This is the first article in a three-part series explaining a number of key aspects of the Australian employee share scheme (ESS) tax rules:
- This 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;
- Our second 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’.
It is common for the owner of a high-growth enterprise to want to involve key stakeholders, such as employees, in the ownership of their enterprise. They do this to better align the interests of their employees with those of the wider enterprise. In this manner, the founders, investors and key employees all have a common interest in growing the medium to longer term value of the enterprise. For many enterprises it is simply not possible to attract and retain the necessary scarce talent without offering them equity.
Such equity is usually granted under an ‘employee share scheme‘ (or ESS). The equity can either take the form of ‘options’ to acquire shares, or shares themselves.
The problem in Australia is that, as a general rule, you as the employee will be taxed on any ‘discount‘ you receive at the time you acquire an interest under an employee share scheme (an ‘ESS interest‘). This discount is taxed in the same way as your ordinary employment income, i.e. at your marginal rate of tax. (Section 83A-25 ITAA)
The problem with this is that you will have a liability to tax at the time you get the ESS interest, but you will not receive any cash to pay the tax bill. Furthermore, it may be that you never realise any ‘benefit’ from the ESS interest. For example, you may lose the benefit of the interest (i.e. by forfeiture), or the interest may become worthless before you are able to dispose of it.
If the general rule was all we had, then it is safe to say that ESS interests would hardly ever be issued at a discount. In fact, given the risks inherent in acquiring shares and rights in your employer, it is doubtful whether ESS interests would exist at all.
For this reason, the Tax Law gives you the opportunity to defer the time at which you are required to calculate and pay tax (i.e. the ‘taxing point’) to a future time when the outcomes of holding or exercising the ESS interest are more certain, and when you are more likely (although not certain) to have some cash to pay the resulting tax bill.
If you qualify for deferral of the tax, then when the deferral comes to an end, the difference between the market value at that time, and what you paid for the ESS interest, will be taxable as ordinary income. This means you will pay your full marginal rates of tax on the income at that later time, (and will therefore not benefit from any CGT concessions).
Do you need to qualify for deferral?
It seems obvious, but you only need to consider if you can defer the tax if you actually receive a ‘discount‘ when you acquire your ESS interest, (if there is no discount, then there is no upfront tax liability). This means that the first place to start is considering if there is a discount. The Tax Law specifies how you calculate the value of the ESS interest and any resulting discount. This is supplemented by Regulations.
To work out if you have a discount, read this.
If after applying these valuation rules you still have a discount, then read on…
The next step is to consider if any of the other concessions reduce the extent of the taxable discount to nil. For example, if you qualify for the ‘start-up concession’ then there will be no taxable discount. Other concessions include the $1,000 concession and the $5,000 salary-sacrifice concession.
To work out if you qualify for the ‘start-up’ concession, read this.
If there is still a taxable discount after looking at the other possible concessions, then read on…
How do you qualify for deferral of the tax on your ESS interest?
If you have a taxable discount that is not eliminated by any other concessions, then you will either have to pay tax at the time you acquire the ESS interest, or qualify for deferral of that tax.
What you need to do to qualify for deferral will depend on what sort of ESS interest you get under the scheme, i.e. whether you get shares or whether you get options to acquire shares.
If the ESS interest is a share
If the ESS interest is a share, then the scheme must satisfy the following general criteria to qualify for tax deferral:
- The ESS interests granted must be ordinary class shares;
- The company in which you get the shares must not be a share trader or investment company; and
- You, together with your associates, must not hold, or have the right to acquire, more than 10% of the shares in the company, or control the exercise of more than 10% of the votes. This includes any shares you acquire or have a right to acquire under the ESS. Note that this threshold relates to all shares in the company, not just ordinary shares.
If the scheme relates to shares, then there is a requirement that it be ‘broadly offered’. In particular, at least 75% of your employer’s permanent Australian-resident employees who have been employed by your employer for at least 3 full years, must be entitled (or have been entitled at an earlier time):
- To acquire shares under the scheme; or
- To acquire shares under another scheme operated by the employer or its holding company.
While this requirement may appear to restrict the ability for a company to create a targeted scheme for senior management, this is not the case. The company can put in place one scheme for general employees, and another scheme for senior management. There is no requirement for both schemes to offer similar terms to all employees. Furthermore, there is no requirement for each employee to be offered the same number of shares under a scheme.
If the scheme relates to shares then you must not be able to dispose of the shares for a minimum of either 3 years from the time you acquire them, or when you cease your employment with the company. This period may be reduced if 100% of the company is sold to a third-party before the 3 years elapses, (and the Commissioner considers this to be a bona fide transaction).
It may be that you are restricted from disposing of the shares for a longer period than the minimum 3 years, and in fact this will often be the case. This is because the deferral of tax will come to an end when you are no longer restricted from selling the shares, (as noted below).
Finally, either one of the following conditions must be satisfied:
- When you acquire the share there is a real risk that, as a result of the scheme conditions, you will forfeit or lose the shares (other than by disposing of them); or
- The shares are acquired under a qualifying ‘salary sacrifice arrangement’.
The concept of there being a ‘real risk’ of forfeiting your shares can be a hard one to get your head around. The policy behind this is to require you to perform to a certain standard or remain with the company for a material period of time, so as to justify the tax deferral.
Fortunately the Commissioner has set out some ‘safe-harbour’ thresholds that will satisfy this requirement. There will be a real risk of forfeiture if you must remain employed by the company for:
- At least 12 months; or
- At least 6 months if the period of deferral is no more than 3 years.
You can design other risks into the scheme. However, you will need to get advice or a ruling to ensure that these are sufficient for the Commissioner to consider them ‘real’.
If the ESS interest is an option
If the ESS interest is a right to acquire a share (i.e. an ‘option’), then the scheme must satisfy the following general criteria:
- The ESS interests granted must be rights to acquire ordinary class shares;
- The company in which you get the options must not be a share trader or investment company; and
- You, together with your associates, must not hold, or have the right to acquire, more than 10% of the shares in the company, or control the exercise of more than 10% of the votes. This includes any shares you acquire or have a right to acquire under the ESS.
If the ESS interest is an option, then the scheme must provide that the options are non-transferable. This is usually stated to be the case for the entire life of the options, because when the options become transferable the deferral of tax comes to an end, (as noted below). It may be that you can apply to the Board to consent to a transfer of the options. However, if this permission was granted, then tax deferral would end.
Finally, when you acquire the options either:
- There must be a real risk that, as a result of the scheme conditions, you will forfeit or lose the options (other than by disposing of or exercising them); or
- The company must explicitly elect as a term of the scheme that deferred taxation applies under Subdivision 83A-C to all holders of options under the scheme.
As you will see, it is much easier to qualify for tax deferral for an option scheme. This is because you do not need to broadly offer the scheme, and you do not need to include any real risk of forfeiture – provided the company is happy to explicitly elect for deferred taxation to apply to all participants.
For this reason, options schemes are often more appropriate for targeted senior management schemes.
When does the deferral come to an end?
If you qualify for deferral, the next question is when this deferral comes to an end? At this point in time you will need to find the cash to pay tax on the difference between the market value of the ESS interest at that time, and the tax cost base of the interest, i.e. the discount to current market value.
If the ESS interest is a share
If the ESS interest is a share, then the discount will be calculated and become taxable at the earlier of when:
- You dispose of the share, (being a time you are likely to realise some cash to pay the tax);
- You are no longer subject to a real risk of forfeiting the share, and the restrictions on your ability to dispose of the share are lifted, (this is usually deferred as far as possible);
- When you cease employment with your employer; and
- 15 years from when you first acquired the share.
The key thing is for the tax to become payable at a time you are likely to have cash to pay the liability. This can become an issue when you cease to be employed, because there is no guarantee that this will coincide with your ability to dispose of the shares and pay the tax.
The extent of this problem will depend on the extent of the discount between what you have paid for the share and its market value. If you received ‘free shares’, or heavily discounted shares, then you are likely to have a material tax problem when you leave employment.
For this reason, it is common for share schemes to also provide a facility for employees to be able to sell their shares back to the company for an agreed or calculated price. Another alternative for the scheme to relate to partly-paid shares which are forfeited if the employee does not fully pay them up following termination of employment.
This is another reason why schemes more often involve non-discounted shares (where no deferral tax place), or options.
If the ESS interest is an option
If the ESS interest is an option, then the discount will be calculated and become taxable at the earlier of when:
- You dispose of the option, (being a time you are likely to realise some cash to pay the tax);
- If you have not exercised the option: you are no longer subject to a real risk of forfeiting the option, and the restrictions on your ability to dispose of the option are first lifted;
- If you exercise the option: the converted share is no longer subject to a real risk of forfeiture, and the converted share is not subject to a disposal restriction, i.e. you convert the option into a freely transferable share;
- When you cease employment with your employer; and
- 15 years from when you first acquired the option.
The same practical considerations apply to options (and to converted shares) as are explained above about share schemes. The main point is that when you cease employment you may become subject to a tax liability on your vested options, at a time when you have no cash to pay the bill. For this reason, many people let their vested options lapse after ceasing employment, because they do not want to take the risk of keeping the options, paying the tax, and potentially not ever realising any cash.
For this reason, when setting up a scheme it is a good idea to provide for an ex-employee to be able to abandon vested options before a tax liability arises.