An employee who acquires an interest under an employee share scheme will generally be required to pay tax. However the time at which this tax is payable, and also the way in which the tax is calculated, will depend on how the scheme has been structured.
Some schemes will allow participants to postpone paying tax on their ESS interests until the occurrence of a particular event (for example, the disposal of their shares or options), whereas others can trigger an immediate tax liability for the year in which their interests are acquired.
This article explores how tax deferral works and changes made to the rules in 2022 that were intended to make ESOPs more attractive and accessible.
When are ESS interests usually taxed?
From the outset, it is important to emphasise that the tax treatment of employee share schemes is a complex subject. Tax rules change regularly, and the tax consequences of any scheme will depend on your particular circumstances. This article is intended to provide a basic summary of the position at the time of its publication.
At a high level, there are 3 ways that shares, options or rights ('ESS interests') are treated for tax purposes.
ESS interests can be acquired under a 'taxed-upfront' scheme, a 'tax-deferred scheme' or a start-up concession scheme. If an ESOP qualifies as a tax-deferred scheme, it cannot also qualify for the start-up tax concession.
What is a taxed-upfront scheme?
If a participant in an employee share scheme is issued ESS interests at a discount (i.e. they pay less than market value for them), the default position is that this discount is treated as income for the purposes of the participant's income tax return.
For example, if a participant acquires shares in a scheme for free but the market value of those shares is $10,000, the participant will have received those shares at a discount of $10,000. Unless the scheme is structured as a tax-deferred scheme or falls within the start-up concession, that $10,000 discount will need to be reported as income earned in the financial year in which the shares were acquired. The participant will be required to pay tax on the discount at their marginal tax rate.
This means that the participant may be required to pay tax on its ESS interests before they have realised any financial benefit from the scheme (for example, through dividends or by participating in a liquidity event such as a share sale or listing). In many cases, this can be a major issue.
However a significant benefit of a 'taxed-upfront' scheme is that, once the discount has been taxed, any future growth in the value of the ESS interest will usually fall within the CGT rules - meaning that participants may qualify for a significant discount on any tax payable at the time they dispose of their ESS interests.
Whether a taxed-upfront scheme is appropriate will depend on several factors, including:
- the value of the discount (if any) that is being offered, and the amount of tax the participant will be required to pay,
- the participants' willingness and/or ability to meet an upfront tax liability,
- the future growth prospects of the company and the attractiveness of potential future CGT relief, and
- whether a tax-deferred scheme or the ESS start-up concessions may provide a better overall outcome.
You can read more about employee share schemes, ESOPs and other factors to consider when designing a scheme here.
What is a tax-deferred scheme?
If a taxed-upfront scheme is not a viable solution, to qualify as a 'tax-deferred' scheme, the scheme will need to meet certain criteria, including among other things, that:
- the interests are acquired at a discount,
- the start-up concessions do not apply to the interests,
- the interests are ordinary shares or options or rights that will convert to ordinary shares,
- the employer is an Australian company,
- the participant is employed by the company (or subsidiary) that issued the interests, and
- the company's predominant business is not a share trading or investment company.
There may be additional eligibility criteria, depending on whether the ESS interests are shares or options (or rights). For example, if options are issued, a participant will only be able to defer paying tax on any discount on their options if:
- the options relate to ordinary shares,
- immediately after receiving the options, the participant will not hold a beneficial interest in more than 10% of the company's shares (any options held by the employee will be included for the purposes of this calculation),
- the broad availability condition is satisfied, being that the scheme is available to at least 75% of Australian resident permanent employees who have completed at least 3 years of service (continuous or not),
- there is a real risk that, under the conditions of the scheme, the participant will forfeit the right, lose it other than by disposing of it, exercising it, or letting it lapse (i.e. the 'real risk of forfeiture' test),
- the scheme genuinely restricts the participant from immediately disposing of the option, and
- the scheme expressly states that it's a tax-deferred scheme.
When is tax payable under a tax-deferred scheme?
Under a tax-deferred scheme, participants will be able to defer their tax liability until the earliest of the following:
- for shares, when there is no risk of forfeiture and no restrictions on disposal of the shares;
- for options and other rights, when the employee exercises the option or right and there is no risk of forfeiting the resulting share and no restrictions on its disposal; or
- 15 years after the employee acquired the ESS interest.
Prior to 1 July 2022, the cessation of employment was also a taxing point, and this was the case regardless of the reason for the departure (e.g. resignation, redundancy, termination etc).
This meant that, prior to 1 July 2022, if an employee left the company, they could face a significant tax liability even if they had no way of disposing of their ESS interests at the time of their departure. This could have left them with a large tax bill despite them not having been able to monetise their interests in the scheme.
Tax treatment of tax-deferred schemes
One drawback of a tax-deferred scheme is that, although participants may be able to defer paying tax, the total amount of tax that they ultimately have to pay may be higher than under a taxed-upfront scheme or under the start-up concessions.
This is because deferring the taxing point on the ESS interests will also have the effect of deferring the period in respect of which any CGT relief might otherwise be available. Consequently, when a participant sells their shares under a tax-deferred scheme, their tax bill following the disposal of their interests could be higher than would have been the case had they been taxed upfront or if the start-up concessions had applied.
Impact of the 2022 changes
As a result of the changes to the rules in 2022, the current position on tax-deferred schemes is intended to align Australia's ESS rules more closely with other international jurisdictions.
The intention is to remove the potential burden on participants at the cessation of employment, making employee share schemes more attractive and accessible. The current rules apply to all ESS interests (including existing ESS interests) that are subject to deferred taxation so long as the cessation of employment occurs on or after 1 July 2022.
Companies are no longer required to report to the ATO when an employee ceases employment on or after 1 July 2022.