With limited exceptions (most notably in relation to eligible start-up schemes), the ESS rules are aimed at ensuring that ESS interests (shares or options rights over shares issued by a company employer or the holding company of the relevant employer) are subject to tax as ordinary income rather than concessionally-taxed capital.
The ESS rules achieve this by taxing any discount to the market value of the relevant ESS interest. However, the timing of when the relevant discount is calculated, either up-front or at the deferred taxing point depends on whether or not the particular ESS interests are eligible for deferral.
It is important to understand that:
- the ESS rules can apply to relationships broader than the ordinary employer/employee relationship;
- the ESS rules apply to the individual employee even if the relevant ESS interest are actually issued to another entity such as a family trust;
- the ESS rules only apply to shares or options/rights over shares in companies – they do not apply to units in unit trusts;
- ESS give rise to State/Territory-based payroll taxes;
- where up-front taxation arises, subject to meeting certain conditions, employees may be able to reduce the amount included in their assessable income by up to $1,000; and
- in relation to an ESS involving unlisted options (even if over listed shares), employees may be able to take advantage of the concessional ‘Table Valuations’ under the ESS regulations.
Taxed up-front schemes
The starting point under the ESS rules is that any discount is taxed up-front in the income year in which the relevant shares or options/rights are granted.
Where an individual is taxed up-front, the relevant discount is included in their assessable income in the ordinary course subject to the possible $1,000 reduction.
Annabelle is a key employee of Tech Co. Tech Co issues Annabelle with shares in the company worth $25,000 in 2017.
The shares are not subject to any vesting conditions.
Annabelle includes the full $25,000 in her assessable income in 2017.
As you can imagine, this can place a significant cash flow constraint on the employee, who must come up with actual cash in order to pay her tax bill on a potentially illiquid asset (shares in a private company).
It was partly for this reason that the relevant start-up ESS concessions were introduced (see below).
Tax deferred schemes
Subject to meeting relevant deferral conditions, which differ for shares versus options/rights (with some overlap), the employee does not calculate the relevant discount as at the grant date but at the earlier of various deferred taxing points.
The critical conditions for deferred taxation include:
- the ESS interests must be ordinary shares or options/rights over ordinary shares (and importantly, ordinary shares are effectively any shares other than preference shares);
- the ESS interests must be subject to a ‘real risk of forfeiture’, that is, they are subject to vesting conditions such as minimum terms of employment, employee or company-specific KPIs or a combination all of them.
For options/rights granted before 1 July 2015 (even if un-vested as at 1 July 2015), the taxing point is generally vesting with a maximum deferral period of 7 years from the grant date.
For options/rights granted on or after 1 July 2015, the taxing point is generally exercise with a maximum deferral period of 15 years from the grant date.
The downside of deferred taxation is that the discount is calculated at the deferred taxing point so that any increase in the value of the ESS interests up to that point will be taxed in the employees hands as ordinary income.
William is lead engineer in a telecommunications company. The company issues William $10,000 worth of options.
Both the company and William satisfy the relevant conditions for deferred taxation and the options vest at the end of 3 years provided that William is still employed by the company and certain company-based KPIs are met.
At the end of 3 years, the options vest. If the options were granted before 1 July 2015 vesting would generally be the taxing point. If the options were granted on or after 1 July 2015 the subsequent exercise of the options will generally be the taxing point.
Either way, however, the increase in the value of options (based on the underlying increase in the company’s share price) between the grant date and the deferred taxing point is assessed to William at the relevant time. For example, if the options were worth $1m on the relevant date William will be taxed at up 45% on the entire discount (excluding levies)!
Eligible start-up concession
In recognition of the difficulties facing start-up companies and their employees, particularly in relation to the latter and the potential for them to be taxed heavily in relation to ESS interests that are highly illiquid and their valuations highly speculative, new rules with effect from 1 July 2015 operate to ensure that, in relation to the issue of options:
- eligible start-ups can save the potentially significant costs of:
- formal legal advice by adopting the Australian Taxation Office template ESS Plan documentation;
- subject to meeting additional criteria – a formal valuation by adopting the safe harbour valuation methodology (which in effect provides a net tangible assets valuation stripping the company of valuable intangibles);
- eligible employees:
- may be able to obtain shares in the company (via exercising the options) at a significant discount to ‘real’ market value which would generally include valuable intangibles ignored under the safe harbour valuation methodology; and
- are only taxed on the eventual disposal of the underlying share following vesting and exercise of the relevant options/rights.
In addition, provided that the combined holding period of options and the underlying shares (post-exercise) is more than 12 months, the relevant employee will generally be able to access the general 50% CGT discount (whereas ordinarily, exercising an option ‘re-starts the clock on the 12 month holding period rule in relation to the underlying share).
There are a number of conditions that must be satisfied, however, in order to qualify for an eligible start-up plan, including but not limited to:
- the strike price of the option must be at least equal to the underlying share price on the grant date (which, subject to separate eligibility criteria, could be determined using the safe harbour valuation methodology);
- the relevant company and all group entities are under 10 years old;
- the relevant company and all group members have total turnover of less than $50m;
- the options must relate to ordinary shares in the relevant company; and
- the particular employee-participant cannot hold more than 10% of shares in the relevant company on a fully diluted basis.
Other ESS plans
If, for whatever reason, the relevant ESS fails to qualify for the eligible start-up concession or none of the other structuring options under the ESS rules are suitable to all relevant stakeholders, other alternatives include:
- a limited recourse loan plan – where employees are issued shares in the company but are required to repay the full market value as at the subscription date over time (watch out for deemed dividend and FBT issues);
- a partly paid share plan – where employees are issued with share partly paid-up to a certain extent and who pay-up the shares to the full market value as at the subscription date over time (generally should not give rise to deemed dividend or FBT issues); and
- a phantom share plan – which isn’t a share plan at all but a right to a cash payment which usually tracks the increase in value of the shares in the company between set dates.
There are numerous issues to consider in relation to the design and implementation of an ESS.
The starting point is achieving the company’s commercial goals of incentivising key employees to kick major goals by tying business levers to individual KPI’s in a meaningful way so that all stakeholders benefit.
Other things being equal, from a tax perspective the start-up concession is the most beneficial to participating employees in that the relevant increase in value will generally be taxed at only half the rate of ordinary income (max. 22.5% instead of max. 45% excluding levies). However, if this is not available, it is a matter of designing a plan that strikes the right balance between achieving the company’s goals and not creating cash flow problems for participating employees.
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Disclaimer – this article does not constitute specific advice and cannot be relied upon as such.