A significant concession, and improvement, was announced to the Employee Share Scheme rules on Tuesday by the Federal Government. Employee shares schemes in emerging businesses had faded from relevance over the last 5 years following the implementation by the former Government in 2009 of measures that had the broad effect of taxing any discount on shares or options issued upfront to employees of most businesses.
Taxation occurred at a time prior to the employee shareholder having any cash flow with which to pay their tax bill – clearly a killer consequence. This removed the major form of employee remuneration that emerging businesses could use as an incentive to employees without affecting free cash flow. It also led to clumsy arrangements where a company would have to “loan” the employee the value of their shares to prevent then obtaining any taxable benefit.
The Tax Office become notorious for 20:20 hindsight valuation reviews which left employees unwilling to expose themselves. Many employees just would not buy the idea of their employer becoming a major creditor. What if the shares tanked? The employee could be stuck with repayment of a loan without any benefit.
The shareholder/ employee loan created a variety of difficulties ranging from potential requirements for the employee to use real cash flow to repay the loan under statutory “Division 7A” private shareholder rules. In some cases the loan became a problem for the employer who was required to manage it under the FBT regime. An employee might make a long term commitment to a company and be subject to a vesting period of 3-5 years before they became entitled to deal with the shares. However when this period expired, the employee would be obligated to “cash-out” their loan, often by taking a fully taxable one-off bonus. This one off bonus often distorted the employee’s real earning position over their period of employment and forced them to be taxed on this component at a tax rate which was unfairly high.
Phasing issues emerged with the 50% CGT discount which generally applies to long term shareholdings. Deficiencies in these rules became so profound for early stage IT companies it became part of the reason emerging businesses began to leave the country. Most notably the IT success story Atlassian. The new rules remove some of the obstacles.
Phasing issues emerged with the 50% CGT discount which generally applies to long term shareholdings.
Actions to consider
- If you presently have any form of share or rights scheme in place, it is likely that it can be “rebooted” under the new rules to drive significantly improved outcomes to employees.
- Remuneration contracts currently being negotiated should be reviewed for the effect of the new rules. The rules you thought applied when you inked the deal may not apply for the term of the arrangement.
- Share schemes are not just for IT businesses. If you have a SME business where you want to incentivise and tie employees into the growth of your business without a cash flow impact on your businesses – there is no better incentive. Costs of administration have dropped significantly in recent years.
- If you are an SME owned “stuck” with the problem of how to exit the business and collateralise ownership interests into cash, employee share schemes can be a key tool in opening a dialogue and pathway to business succession.
- Employee share schemes also have relevance to family businesses where they can be used as a tool to incentivise high performance in the next generation family owners. They are a form of participation which is not just a “gift”. They can be a key tool to assist with perceptions of fairness between family members who are “in the business” and those that are not.
A summary of key points in the new rules
- Discounted options will generally be taxed when they are exercised (converted to shares), rather than when the employee receives the options.
- Shares provided at a small discount by eligible start-up companies to will not be subject to up-front taxation, if held for three years. Options under certain conditions will have taxation deferred until sale.
- Small discounts will be exempt from tax
- The maximum time for tax deferral is lifted from seven years to 15 years.
- The existing $1,000 up-front tax concession for employees who earn less than $180,000 per year will be retained.
- The rules are expected to become effective from 1 July 2015. Transitional arrangements are presently unclear.