This is the second article in a three-part series explaining a number of key aspects of the Australian employee share scheme (ESS) tax rules:
- The first article discusses how you qualify to defer any tax otherwise payable on shares and options you acquire under an ESS, and when that deferral comes to an end;
- This article explains how you work out the ‘discount’ (if any) that arises when you acquire an interest under an ESS, in other words, how much tax you may be up for; and
- Our final article explains how to access and the benefits that arise under the ‘start-up concession‘.
In very basic terms, you only have a tax issue to deal with under an ’employee share scheme’ (an ESS) if there is a ‘discount’ at the time you grant the ESS interest to your employees.
Working out if there is a discount, and what the extent of the discount is, are therefore two critical threshold questions.
To kick things off – there is a ‘discount’ if the amount paid by the employee to acquire the ESS interest is less than the market value of the ESS interest at that time. So this requires us to identify two things:
- The amount paid (or payable) by the employee to acquire the ESS interest; and
- The market value of the ESS interest at the time it is granted.
This may seem like a simple and obvious concept. But the devil is in the detail.
Dealing with options
If the ESS interest is a ‘right to acquire a share’ (i.e. an ‘option’), the amount paid by the employee to acquire the option (i.e. the ‘option price‘) is not the same thing as the amount the employee may be required to pay in the future to convert the option into a share. The amount that needs to be paid when the option is converted into a share is called the ‘exercise price‘.
For example, an employee may be required to pay 20c to acquire an option, and then also be required to pay a further $1.00 when the employee later exercises the option to acquire the underlying converted share. The 20c is the ‘option price’. The $1.00 is the ‘exercise price’.
When you give an employee an option, the option itself has a market value at that time. Even if the price the employee needs to pay at a later time to exercise the option (i.e. the ‘exercise price’) is equal to the market value of the underlying share (i.e. the exercise price is not itself discounted), the option itself may still have a market value when it is created. This is because an option has a ‘time value’, i.e. it has value merely because it gives the employee the right to acquire a share in the future, for a price that is calculated today.
For example, let’s say you give an employee an option to acquire an ordinary share at an exercise price of $1.00, and at the time you grant the option the market value of ordinary shares in your company is also $1.00. You may think that there is no ‘discount’, because the exercise price ($1.00) is equal to the market value of the share ($1.00). However, the option itself has additional value because the employee does not have to pay the exercise price today – they can wait to see if the market value of the underlying shares goes up, and then still pay $1.00. This means that the option itself may have a value of say 20c when it is created. The market value of options is influenced by a number of things, most importantly, the length of time over which the option can be exercised into the future, and any conditions limiting the ability to exercise the option.
So how is this relevant? If the market value of the option at the time it is granted (e.g. 20c) is higher than the option price that the employee is required to pay for the option when it is granted (i.e. nil), then the option will be granted as a ‘discount‘ (i.e. 20c). It is this discount that gets captured by the ESS provisions, i.e. subject to being able to take advantage of deferred tax, the employee will have a tax bill day one.
Most schemes that involve options do not require the employee to pay an option price, i.e. no upfront payment is required, (although some schemes in more established companies do require some payment upfront). If nothing is paid to acquire the option, then the ‘discount’ at the time of grant will be equal to the full market value of the option (i.e. 20c in the above example).
Dealing with shares
If the ESS interest is a share, then the market value of the ESS interest will be the market value of the share – because there is no ‘time value’ when the employee acquires a share. A share is a share. You either own it or you don’t.
The discount will therefore be equal to the difference between the amount the employee must pay to acquire the share under the ESS, and the market value of the share at that time. For example, if the ESS allows an employee to acquire a share for 70c, and the market value of the share at that time is $1.00, then the ‘discount’ will be 30c.
What is market value?
The problem with valuing an ESS interest (either an option or a share) is that many companies taking advantage of these provisions are ‘unlisted’, and therefore working out the market value of an option or a share can be very tricky. In many cases there simply is not a ‘market’ for the shares.
Once again, determining market value of options is more involved than determining the market value of shares, because an option has a ‘time value’ over and above the fundamental value of the underlying shares. Because valuing options is so difficult, the Regulations to the Tax Law provide some methods for determining the market value of an option. The bad news is that these methods are not very favourable. This is because they impute the ‘time value’ of an option, but they do not take into account the very real risks to the employee that the options may never vest, or may be forfeited.
If the company is unlisted then you can elect to use one of two methods to value an option:
- Engaging a qualified person to determine ‘true market value‘; or
- Applying the statutory method that is a rough guide to market value.
Adopting true market value
The first method is simply to determine the ‘market value’ of the option. This means that you can employ a professional to undertake an analysis of the market value of the options being granted. While this sounds straight-forward, the valuer will need to analyse the financial performance and potential of the company, take into account the time-value of the options, and then adjust for various marketing and company risks. This can be an expensive process.
The Tax Law provides that when performing this calculation the valuer must ignore any terms of the options that prevent you from converting the option into money. We interpret this to mean that the valuer must assume that the restriction on selling the option does not apply, and that there is in fact a ‘fictional’ market into which you could sell the option. These are both very ‘artificial’ assumptions. The truth is that the real ‘market value’ of your options is most likely nil without this assumption – and quite frankly, that is how the tax law should apply to them! (But let’s not get political…)
Even if we assume that the option can be sold to a third party, this does not mean that the option will have a material value. For many small, unlisted and speculative companies, the true market value of the option (even taking into account this assumption) is likely to be negligible. The Tax Office recognises that the valuer must:
“... take into account the value of tangible and intangible assets of the company, the present value of anticipated future cash flows, the market value of similar businesses, including the use of earnings multiples, and any uplifts for control premiums, and discounts for lack of marketability and key person risk.”
In short, for those companies that are prepared to spend some money with a qualified valuer, the chances are that the value of the options will be determined to be very small.
Adopting the statutory method
The alternative to adopting true market value is to apply the statutory valuation method set out in the Regulations to the Tax Act.
First you divide the market value of the share into which the option can be converted, by the exercise price for the option. For example, if a share in the company is currently valued at $1.00, and the exercise price is $1.10, then the result will be 0.909. You then multiply that number by 100, to arrive at a ‘calculation percentage‘, in this case 90.9%.
If the calculation percentage is less than 50%, then the option has no value. This would require the exercise price to be twice the value of the underlying share, i.e. an exercise price of $2,00 with an underlying share value of $1.00. In other words, the value of the company would need to double before you would get any benefit from being issued the option!
If the calculation percentage is more than 50%, then you need to refer to a couple of tables in the Regulations to work out the value of the option.
If the calculation percentage is between 50% and 110%, then you use Table 1:
You select how many months the option lasts for on the left hand axis, and then the calculation percentage across the top axis. The percentage in the table is then multiplied by the lowest possible exercise price for the option, to arrive at the ‘value of the option’ at the time of grant.
If the calculation percentage is higher than 110%, then you need to look to Table 2 in the Regs:
You select how many months the option lasts for on the left hand axis, and then select the corresponding ‘base percentage’. So if the option lasts for 120 months (i.e. 10 years), the base percentage would be 13.3%.
You then subtract 110% from the calculation percentage. So if the calculation percentage is 120%, this would leave 10% (120% – 110%). You then multiply the result by 100. In this example, that would result in 10. You then multiply this by the value by the percentage in column 2 of Table 2. In this example that would result in 6 (i.e. 10 multiple by 0.6).
The value of the option is then worked out as the base percentage (i.e. 13.3%) plus the excess percentage (i.e. 6%), (i.e. 19.3%), multiplied by the exercise price.
The fundamental flaw in the values adopted in these tables is that they do not take into account the fact that the option may not be able to be exercised for a significant period of time, i.e. the ‘exercise window’ may be very small. In fact, the option may never actually ‘vest’ and allow you to convert the option into a share!
But perhaps a more fundamental issue is the fact that this method relies on knowing the market value of the underlying shares into which the options convert. In cases where the company has recently raised capital, or there has been another meaningful transaction in ordinary shares, then working out this value will be relatively straight-forward. However, in other cases it will be very difficult (and expensive) for anyone to work out this value. Furthermore, in many start-ups investors invest in preferential share classes, which bear little (if any) resemblance to the value of ordinary shares. So even a recent capital raising may not provide any meaningful insight into the value of ordinary shares.