Government announces changes impacting Employee Share Schemes
The Government recently released The Industry Innovation and Competitiveness Agenda; a high level directional statement of the Government's approach to Industry and Innovation policy, as well as details of 17 specific announcements worth $400 million.
The package includes proposed changes to employee share ownership schemes (ESOP's) aimed at aligning the tax treatment of the scheme with international experience and providing further concessions to start-up businesses. An ESOP is one specific scheme business owners can use to align employee compensation with growth in business value, usually by offering employees options or shares in the business.
A key challenge for any business owner is to attract and retain experienced talent. This applies as much to 'start-up' businesses as to businesses scaling to support faster growth or an IPO, and business owners thinking about succession and exit options. In each case, hiring the right talent to build or preserve the culture the business needs is a critical decision.
ESOPs can be an excellent alternative to cash bonuses as a cost effective way for business owners to attract, motivate, lock-in and reward management teams and key employees for delivering results that grow business value over time. As a longer term incentive, ESOP's serve to align and focus employee resources and effort to key business outcomes.
How does an ESOP work?
Under an ESOP, employees are granted share options they can 'exercise' to buy shares in their company at a later date based on the current share price usually in exchange for accepting lower short term remuneration. If the business succeeds, the difference between the price of the share when the employee ultimately sells it and the exercise price of the ESOP stock option can produce a significant windfall.
In most countries, ESOP's are taxed in the hands of the employee when the share is ultimately sold.
But in Australia since 2009, the default position has been that ESOP's have been taxed in the hands of the participating employee when the options are issued. This leaves the employee with a liability to pay tax well in advance of the exercise date and before any potential windfall has had an opportunity to accumulate. This effectively saddles the employee with a downside risk if the value of the share falls, eroding the value of the plan. While there are work around solutions, they are necessarily more complex compared to ESOPs overseas.
What changes have been announced to ESOP's?
The following principles apply to all listed and unlisted companies. The changes are quite detailed, so only the high level concepts have been highlighted:
- Income tax no longer applies to options at the time they are issued. Tax will be deferred in the hands of the employee until the options are exercised. At that time, tax will be payable on the market value of the options at the time of issue, unless another taxing point occurs before then. CGT will be payable on the difference between the market value of the share at time of sale and the exercise price;
- For shares issued to employees that are not at risk of forfeiture, income tax will remain payable on the market value of the shares when issued. CGT will be payable on sale on the difference between the market value of the share and the market value of the share at the exercise date;
- If shares are at risk of forfeiture, tax is deferred until the share is ultimately sold, or there is an earlier CGT taxing point.
A concession has been introduced for start-up business, defined as unlisted companies which have been incorporated for less than 10 years, with turnover under $50 million, and where options or shares are held by the employee for a period of three years.
- Where options are issued at an exercise price which exceeds the current market value of the share, tax is deferred until the share is sold. Income tax is not payable at the time the options are exercised. CGT is payable when the share is sold on the difference between the sale price and the exercise price. The discount is not taxed;
- For shares issued to employees at a discount, tax can be deferred until the share is sold provided the discount is not more than 15%. CGT is payable when the share is sold on the difference between the sale price and the market value of the share at the time of acquisition. The discount is not taxed.
The Government has extended the maximum time for tax deferral from seven to 15 years to allow start-ups more time to develop into successful businesses.
The Government will undertake more detailed discussion with industry in relation to these announcements. Concerns have already been expressed about liquidity issues at the time of exercise and sale that still leave employees with a tax bill.
The long and the short of it
1. ESOP's are more attractive because under the above conditions the taxing point can be deferred until the employee has the ability to sell the shares;
2. ESOP's are more attractive to unlisted start-ups and more in line with similar taxing arrangements internationally.
While we eagerly await the final legislation, please contact our ESOP specialists if you would like to discuss how this may affect your business:
Nick Falzon or Iain Spittal in Sydney | Darren Shone in Newcastle | Or any of our locations around Australia