The Federal Government has recently made changes to corporation law disclosure requirements for employee share schemes (ESS), revealed in the 2022 Budget.
Among the changes are the ability to offer more meaningful amounts of equity, including lifting the maximum cap from $5,000 per year per participant to $30,000, as well as a simplified regulatory regime and a relaxation of disclosure rules.
While these legal changes are welcome and will assist employers, there remain significant hurdles for private companies that remain unresolved. Viable solutions are urgently needed to minimise private companies turning their backs on ESS’s altogether.
Let’s briefly recap how ESS works from a tax perspective. A grant of an ESS interest is considered assessable income – the recipient (ie, an employee) receives an asset (the ESS interest) and the discount is assessable for tax purposes.
Division 83A of the Income Tax Assessment Act 1997 directs how ESS income is assessed – and it can be either upfront or deferred. Upfront is the employee’s asset being assessed on grant, whereas deferred means it is assessed on vesting or exercise.
Dealing with upfront or deferred for employees of listed companies is usually straight forward, as employees can sell a portion, or all, of the ESS interests received on the open market and use the proceeds to fund the tax liability.
However, this avenue is not available for private companies, which results in employees being unable to turn their award of equity into liquid funds. There is no “easy option” to fund the tax payable on the receipt of an ESS interest.
This liquidity issue is generally dealt with in one of the following four ways, although the solutions are not without their own issues, as I’ve outlined below.
- Tax deferred scheme: This route works well where shareholders are planning an exit event (such as a trade sale or IPO) as the timing of taxation generally aligns with a liquidity event for the employees. However, this is not a viable option for mature companies where the intention is for employees to enjoy long term dividend revenue streams as opposed to a capital gain. Furthermore, employees are not able to obtain concessional capital games tax (CGT) treatment under this scheme.
- Removal of the ESS grant from the ESS provisions: This is completed by way of funded schemes where cash is provided to employees, either in the form of a bonus or a loan. Cash is then used to acquire the ESS interests.
Both routes can work well, but possible challenges include:
- Difficulty building in vesting conditions due to share buy-back rules;
- Loan funded schemes that can only be utilised once per employee without Division 7A implications;
- ESS interests acquired under loan backed schemes generally cannot be alienated to associates of the employees, such as family trusts, without fringe benefit tax implications.
- Combined use of the tax upfront scheme and grants: The value of interest is reduced by providing employees with ‘out of the money options’ where the exercise price is at least greater than or equal to the underlying share price. This results in a low (and generally manageable) amount of tax upfront with the added benefit of getting the ESS interest ‘on capital account’, allowing for potential CGT discount on long-term capital gains.
Challenges here include the inability to have vesting conditions – (vesting conditions will likely result in deferred taxation), a second liquidity issue in dealing with the exercise price, and issues surrounding the interaction of the CGT discount acquisition rules and options leading to a frustrating outcome.
Specifically, the exercise of an option and receipt of an underlying share results in the resetting of the acquisition date for CGT discount purposes. This means that in the case of an exercise and immediate subsequent sale of shares, the option holding vendor can only access the CGT discount by selling the option instead of the share.
Completing the transaction in this manner results in no economic difference for either purchaser or vendor, but does create extra friction in the deal (especially when dealing with foreign purchasers who are used to cashless exercise) and raises the risk of anti-avoidance provisions.
- ESS start-up concessions: Where available, concessions allow employees to either acquire ‘out of the money options’ with no tax upfront or to acquire shares with a discount. Most importantly, the start-up concessions often allow for a generous safe harbour valuation approach which enables significant simplification of the liquidity issue as it both reduces the immediate exposure to income tax and cost of exercise for options.
Liquidity issues are particularly vexing for companies where there is an expectation of a dividend yield rather than capital gains. This is common in the instance where there is a desire to rapidly gain equity, so employees can benefit from revenue streams, and there is no inbuilt funding mechanism for an exit event. This issue is also present within capital growth companies where there is a goal to secure employees as ‘owners’ so that the concessional CGT treatment on the eventual exit can be used.
Valuation of underlying shares
Valuing underlying shares is a complex issue faced by private companies as they often find difficulty determining the employee’s exposure to income tax due to ESS, or the value of the ESS interest acquired (for a loan or bonus funded scheme).
This process is generally straight forward for a listed company, or for an employer that is eligible to access the start-up concessions (assuming certain other criteria is met), as the employer can rely on a safe harbour valuation approach.
However for any other employer, there is often no simple indicator of the company’s value. This can result in the company having to complete an expensive valuation exercise that is not otherwise required, or alternatively expose its employees to risk – for example, if the employer gets it wrong and undervalues the company, the exposure to income tax shortfalls will be felt by the employees.
Several legislative and administrative changes could lead to the simplification of income tax treatment of ESS’s in Australia:
- Liquidity challenges could be reduced if employers were able to opt in to an ESS withholding system, allowing them to withhold the income tax on the ESS income to their employees remit to the ATO. This would effectively shift the liquidity issue to employers (on an optional basis). While employers can, in certain circumstances, utilise this approach through bonus funded schemes, these are not always appropriate and the employment related on-costs (and in particular superannuation) can make this route expensive for the employer.
- Consideration should be given to loan-funded schemes being carved out from Division 7A for small percentage shareholders. It does not seem that the provision of a loan to allow an employee, including an employee that is already a minority shareholder, is the type of loan that should enliven Division 7A. This form of loan is clearly not a distribution of retained earnings to these employees by way of loan and therefore it would be appropriate for a carve out to be available.
- Vesting conditions for bonus and loan funded schemes could be simplified, particularly the share buy-back rules which can significantly complicate applying vesting conditions to such schemes.
- Access to the safe harbour valuation provisions is possibly the most valuable aspect of accessing the ESS start-up concession. Not only does it simplify the issue of ESS interests, often allowing for their issue without obtaining a valuation, but the net tangible asset approach allows for the provision of ESS interests at a significant discount to actual market values.
- The ESS rules could be made more accessible with the provision of additional safe-harbours or accepted valuation approaches, or alternatively by allowing for employers to have the option of obtaining a valuation from the Commissioner, such as occurs in the United Kingdom.
- Finally, there is a challenge of accessing the general CGT discount for ESS interests that are options, as the exercise of the option refreshes the date of acquisition, requiring a further 12-month wait after exercise before the general CGT discount is available. Start-up concessions allow for options issued under the start-up concessions to not reset their acquisition date on exercise. Refreshing the acquisition date can lead to commercial and practical challenges, and encourages employees to attempt to achieve the same result by changing the structure of share sales – by allowing sales of options as well.
The use of employee share schemes provides benefits to all parties involved while also creating alignment between employees and business owners and is growing in popularity around the world.
If changes can be made to ESS treatments, then it is possible that Australia could carve the path for others on how to have a regulatory environment that allows for such schemes to proliferate.