The tax rules that apply to employee share schemes in Australia are extremely complicated. This post explains the basics, and also explains how companies commonly structure employee share schemes in response to them.
A well-structured employee share scheme can deliver a financial incentive to employees that, in net terms, could significantly exceed any amount they could stand to receive under a traditional salary or bonus arrangement.
Whereas salary and cash bonuses will always be taxed at marginal rates, some employee share schemes open the door to substantial discounts on capital gains under the CGT regime.
However one of the main drawbacks of employee share schemes is that they can be incredibly complicated, particularly when it comes to tax. The employee share scheme tax rules are rigid and, in some respects, highly prescriptive.
Some tax concessions will only be available if you structure your scheme in a particular way. For example, some concessions will only be available if the interests issued to employees are ordinary shares, including voting rights. For some companies (not all), this is not an attractive proposition. In addition, some types of concession will only apply to start-ups, as defined in the tax rules. (See more on this below.)
Tax considerations should never be the driving force in the design of an employee share scheme. However you will need to consider them carefully, in the context of your commercial objectives, to maximise the potential incentive you are aiming to provide. We would strongly recommend engaging specialist lawyers and tax advisors to work together in designing any ESOP, to ensure the best outcome is achieved.
Please note that there will be exceptions and qualifications to the general principles set out below and that the tax rules applying to employee share schemes are complex and change regularly. You should always seek specialist tax advice that is specific to your company’s circumstances before implementing an employee share scheme.
Key tax considerations for ESOPs
To ensure your scheme provides the maximum possible incentive for participants, two key tax considerations are:
- How much tax, if any, will participants be required to pay when they join the scheme?
- How much tax will participants be required to pay when they eventually dispose of their shares or options - and specifically, will they be able to access any tax discounts under the CGT rules when they do so?
The problem of upfront tax
If an employee receives an interest (such as a share) under an employee share scheme, they will need to pay tax on any difference between the amount they pay for the interest and its market value.
In the tax rules, the difference between the market value of an employee share scheme interest and the amount paid by the employee for that interest is known as the ‘discount’.
For example, say you issue shares to an employee with a value of $20,000.
If the employee is not required to pay anything for those shares, the discount will be $20,000. Ordinarily, the employee would need to include this $20,000 discount as taxable income in the employee’s tax return to the ATO – and this would be included in the tax return for the year in which the shares are issued.
If the employee is required to pay (say) $15,000 on the shares, the discount would be $5,000, and that is the amount they would need to pay tax on.
The obvious problem with this upfront tax requirement is that, if your company has any value, and if you are proposing to issue shares to employees at a discount, the employee would ordinarily have to pay tax to the ATO when they acquire their interests in the company, without necessarily receiving any additional amount of cash from the company to fund this additional tax liability.
There are a range of different strategies available to companies to avoid this problem, all of which affect the scheme design. Some of the more common structures are set out below.
Non-Recourse Loan Employee Share Scheme
Some companies will offer a ‘non-recourse’ loan to their employees to enable them to pay for shares issued by the company under an employee share scheme.
A non-recourse loan means that the company can have recourse to the employee’s shares to repay the loan, but cannot otherwise take any action against the employee if the loan is not repaid.
A non-recourse loan is usually repaid from dividends declared on the shares and, if the shares are sold, from the proceeds of sale. The main attraction to employees with this type of scheme is the prospect of receiving future dividends and/or a capital return in the event the company is listed or sold.
If an employee leaves the company and there is still an amount payable on the non-recourse loan, the employee’s shares are typically sold or bought back by the company and this will have the effect of discharging the loan. Where the value of the shares is less than the balance of the loan, the company is not entitled to have any further recourse against the employee.
One of the main attractions of this type of scheme is that, because the employee will own (and be taken to have paid for) the shares outright from the moment they are issued, they should be able to access CGT relief on any capital gain they make on the shares when they are sold. They are sometimes used where the employee would not otherwise be able to treat their employee share scheme interest as a capital item from a tax perspective, such as under the start-up concessions (discussed below).
Another advantage of this type of scheme is that any type of share can be issued. For example, if the company would prefer for its employees to not have voting rights, a new class of (non-voting) share could be created and issued to employees purely for the purposes of the scheme.
One limitation on this type of scheme however is that, if the loan is interest-free and otherwise not on arm’s length terms, there are instances where a liability for fringe benefits tax (FBT) can apply. If the company intends to issue different tranches of shares to the same employee over time, there are additional issues that require careful attention (One strategy adopted by companies in respect of this issue is to issue all shares upfront, and to attach vesting rules to the shares at the time of issue.)
Shares under this type of arrangement tend to be issued at their market value, so as to ensure the employee does not receive any discount that might attract a tax liability at the time the shares are issued.
Another way that the problem of upfront tax can be avoided is through the use of options. An option gives the holder the right to buy a share at a specified exercise price.
Under this type of scheme, the exercise price must be at least equal to the market value of the shares at the time the option is issued. Normally (but not always), no or nominal consideration is payable for the option itself.
Options would not normally ‘vest’ (ie become capable of being exercised) until a certain period of time has passed and/or specified performance targets have been achieved. These ‘vesting rules’ are usually designed to discourage key employees from leaving and/or incentivise strong company performance, and vary from company to company to reflect their specific requirements. Read more about vesting periods and rules here.
The main attraction to employees with this type of structure is the prospect of receiving a capital return if the company is sold or listed. Often (but not always), in addition to vesting rules, options are not capable of being exercised until the company is sold or listed. This type of structure allows participants to participate in a sale or listing, effectively as shareholders, but on the basis that they could not become shareholders or have any voting rights before that time.
Where the company is classified as a start-up for the purposes of the tax rules, participants may be eligible for CGT concessions on any capital gain they make on their ESS interests. (Where the company is not classified as a start-up, different rules apply. Read more about how option schemes work here.)
Employee Share Scheme Start-up Concessions
For the purposes of the employee share scheme tax rules, a company will be treated as a start-up where the company:
- is an Australian company,
- is not listed on a stock exchange,
- has been incorporated for less than 10 years,
- has an aggregated turnover of less than $50 million.
Where the company is a member of a corporate group, the ATO will apply the ‘10 year’ and ‘$50 million’ rules at a group level, rather than at an individual company level. For example, if the aggregate turnover of a group of companies is $100 million, or if any of the companies within the group is older than 10 years, none of the individual companies within the group will be eligible for the start-up concessions.
Where the company intends to issue options (rather than shares) under the scheme, to qualify for the start-up concessions:
- the options must be options to acquire ordinary shares (which would mean, among other things, participants would have voting rights if the options are exercised),
- immediately after the grant of the option, the relevant employee must not hold a beneficial interest in more than 10% of the company’s shares (and any options held by the employee will be included for the purposes of this calculation),
- the exercise price of the options must be greater than or equal to the market value of an ordinary share at the time the option is granted, and
- the options, and any shares that are acquired on the exercise of those options, must not be capable of being sold within 3 years of the issue date.
Other conditions may also need to be satisfied to ensure the start-up tax concessions will be available. One of the main benefits of the start-up concessions is that, when the relevant ESOP interests are sold, the ESOP participant may be entitled to substantial discounts on the CGT that would otherwise be applied by the ATO.
Access to the start-up concessions are not limited to schemes that involve the use of options. Start-up concessions can also apply to schemes that involve the issue of shares - however different rules and eligibility criteria apply. Read more about the eligibility criteria for the start-up concession here.
Tax Deferred Schemes
A third way that companies deal with the problem of upfront tax is to implement a ‘tax deferred’ scheme. Under this type of scheme, the employee’s liability to pay tax on the discount they receive at the time of acquiring their shares or options is ‘deferred’ until a later period in time.
To qualify as a tax deferred scheme, the ESOP needs to be structured in a very specific way. Different rules apply depending on:
- whether participants will receive options or shares, and
- if participants will receive shares, whether the shares are acquired under certain salary sacrifice arrangements.
- all of the interests available for acquisition under the scheme relate to ordinary shares,
- immediately after receiving their interests, the relevant employee will not hold a beneficial interest in more than 10% of the company’s shares (and any options held by the employee will be included for the purposes of this calculation),
- the options are subject to either (1) a real risk of forfeiture or (2) restrictions preventing their immediate disposal, and
- the scheme's rules specifically state that it is a tax-deferred scheme.
Under this type of scheme, the tax is deferred until the earliest of the following:
- there is no real risk of forfeiting the option and the scheme no longer genuinely restricts disposal of the option,
- when the employee exercises the option, there is no real risk of forfeiting the underlying share and the scheme no longer genuinely restricts the disposal of the resulting share, and
- 15 years after the employee acquired the option.
Where participants receive shares (rather than options), some of the principles above apply, and there are additional requirements as well.
For example, in order to qualify for deferred tax on any discount given to shares, at least 75% of the permanent employees of the company who have completed at least 3 years of service and who are Australian residents must be, or at some earlier time must have been, entitled to acquire interests under an employee share scheme operated by the company.
Although tax deferred schemes provide an upfront cashflow benefit to participants (by deferring the point in time at which tax is payable on the discount), the downside is that participants will not have access to the more favourable CGT regime until after their options or shares are first assessed for tax. The consequence is that, when a participant ultimately disposes of the interests they acquire under the scheme, they may have to pay a lot more tax than would have been the case had they paid tax on the discount upfront.
As mentioned at the outset, this article is merely a high level summary of some of the broader principles that apply to the taxation of employee share schemes in Australia at the date this article was written. There will be exceptions and qualifications to some of the principles set out above. It is critical that you seek specialist tax advice before implementing any type of employee option or share scheme.
If you are thinking of setting up an ESOP, tax issues are only one piece of the puzzle. If you're not sure where to start, or if you'd like to know more about how an ESOP might work in the context of your company, you can read more about them here.