Employee Share Schemes: Pros, Cons and Tax Implications

0:00
You're listening to Explain That by Velocity Legal, the podcast that keeps business owners and professional advisers ahead of the curve in an ever-changing legal landscape.

Incentivising employees through equity can be powerful, but it's certainly not plug and play.

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Getting equity right requires more than good intentions. It requires a full understanding of the benefits, structural options and the obligations that sit behind them.

This episode cuts through the hype and discusses the commercial and tax law issues involved with incentivising employees with equity. To do so, I'm joined by two guests.

0:37
Firstly, Edward Hart, Senior Associate in Velocity Legal's Commercial Law team. Welcome to the show.

Thanks, Andrew.

And Archana Manapakkam, Special Counsel in Velocity Legal's Tax team. Welcome, Archana.

Thanks, pleasure to be here.

Welcome, guys. I'm really looking forward to unpacking this discussion about employee equity.

0:56
It's such a big topic and something that you can't really do justice to in one single episode.

So hopefully today we'll get a bit of an overview about some of the considerations and the type of things that you ask clients.

But I wanted to start firstly with you, Ed, just talking about why would you issue equity to, you're a business owner, you've got full control and you come to someone like you and say, hey, I want to incentivise some staff and issue equity.

1:24
What's the pros and cons of that? What would you say?

So the first part that comes to mind is really aligning the values of the company and staff. I mean, I think it's much more powerful for an employee to be also a shareholder. That can really align all the values and motivate them as you move along.

1:43
The other reason why I think it's powerful, particularly for startup businesses, is it's not cash heavy in the start.

And as we know, startup businesses obviously don't have massive reserves of cash to give giant bonuses and profit shares.

So it's a pretty easy way to motivate staff without having to front up massive amounts of cash.

2:04
People don't actually often think about some of the cons.

If your governing documents aren't drafted properly, you can be giving away too many rights to employees who then become minority shareholders.

So things like voting rights. You can also dilute shareholdings by having too many shareholders because you're actually generally with an employee share scheme, which we'll touch on shortly, you're issuing shares, essentially creating new shares, and that will naturally dilute the shareholding of other shareholders.

2:37
On the rights of employees when they become shareholders, with properly drafted documents that can be worked around.

So we often issue share classes that don't have voting rights, for example.

So these shareholders are entitled to dividends of the company, but they don't really take part in the management, which is generally what we want in an employee share scheme.

2:59
So there's definitely lots of pros and lots of cons.

Yeah.

Now, Archana, are they sort of similar considerations you would have? Someone's coming to you and saying, hey, I'm thinking about potentially some sort of equity with staff. Pros and cons, pros being, I guess, that ownership mentality and perhaps incentivising, and then cons being really complexity and do you really want this?

3:25
Yes, I think so.

I think Ed summarized some of the key commercial considerations.

In terms of another point would be incentivising, but also staff retention.

So there are certain, if we issue, and we'll come to this probably later.

3:46
If you issue equity under some special rules about employee share schemes in the tax legislation, often there needs to be a minimum holding period.

So usually you'd have a retention, try to have a retention for three years, or that would promote retention for three years.

4:05
In terms of pros, if you are issuing, if you're giving a bonus scheme, if you're offering a bonus, for example, that's very cash heavy, as Ed was saying, but also it's fully taxable as essentially salary and wages.

4:27
But if you use some form of equity scheme, for example, it can be very tax advantageous.

And it takes it from just, you know, salary and wages to potentially business owner amounts of some variety.

4:45
Yeah. But there are cons, as Ed was saying. Documentation is, you need to, it's a lot more document heavy when you're issuing equity rather than putting a bonus scheme in place.

It's more complex than having a bonus scheme.

5:03
And obviously you're giving them entitlements beyond just entitlements as an employee.

So you're potentially giving voting rights, dividend rights, diluting your shareholdings.

5:20
So there are some considerations, these considerations that you need to take into account when you're considering how to go about what sort of employee incentive scheme you offer.

So I'll jump on to the next area.

So this concept of employee equity, we've said, okay, all right, I hear you. We could do a bonus, but let's say no, I want to go down this employee equity path.

5:39
And we've already hinted at some of the options available there.

Let's start with perhaps what's most commonly referred to, I guess, in the market, which is an employee share scheme or ESS.

6:00
Edward, do you want to start with what is an ESS? What are we actually talking about?

Sure. So it's essentially a scheme under which employees are issued shares in the company.

It's a broad catch-all term that actually includes employee share option plans as well under the Corporations Act.

6:18
So that's essentially when employees are issued options or a future right to obtain shares in the company.

And that'll have vesting conditions attached.

Archana spoke about retention and motivation. Vesting conditions are a good way of doing that. They can be time-based or performance-based.

6:36
Yeah, essentially it's just a scheme where employees can obtain shares in a company.

And they issue the shares or they're transferred shares by existing shareholders, but.

Typically you're issued, yeah, because you'd have, we'll come to this probably a little bit later, but sometimes employees, business owners are more about cashing out and passing a business on rather than incentivising someone.

7:03
And really I think the point is saying with the ESS is that this is really about issuing shares, not cashing out as a business owner.

99% of the time, that's what we'd say.

Yep, yep.

Well, Archana, I know a lot of this is driven by tax in terms of how you have to construct to fall into the right rules.

7:24
I want to start by asking you what's the default tax position?

All right, I'm an employee. I'm getting given something. How does the tax system treat that?

So if an employee is being issued with equity, so either shares or options at a discount, then there's a question about how that discount is taxed.

7:47
So in terms of the rules, those are specified in Division 83A of the income tax legislation, that is the 97 Act.

And under those rules, the default position is that the discount, so whatever they have to pay versus the market value, the discount of that is taxed upfront in the hands of the employee.

8:11
So basically like salary and wages?

Yeah.

So if I've got a company, $1,000,000, I decide to issue employee 10%, presumably worth 100 grand. They pay nothing for it.

What he's saying is the upfront position is that it's like them getting $100,000 of salary, only in terms of what they're paying tax only, they don't have any cash.

8:33
Pretty much, yeah. So they're taxed on that upfront.

Yeah.

So that's the default position. It's quite undesirable for obvious reasons.

Yeah, it's really an unfunded liability at that point.

Well, if you're trying to incentivise your employees, they have to pay tax upfront on something that they haven't received anything really in terms of cash.

8:53
Yeah, that's not really a great way to incentivise.

No. So that's the default position, but it's possible to actually, depending on the circumstances, for that discount to either be taxed at a later point in time, which is called a deferred taxing point under the deferred taxation rules in the ESS rules.

9:17
Or it's possible that that discount is not taxed as income at all under the ESS rules, but falls within what's called the startup concession regime.

It's actually taxed under the CGT rules when whatever the equity is, is disposed of.

9:40
So default position, not great. Two other options, one defer, one potentially sort of eliminate or even possibly better.

So I can imagine, Ed, would you say that all the ESSs you've been involved in, it sounds like not many of them would want to be taxed upfront?

10:03
No, of course not. Yeah.

And Archana summarized it beautifully.

Yeah, yeah, yeah.

So I want to drill in, Archana, on the key requirement to get that deferred treatment, which I understand is about essentially locking up the equity. Is that right?

10:21
Yeah. So there are a number of conditions that need to be satisfied in order to access deferred taxation.

And one of the key requirements is what's called a real risk of forfeiture.

10:37
So there are two key requirements.

There is also a three-year restriction on disposal as well, but the key requirement is a real risk of forfeiture, which is that, say the employees, they should be shares or options, they must be subject to certain exceptions, generally a real risk that they could lose that equity other than by way of disposing of that equity or, in the case of options, exercising those options or letting them lapse.

11:08
So that's the key requirement.

And what does that mean?

That was my next question, so.

You pre-empted it.

Jumping ahead, what is a real risk of forfeiture?

So it means that there's a real risk that the employee could lose what's being granted to them.

11:24
And that could be, for example, that whatever they're issued with is subject to meeting certain performance hurdles.

So you can retain these if you receive this sort of rating in your review. It could be that it's also subject to, say, project milestones.

11:49
So if we get X amount of funding or if we win this project, something like that.

So those are some examples of real risk of forfeiture.

Yeah, yeah. It can't be a given.

12:04
It can't be that you're definitely going to get this. There needs to be at least some risk that it won't materialise.

And it has to be a real risk, so not something hypothetical or something so far fetched that it can't really be considered a genuine risk.

A real risk.

I think the most common ones I've seen in practice at least is sort of a service-based one, as in, you know, you've got to stay this amount of time, and then other ones that are some sort of profit type metric. Is that your experience as well?

12:32
Yeah, yeah. It's generally time-based or service-based.

Yeah. Yep, yep, yep.

Okay. So we've got upfront taxation, we've got deferred where we need that real risk of forfeiture, and that third category, Archana, of what we call startup concessions.

12:49
And they're really, I mean, what's your view on this? My understanding is if you can get them, that's really the way to go because it's going to be the best treatment.

That's the holy grail, really. That's what you want.

So there are 11 conditions, I believe, that need to be satisfied to be able to access the startup concessions.

13:13
It needs to be a startup, that's one of the conditions.

So it needs to be that the company that's issuing the equity, and I believe all of the other subsidiaries and holding companies, associated companies, they need to have been incorporated within the last 10 years.

13:32
So that's one of the key conditions.

Now, if you can access that, then basically, if you can access that, you can issue your equity at a substantially reduced market value, basically at a substantially lower value than what the market is, and potentially still access the startup concessions.

14:00
So not have that discount taxed.

Yeah. And we probably haven't made the point, but when we're going back to working out actually what you said about that discount, it's not a discount on what's on the balance sheet.

Normally, it's a discount on what someone would pay for that equity based on normal valuation principles and goodwill and all that sort of stuff.

14:21
But the difference with those startup rules is that you can essentially use potentially like just a balance sheet rather than all that goodwill and things like that.

Yeah, there is this condition which is called the market value condition.

So a lot of conditions, a lot of jargon there.

14:39
So if you basically meet all the other conditions, including that condition that it's a startup, so incorporated within the last 10 years, the market value has to, in the case of shares, the shares have to be issued for their market value.

15:01
So that's employee share schemes.

In the case of employee share options, the exercise price of the option needs to be its market value as of the date that the option was issued.

Okay.

So the options could potentially be issued for nothing, but it's the exercise price that's important in calculating that exercise price.

15:23
If you fall within the startup concessions, there are two ATO-approved safe harbour methods for calculating market value, and they're really concessional.

15:41
So you can use the balance sheet, and it's based on the net tangible assets of the company only.

So for startups, most of the value is derived usually from intangible assets.

So IP, goodwill, those sort of things, you take those out and you calculate it, and what are the actual physical assets? That might be very much.

16:05
So the market value might be a very, very low figure, which means that if the equity issued is issued for that very low market value, then they might be getting a benefit of, like in your example from earlier, $100,000, but they might be paying $10.

16:27
Yeah, yeah. That's a pretty good deal.

That's a pretty good deal.

That's a really good deal.

And then what happens when you access that is that the entire big discount doesn't get taxed either upfront or deferred.

16:42
It actually gets taxed when you ultimately sell the equity, in which case you could potentially get a 50% CGT discount.

Yeah, very tax heavy. I know you guys love tax.

I might have a few follow-up questions.

Well, you can't, I mean, you just can't do employee equity without an understanding of tax. I mean, that's the reality.

17:00
That leads into a question I was going to ask Edward about, the documentation, because sometimes I've seen the documentation done incorrectly from a tax perspective, which then just neuters your whole thing and just doesn't achieve what you want to.

17:18
But the question was what the documentation was looking at. What's the Corporations Act regulatory position on these ESSs?

Yeah. So the core document is the plan rules. That's really the contract between the employees and the company.

And whatever concessions we're looking to access from a tax perspective, that will actually inform our drafting of the documents.

17:39
So we have to really draft that pretty carefully to make sure they can access them.

Outside of that, there'll be a participation letter that goes to each individual employee and sets out their specific offer and any vesting conditions and the exercise price.

17:58
So it can be document heavy.

The Corporations Act does allow some sort of regulatory relief from things like disclosure requirements, whitewashing requirements. So that provides some relief.

But I mean, that one document can apply to 100 employees.

18:16
So it's not too onerous on a company to have it prepared, but of course it's more onerous than just paying a bonus.

100%. Yeah, yeah.

We'll come to co-ownership in a little bit because I want to get into that a little bit later, but I want to move from these employee share schemes just to talk about perhaps some different things.

18:33
Maybe we're not talking about an issue, but maybe just some of the other alternatives that are available.

What are the other options that a business owner might be thinking about?

I guess started off, a straight sale, I guess, is possibly one, Archana. What's the tax position going to be on a straight sale?

18:51
Well, I mean, the owner, whoever is selling those shares, would be taxed on any gain, and it'd be based on the market value of whatever they're selling.

So unless it's a gift, it's probably not considered to be an arm's length dealing if they're going to be selling it for nothing or substantially reduced value.

19:19
So yeah, it could trigger a capital gain potentially.

And on top of that, potentially stuff for the employee as well, because they're not paying again, I think technically.

Yeah, it is actually.

Yeah, it could still be salary and wages for the employee as well.

19:41
Yeah, it could potentially fall within the ESS rules if there's some discount there.

So the ESS rules in the tax legislation don't just apply to the issue. It's acquisition broadly.

So the acquisition can be by way of a transfer of shares as well.

So let's say with that knowledge in the bank, we say, okay, that's off the table.

20:00
We're not going to issue. We're not going to transfer equity for nothing.

Perhaps what we'll do is the employee doesn't have the money upfront, but they're going to pay for it later on through a sort of vendor-funded arrangement.

20:18
How common is that, and what sort of considerations are there?

So it is quite common to have a loan-funded employee share scheme, for example.

You just need to be mindful of how you, it needs, if it falls within the employee share scheme rules, which are quite technical.

20:41
So it needs to be in respect of ordinary shares, for example.

You need to be mindful of Division 7A.

So if they're an existing shareholder and, say, the company is providing a loan, it could potentially be treated as a dividend in the hands of the borrower.

21:06
If they are, so you have to do it only once, basically before they even become a shareholder.

You also should be cognisant of potential FBT liability.

Now if it's issued in circumstances where the equity falls within the employee share scheme rules in the tax legislation, usually it wouldn't attract FBT.

21:28
But if it doesn't fall within the employee share scheme rules, there could be an FBT liability depending on whether it's issued to the person individually or their family trust.

And just another thing to be aware of on that one is you do need to make sure you've got shareholder approval in the form of a resolution just to avoid whitewashing procedures, which I won't go into now because they're pretty heavy, but they can be quite onerous.

21:53
So you've got to make sure you get shareholder approval anytime you're giving a loan to acquire shares.

And I suppose obviously a loan agreement that deals with defaults and what's the security and all that sort of.

Standard loan terms. But yeah, we'd always recommend a proper agreement rather than a sheet of paper.

22:10
Yep, yeah, yeah.

And before they get the offer, get the equity as well.

Yeah.

Well, I want to come to those co-ownership type arrangements.

So everything we've talked about so far has got some sort of rights for the employee.

22:32
I'll start with a very obvious question, but how important is that co-ownership agreement in those situations?

Yeah, absolutely crucial.

Anytime you've got a co-ownership arrangement, that is the governing document, and it sets out all the rights and obligations of all shareholders, including very, very small shareholders, which often pops up in these sort of situations where employees are given really small shareholdings.

22:57
I think sometimes people don't turn their minds to that fact.

As we've said before, if someone has 0.01% of a company, they still do have rights.

Rights, dividends and rights are.

Dividends, which is what we want. That's kind of the whole point of it.

23:13
But you don't want them having control and you don't want them to actually be able to stop a sale in the future, particularly for these companies that are trying to boost themselves up for a sale.

So often shareholders agreements will have a drag along clause in there, which essentially means the majority shareholder can drag along the minority shareholders and force them to sell where there's a potential buyer.

23:34
So that's definitely something that needs to be in every co-ownership agreement before implementing something like this.

And what are the main or other points from a co-ownership agreement perspective that you'd be looking at specifically in this context of employees and equity?

23:49
Yeah. So bad leaver, good leaver provisions in a shareholders agreement, we would be looking to insert that in the shareholders agreement and the plan document, and just making sure that's aligned.

So essentially that contemplates what happens when an employee leaves a business, under what circumstances.

24:05
So good leavers are generally people that have received a redundancy or they've unfortunately passed away.

Bad leavers are people that may have unfortunately employment terminated.

So in that instance where they're a bad leaver, often they'd be forced to sell any vested options or shares.

24:23
And when they're a good leaver, they're often allowed to keep it.

But it's obviously a case-by-case basis and just making sure that those two documents align.

And then other things, maybe your decision-making thresholds, restraints of trade.

Yeah. So restraints of trade is an interesting one actually, because I know there is an exemption coming in for employees of course.

Yes, employees under $175,000 salary, but courts are much more likely to enforce restraints of trade in a shareholders agreement.

24:50
Because they're an owner.

Because they're a shareholder rather than an employee.

So in that context, that can be beneficial to businesses. They can restrain employees who they wouldn't otherwise have been able to.

So that's an interesting little wrinkle.

When we're thinking about these, we've talked about a number of different options and I appreciate they're complex.

25:08
There's complex tax considerations, there's complex commercial considerations.

That might seem overwhelming for a private business owner thinking, okay, what do I do? It's all too hard.

Where do they even start? What are the questions? What are the things that they need to think about?

25:24
I'll ask both of you this question, but I'll start with you, Edward.

Yeah. I mean, my first port of call if I was a business owner would be making sure my governing documents are all in order.

So my shareholders agreement and constitution, as we've mentioned a few times throughout this podcast, they kind of inform a lot of the drafting around these things.

25:44
And if they're not aligned with the way they want to actually set up the scheme, then it's going to be a big issue.

Really thinking about what is available to the business, what stage of growth are they at?

For growth businesses, it's probably better to actually provide equity.

26:00
It's so much better from a cash perspective. Whereas businesses that are a bit further along, they can probably think about maybe simplifying things and just simply giving a bonus.

So it really depends on where they're at.

Where they're at, that stage.

Yeah.

What about from your perspective, Archana? What sort of consideration, where does someone start? What do they consider?

26:18
Well, firstly, are they willing to give equity, full equity, ordinary shares, voting rights and all of that?

If they're not, then we need to think of some other models.

When were they incorporated? What's in the business?

26:35
So take a look at the financials. Those are some of the key things, just to get the lay of the land, what they're trying to achieve.

And then we'd probably then look at potential options.

Maybe they need to get a valuation done, but that's when you actually come up with a strategy.

26:54
Then you'd need to go about implementing it, and that would often involve getting a valuation as one of the first steps.

And some businesses aren't even in companies as well. I mean, you might have a business in a unit trust or sole trader or a discretionary trust.

Or.

You might need to think about restructuring as well to even get into a corporate.

27:12
That's right.

As well, yeah.

And then having those discussions, I guess, with the selected people who are, this is going to.

Yeah, because there would be a number of different discussions that would go on, on a practical level between the business owner and the potential employees who are coming in as equity.

27:34
And once you, if, for example, the company was incorporated less than 10 years ago and they're willing to give full equity, and you look at the balance sheet.

Well, you first have to find out what the existing shareholdings are as well.

Then you look at the balance sheet and you think, well, if we're going to be able to access the startup concessions, it will be based on the net tangible asset value only.

27:58
So maybe you get as many tangible, if there's a way of transferring tangible assets out first without incurring tax on that.

You do these pre-issue transactions to optimise the benefit that you're providing.

28:21
Yeah, yeah, restructuring in advance.

Yeah.

Another thing to consider is whether you need to issue a dividend prior to implementing one of these schemes.

Absolutely. I mean, if there's lots of money sitting in the company, or any really, once shareholders come in, they can most likely access that by dividends themselves.

28:39
So that's definitely something to consider.

Absolutely.

And I think one of the takeaways for me from that is that we've sort of talked about this broad topic of equity and employees, and there's a number of different models.

Are we issuing? Are we transferring?

We're talking about ordinary, we're talking about something different.

28:57
Are we talking about a growth business? Are we talking about a mature business?

And what I've learned is that the answers to those questions will probably inform you, at least to some extent, on what you're going to do going forward or what the things are to consider.

It's certainly a complicated area.

29:14
There's a massive overlap of tax and commercial, and it's important to get both right.

It can feel scary and a little bit complicated, but I think if you're seriously considering this, speak to an adviser who specialises in employees and equity.

29:33
And I know two great ones right in front of me.

So I'd really recommend that you reach out to either Edward or Archana.

Thanks once again for being part of the episode.

Thanks, Andrew.

Thanks, Andrew.