Avoid a common structuring trap when participating in a start-up ESOP
Most people in the Australian start-up world would be broadly aware of the beneficial changes to Australia’s employee share scheme (“ESS”) rules from 1 July 2015 (“2015 Amendments”).
The previous regime gave rise to potential tax and cash flow problems, for example:
- by taxing employee participants at vesting in circumstances where their ESS interests (whether shares or options/rights) were (or related to) minor shareholdings in highly illiquid companies;
- given the high failure rate of start-up companies, value was often ephemeral and employee participants were commonly taxed on income account (at up to 45% + levies) at vesting only for those companies to subsequently fall over such that participants derived no benefit whatsoever and yet were heavily taxed under the ESS rules; and
- specifically in relation to employee share option plans (“ESOPs”), employee participants had to exercise their vested options and hold the underlying shares for at least 12 months (“12-Month Holding Period Rule”) in order to access the 50% CGT discount in the event of an exit (and if an offer came out of nowhere, many employees with vested but unexercised options were caught short in this regard).
To combat the deficiencies outlined above, the 2015 Amendments introduced an eligible start-up concession which, in relation to ESOPs and subject to meeting various conditions, resulted in employee participants not being taxed up-front, at vesting or at exercise, but generally only on the eventual disposal of the underlying shares post-exercise (“Start-Up ESOP”).
In relation to shares acquired following the exercise of options granted under a Start-Up ESOP, the holding period of the option itself counts towards the holding period of the underlying shares post- exercise for the purposes of the 12-Month Holding Period Rule. That is, unlike under the general CGT rules, whereby the start-date for the purposes of the 12-Month Holding Period Rule effectively resets on the exercise of an option and the grant of the underlying share, they are effectively treated as a single asset in this regard.
Participating in an ESOP via a family trust
It is common to hold assets in a family trust to take advantage of both their asset protection and tax benefits. Under the ESS regime, where an associate of an employee participant (including the trustee of a family trust) acquires an ESS interest in relation to the employee’s employment, those ESS interests are treated as being acquired by the individual employee for the purposes of Division 83A of the Income Tax Assessment Act 1997.
This is known as the ‘Associate Rule’.
If the Start-Up ESOP rules apply, the family trust is effectively ignored in accordance with Associate Rule and there is no amount that is included in the individual employee’s assessable income.
However, this is not the end of the matter. If the relevant options under a Start-Up ESOP are held by a family trust and they vest, are subsequently exercised and the trustee wishes to dispose of the underlying shares, an issue arises as to the acquisition date of the shares for the purposes of the 12-Month Holding Period Rule.
Exception to general acquisition rules and interaction with Associate Rule
The acquisition rules under the CGT regime state, amongst other things, that shares an acquirer acquires by exercising ESS interests (including options or rights under an ESS) where the Start-Up ESOP rules applied to reduce the amount to be included in the acquirer’s assessable income are taken to be acquired when the acquirer acquired those interests (options or rights).
The complexity surrounds the meaning of an ‘acquirer’ and its interaction with the Associate Rule, that is, by virtue of the Associate Rule, it is only the individual employee participant whose tax liability may be reduced under the Start-Up ESOP rules. Therefore, even though the Start-Up ESOP rules may operate to reduce the individual employee participant’s liability under the ESS tax regime, unless the options are issued to the individual employee participant, the special acquisition rules in relation to shares derived from Start-Up ESOP options will not apply, leaving the general acquisition rules to apply whereby the shares must be held for at least 12 months post-exercise in order to satisfy the 12-Month Holding Period Rule.
The Start-Up ESOP rules can be very beneficial in terms facilitating access to discount capital gains on shares acquired following the exercise of options granted under an ESS. However, given that an exit may come along at any time in a start-up context, clients must be careful to ensure that they fall within the special acquisition rules in relation to their shares otherwise, they may miss out on discount capital gains tax treatment on exit.
If you or your clients need any assistance in relation to the design of your ESS and the tax consequences of same, feel free to get in touch!