‘Who’s paying for this?’ – tax considerations for Employee Share and Option Plans
By Rajan Verma, Director, Velocity Legal
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:
#1 – Upfront taxation is the default position
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.
#2 – $1,000 concession
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.
#3 – Deferral concession – but be aware of the trade off
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):
- the real risk of forfeiture passes; or
- the individual ceases their employment with the company; or
- 15 years.
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.
#4 – If you want to offer an ESOP to only some staff, you will need to give them options (not shares)
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.
#5 – There are special rules for ‘start ups’
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:
- the entire discount amount is exempt from tax (i.e. the $1,000 limitation does not apply), provided the discount on the shares in the start up does not exceed 15% of their market value;
- concessional valuation rules may be available which allow the start up company to ignore goodwill and other intangible assets when working out the value of shares in the company. This not only reduces implementation costs for the company (as a formal valuation is not required), but can enable the start up company to offer a more generous ESOP arrangement than possible for other companies. This is because these rules can dramatically impact the ‘market value’ and hence ‘discount’ provided.
#6. The ESOP tax rules do not just apply to traditional employees
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.
#7. There are other ways
ESOPs are not the only way to incentivise staff. There are other ways to reward and incentivise staff, including:
- ‘phantom equity’ or ‘profit sharing ‘arrangements which remunerate staff in a similar manner to a shareholder without actually giving them shares. There are no CGT concession benefits under these arrangements, but they are simple to operate;
- company loans to staff to enable them to purchase shares in the company for their market value. Care must be taken to ensure the loans are not treated as a deemed dividend under Division 7A of the Income Tax Assessment Act 1936 (Cth), is not subject to Fringe Benefits Tax, or raise financial assistance issues under the Corporations Act 2001 (Cth); or
- employee share trust arrangements. These are operated like an ESOP, except the shares and options are held through a trust for the benefit of the staff.
Each alternative option has its drawbacks, but in an appropriate circumstance an alternative to an ESOP may prove to be a better choice.
#8. The ESOP rules are complex
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.
Rajan is all about tax structuring and restructuring. He gets satisfaction from helping his clients obtain real tax benefits, such as CGT concessions or stamp duty exemptions. He has also learnt that saving tax is a great way to make friends. When things get too hard, Rajan is the guy you need to sort things out.