Employee share schemes are excellent for making the employees think like owners by letting them acquire shares in the company. As a result, the business not only becomes more productive but also profitable and resilient.
An employee share scheme may provide such a financial incentive to employees that could exceed any amount provided under a traditional salary or bonus agreement, given that it is well thought through.
While an employee’s salary and cash bonuses are taxed at marginal rates, there exist some employee share schemes where they can enjoy considerable discounts on capital gains, thanks to the capital gains tax (CGT) regime.
However, the major problem with employee share schemes is that they are quite complicated to comprehend, especially when it comes to tax. There are some strict tax rules applied to them which you have to understand.
To access some tax concessions, you will need to structure the schemes in a particular way or will only apply to start-ups. So, it is crucial that you pay attention to such rules before implementing an employee share scheme.
Suppose an employee has received an interest (a share, for instance) under an ESS or an employee share scheme. They must pay tax on the difference between the amount paid for it and its market value.
This difference is known as ‘discount’, and to calculate the discount on employee share scheme or ESS interests, you will need the market value of the shares.
In case the employee paid absolutely no money for the share issued by the company, the discount will be the market value of the share.
Now, the ATO (Australian Taxation Office) has stated that the employee receiving the shares must be taxed at the discount value of the shares. The employee will have to include the discount value in the taxable income in the tax return for the same year the shares are issued.
The major issue with the upfront tax requirement is that a company with some value, when proposing to issue shares to its employees at a discount, the employees will need to pay tax when they acquire their interests without receiving any additional cash. It is the reason why the upfront tax is considered somewhat problematic.
There are different structures for employee share schemes that can help a company avoid the problem of upfront tax, and some of the most common ones are shared here.
Non-Recourse Loan Employee Share Scheme
Some companies provide non-recourse loans to employees to let them pay for the share issued under an employee share scheme. Such a loan enables the company to have recourse to the shares of the employee to repay the loan.
However, the company cannot take action against the employee if the loan isn’t repaid.
A non-recourse loan is repaid using the dividends declared on the shares, and in case they are sold, the earnings of the sale are used for repaying. If the employee decides to leave the company and the complete amount of this loan hasn’t been paid, the shares received by that individual are either bought back or sold by the company.
For those instances where the balance of the loan is more than the value of the shares, the company cannot have any further recourse against that employee.
One of the major advantages of this kind of scheme is that the employee will own the share completely the moment it was issued, which will result in them being able to access the CGT (capital gains tax) relief on any capital gain made on the share when sold.
Another benefit of this kind of scheme is that the company can issue any kind of share it wants. A new class of shares can be created and issued solely for the purposes of the scheme if it wishes to do so.
However, there are some chances that when the loan is interest-free or not on arm’s length terms, the liability of FBT (fringe benefits tax) may apply. Also, since the shares under this arrangement are usually issued at their market value, the business has to ensure that the employees are not receiving any discount that could attract a tax liability at the time of issuing the shares.
Another way to avoid the issues or problems of upfront tax is the use of options. An option gives its holder the right to purchase the share at a specified exercise price.
The exercise price has to be at least equal to the shares’ market value when the option is issued. Mostly, no or nominal consideration has to be paid for the option itself, but it is not always necessary.
Unless specified performance targets have been achieved or/and a certain period has passed, options wouldn’t normally vest, i.e., will not be exercised. The vesting rules vary from one company to another.
The prime advantage of the option schemes is the vision of receiving a capital return if the company is listed or sold. In the majority of cases, options cannot be exercised until it is either sold or listed. This structure allows the employees to participate in a listing or sale as effectively as a shareholder.
In case the company is classified as a start-up for tax purposes, the participants would be eligible for CGT (capital gains tax) concessions on the capital gains made on the ESS interests.
Employee Share Scheme Start-up Concessions
For the employee share scheme tax rules, a company will be considered and treated as a start-up if it:
- is an Australian company
- has been incorporated for less than a decade (10 years)
- isn’t listed on a stock exchange
- has an aggregated turnover of not exceeding $50 million
For the companies that are a part of corporate groups, the ATO applies the turnover and incorporation period rules at the group level instead of at the individual company level.
Using options rather than shares
If a company intend to issue options (not shares) under this scheme, it has to fulfil the following eligibility requirements to qualify for the start-up concessions:
- The options have to be options to acquire ordinary shares (which would give the participants voting rights for the time when the options are exercised),
- Right after the grant of the option, the associated employee mustn’t hold a beneficiary interest in more than 10% of the shares of the company (every option held by that employee will be included in this calculation),
- The exercise price of the options needs to be either equal to or greater than the market value of the ordinary share at the time it is granted.
- The options, or any shares acquired on the exercise of those options, shouldn’t have the capability of being sold within three years of being issued.
A couple more conditions will also have to be satisfied to make sure that the start-up concessions are available.
What makes start-up tax concessions so beneficial is when the relevant ESOP (employee stock ownership plan) interests are sold, the participant might be entitled to substantial discounts or the Capital Gains Tax that the ATO would have applied.
Tax Deferred Schemes
Here is another kind of employee share scheme. In a tax-deferred scheme, the liability of an employee to pay tax on the received discount at the time of acquiring their options or shares is ‘deferred’ until a later period.
In the case when options are issued (but not shares), the employee can only defer paying tax on the discount on their options if:
- Every interest available for acquisition under this scheme relates to ordinary shares,
- After receiving the interest or interests, the employee will not be holding a beneficial interest in more than 10% of the total shares of the company (All the options held by that employee are considered to calculate this),
- The options are subject to either restricts preventing their immediate disposal or a real risk of forfeiture, and
- The scheme’s rules clearly state that it’s a tax-deferred scheme.
The tax is deferred until:
- There’s no real risk of forfeiting the options,
- The scheme no longer restricts the disposal of options,
- When the option is exercised by the employee, there is no real risk of forfeiting the underlying share, and also the scheme does not restrict the resulting share’s disposal, and
- 15 years after the acquisition of the option by the employee.
Advantages and Disadvantages
Tax-deferred schemes provide their participants with an upfront cashflow benefit by deferring the time at which the tax on the discount is to be paid.
However, in this case, the participants will not be able to access a more favourable CGT (Capital Gains Tax) regime until after the options or shares are assessed for tax.
Another downfall is that when a participant disposes of the interests acquired under the scheme, they may need to pay a lot more tax than they would have paid on the discount upfront.
Forfeiture or loss of ESS interests
If there’s a real risk of the benefits of the employee share schemes interests never being realised because they may be forfeited, there’s a provision that the tax will be deferred until a deferred taxing point.
Disclaimer: The information on this website is for general purposes only and should not be relied upon for making legal or other decisions. The advice provided in this article is general in nature and is not subject to the personal financial situation and needs of any individual. Clear Tax tries to keep the information accurate and up-to-date; however, you should bear in mind with changing circumstances, the accuracy and reliability of the information will not necessarily remain the same. The information is by no means a substitute for financial advice.