The taxation of employee share schemes (“ESS”) has undergone significant amendments under successive Governments over the last decade. The current rules under Division 83A of the Income Tax Assessment Act 1997 (“ITAA 1997”) have applied since 1 July 2009 (although significant amendments were introduced with effect from 1 July 2015).
This paper highlights the general operation of the ESS rules and particular issues in relation to foreign-resident employees coming to Australia as ESS participants subject to ongoing vesting conditions (e.g. continuing employment for the relevant company/corporate group).
The starting point – upfront or deferred taxation?
An ESS is a scheme under which ‘ESS interests’ in a company are provided to employees, or associates of employees, of the company or a subsidiary.
In turn, an ESS interest in a company is either:
- a share in the company; or
- a right to acquire a share in the company (e.g.an option).
Relevantly, it is important to note that for ESS purposes:
- the rules extend not only to ‘employees’ as defined at common law, but also to certain relationships similar to employment; and
- where an employee participant participates in an ESS indirectly via an associate, the associate is effectively ignored and any actions of the associate attributed to the employee participant in determining the tax implications under the ESS rules.
The starting point is that a taxpayer includes in their assessable income any ‘discount’ provided in relation to an ESS interest in the income year it is acquired. The discount is the difference between the market value of the ESS interest granted and the consideration provided by the employee participant (if any).
Despite the general position outlined above, special rules may apply to reduce (including to nil) the discount otherwise assessable in the hands of an employee participant where:
- the ESS is operated by an eligible start-up company in relation to eligible employees; or
- amongst other things, the employee participants have adjusted taxable income of no more than $180,000 (up to a maximum $1,000 reduction).
Subject to meeting certain conditions (which differ depending on whether the ESS relates to shares or rights in relation to shares), employee participants are not taxed upfront and are instead taxed at the ‘deferred taxing point’.
Some of the critical conditions for deferred taxation are:
- in relation to an ESS involving shares, either:
- the shares are subject to a real risk of forfeiture; or
- part of a salary sacrifice arrangement (subject to a maximum $5,000 limit);
- in relation to an ESS involving rights to shares, either:
- the rights are subject to a real risk of forfeiture; or
- the ESS plan rules genuinely restrict participants from immediately disposing of the right and expressly states that Subdivision 83A of the ITAA 1997 applies; and
- in relation to either type of ESS, it involves either ordinary shares or rights in relation to ordinary shares only.
Where deferred taxation is available, the employee participant includes the market value of the ESS interest (less the cost base of those interests) in their assessable income for the income year in which the deferred taxing point occurs.
|For Shares||For Rights (incl. Options)|
|No longer real risk of forfeiture or (if applicable) restriction on disposal of the share||You have not exercised the right, no longer real risk of forfeiture and (if applicable) no longer any restriction on disposing of the right|
|Cessation of employment to which ESS interest relates||Cessation of employment to which ESS interest relates|
|15th anniversary of grant date||15th anniversary of grant date|
|–||You have exercised the right, no longer real risk of forfeiture and (if applicable) no longer any restriction on disposal of the underlying share|
Cross-border ESS issues
The global mobility of the workforce can give rise to complications where foreign-resident participants in a deferred tax ESS are seconded or relocate to Australia. In this regard, variables include:
- the type of ESS (as determined under Division 83A of the ITAA 1997);
- if it is a deferred tax plan, whether the ESS interests have fully vested prior to arriving in Australia; and
- whether the foreign-resident participant:
- became an Australian resident at any stage?
- if so, whether they qualified as a temporary resident for Australian tax purposes?
- is (or at some stage was) tax-resident of a country with which Australia has a Double Tax Agreement (“DTA”)?
- if so, the impact of the DTA (which overrides domestic Australian tax law to the extent of any inconsistency save for anti-avoidance considerations under Part IVA of the Income Tax Assessment Act 1936).
In the context of foreign employment, the Explanatory Memorandum to the Tax Laws Amendment (2009 Measures No. 2) Bill 2009 (“EM”) states:
“Under the core rules of the Australian income tax system, an Australian resident taxpayer is subject to income tax on their worldwide income. A foreign resident taxpayer is only subject to Australian income tax on their Australian sourced income.
Under the existing law, this outcome is achieved by excluding discounts from interests acquired under employee share schemes from tax under the employee share scheme tax rules, to the extent that they relate to foreign service of a taxpayer.
This mechanism operates in a manner inconsistent with core rules. The new rules use the core rules to achieve the desired outcome. The new rules instead include source rules and rely on the core rules to the exclude foreign sourced income of foreign residents from Australian income tax. That is, the employee share scheme rules attribute a source to discounts received on securities acquired under employee share schemes.”
“Australian resident taxpayers are subject to Australian income tax on all discounts they receive under employee share schemes regardless of whether they received it in relation to employment in Australia or outside Australia. However, this may be affected by Australia’s double tax treaties and the temporary residents rules.”
Therefore, if a foreign-resident ESS participant becomes an Australian resident whilst subject to ongoing vesting criteria such as continued employment and remain Australian resident as at the deferred taxing point, they will be fully taxable in Australia (unless they qualify as temporary residents or benefit under an applicable DTA).
Temporary resident rules
The temporary resident rules provide for concessional tax treatment of foreign-resident individuals that become Australian residents for tax purposes where they meet certain eligibility criteria (including holding certain temporary visas).
The relevant rules limit Australia’s taxing rights to Australian source income only (except for foreign source employment income derived whilst a temporary resident such as where a temporary resident was sent overseas for work for 4 weeks before returning to Australia).
Foreign-resident ESS participant fully vested prior to Australian residence
Where a foreign-resident’s ESS interests fully vest prior to arriving in Australia, whether under an upfront scheme or a deferred tax scheme, there will be no Australian tax implications under Division 83A of the ITAA 1997 (although there may be CGT implications going forward in relation to any shares or options held).
In this regard, practitioners must carefully review the relevant ESS plan documents to determine the tax implications accordingly. For example, a critical distinction is maintained between vesting periods and mere ‘blocking periods’.
In this regard, the OECD Commentary on the Model Tax Convention states:
“as a general rule, an employee stock-option should not be considered to relate to any services rendered after the period of employment that is required as a condition for the employee to acquire the right to exercise that option.
. . .
In applying the above principle, however, it is important to distinguish between a period of employment that is required to obtain the right to exercise an employee stock-option and a period of time that is merely a delay before such option may be exercised (a blocking period). Thus, for example, an option that is granted to an employee on the condition that he remains employed by the same employer (or an associated enterprise) during a period of three years can be considered to be derived from the services performed during these three years while an option that is granted, without any condition of subsequent employment, to an employee on a given date but which, under its terms and conditions, can only be exercised after a delay of three years, should not be considered to relate to the employment performed during these years as the benefit of such an option would accrue to its recipient even if he were to leave his employment immediately after receiving it and waited the required three years before exercising it.”
If a foreign-resident individual arrives in Australia with fully vested ESS interests subject to an ongoing blocking period, they will still fall outside Division U83A of the ITAA 1997 (although again, there may be CGT implications going forward).
Foreign income tax offsets
Where Australia has taxing rights in relation to ESS interests, an issue arises as to the grant of double tax relief (either domestically or under an applicable DTA).
Domestically, Australia provides foreign income tax offsets to Australian residents taxed overseas on a source basis.
Under Australia’s DTA’s, employment income (including income derived under an ESS) is only assessable in the individual’s country of residence unless the employment is performed in the other country). However, the source country has no taxing rights at all where:
- the foreign resident individual is present in the source State for a period or periods not exceeding in the aggregate 183 days in any twelve month period commencing or ending in the income year concerned; and
- the remuneration is paid by, or on behalf of, an employer who is not a resident of the source State, and
- the remuneration is not borne by a permanent establishment which the employer has in the source State.
If the default position applies, then the foreign-resident individual will be taxed in Australia to the extent of the Australian source only (and the residence country will be required to provide a foreign tax credit for the Australian tax paid).
If the exception applies, the foreign-resident individual will not be taxed in Australia at all.
Table of common outcomes
The following table assumes that a foreign-resident individual arrives in Australia as a participant in a deferred tax ESS (that is, after the grant but before the deferred taxing point).
The table summarises some common outcomes in these circumstances, however, the specific tax consequences of a particular client depend on all the relevant facts and circumstances of the individual taxpayer and ESS plan documentation:
|Australian Resident (Domestic)||DTA||DTA Residency Tie-breaker||Does DTA Exemption apply?||Temporary Resident?||Credit for foreign tax paid||Tax Outcome|
|No||No||N/A||N/A||N/A||N/A||Taxed on Australian source portion|
|No||Yes||N/A||Yes||N/A||N/A||Not taxed in Australia|
|No||Yes||N/A||No||N/A||N/A||Taxed on Australian source portion|
|Yes||No||N/A||N/A||Yes||N/A||Taxed on Australian source portion|
|Yes||No||N/A||N/A||No||Yes||Taxed on entire amount less FITO** at DTP*|
* DTP = Deferred Taxing Point
** FITO = Foreign Income Tax Offset
 Subsection 83A-10(2) of the ITAA 1997
 Subsection 83A-10(1) of the ITAA 1997
 See Hollis v Vabu Pty Ltd  HCA 44
 Section 83A-325 of the ITAA 1997
 See section 83A-305 of the ITAA 1997
 Subsection 83A-25(1) of the ITAA 1997
 See section 83A-33 of the ITAA 1997
 See section 83A-35 of the ITAA 1997
 See section 83A-105 of the ITAA 1997
 See paragraph 83A-105(1)(c)(ii) of the ITAA 1997
 See paragraph 83A-105(1)(d) of the ITAA 1997
 See paragraph 83A-105(1)(b) of the ITAA 1997, subsection 83A-45(2) of the ITAA 1997 and Norman v. Norman (1990) 19 NSWLR 314
 Subsection 83A-110(1) of the ITAA 1997
 See section 83A-115 of the ITAA 1997
 See section 83A-120 of the ITAA 1997
 At paragraph 1.347 – 1.350
 At paragraph 1.355
 See Division 768-R of the ITAA 1997
 See section 995-1 of the ITAA 1997
 See section 768-910 of the ITAA 1997
 See, for example, sections 855-45 (market value cost base uplift of CGT assets (other than ‘taxable Australian property’ or pre-CGT assets) for individuals that become Australian residents) and 768-950 of the ITAA 1997 (market value cost base uplift where temporary resident ceases to be a temporary resident but remains an Australian resident) or under an applicable Double Tax Agreement
 At paragraph 12.7 – 12.8
 See Division 770 of the ITAA 1997
 See Article 15(1) of the OECD Model Tax Convention
 See Article 15(2) of the OECD Model Tax Convention
 See Article 23B of the OECD Model Tax Convention
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Note – This article was published in the April 2016 edition of inTax Magazine (a Thomson Reuters publication)
Disclaimer – This article does not constitute specific advice and cannot be relied upon as such.