the employer and the individual.
This article in no way constitutes legal advice. It is general in nature and is the opinion of the author only. You should seek legal advice tailored to your individual circumstances before acting on anything related to this article.
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