By Domenic Festa (Accredited Tax Specialist and Chartered Tax Adviser)
Effective Date: 30 April 2015
A growing business will often identify one or more key employees that are considered instrumental in driving the business. These key employees will be a minority in number. In order to retain and provide incentives to these key employees, the founder may wish to provide an equity interest in the business. A significant issue is to provide the equity in a tax effective manner.
Employee Share Scheme provisions – Current Law
When faced with this issue, the usual starting point is the specific Employee Share Scheme provisions, currently contained in Division 83A of the Income Tax Assessment Act 1997. These provisions were initially introduced as an anti-avoidance provision to overcome planning arrangements that effected the issue of such an interest not being included in assessable income.
The main thrust of these provisions is to include in assessable income the discount to market value of the issue price of the interest (shares or options).
Example
Jim is the founder of Start-Up Pty Ltd, a company that has been in existence and trading for two years in the IT industry (the same principles apply for businesses in other industries – retail, manufacturing, distribution, professional services, biotechnology). The business has a current market value of $ 2 million. Jim has identified Peter as a key employee that has been instrumental in doubling the markets of the business in the last six months. Jim is looking at alternatives to issue a 10% interest in the business to Peter. His preference is to issue this equity for no consideration. He anticipates the business will be worth in excess of $6 million in five years time and sees the issue of equity as a mechanism to retain Peter in the business.
In this case, a 10% interest has a value of $200,000 with a preferred issue price of nil or $1. The Employee Share Scheme provisions operate to include the discount ($200,000) in Peter’s assessable income at the time of issue of the interest. This is the case, whether the interest is issued directly to Peter or to an associate.
It might be considered that a means of overcoming this issue would be to issue options with an exercise price equal to the current market value.
Employee Share Scheme provisions apply complicated valuation methods for options which have the effect that an option issued with an exercise price equal to current market value but not payable for a number of years is considered to be issued at a discount.
In either case, the tax result is unsatisfactory to an SME. There is a triggering of a tax liability payable by the key employee for the year of issue of the interest.
Limited concessions
Many advisers look at the Employee Share Scheme provisions as a means of providing a tax advantage. The reality is the concessions are limited – Excluding $1000 from assessable income and deferral of the taxing event.
In addition, concessions are only available if the offer is available to at least 75% of permanent employees (referred to as the broad availability condition). This is a condition that is unsatisfactory to SMEs looking to benefit key employees.
Alternatives to overcome the Current Law
Employee Share Scheme provisions only apply where the equity interest is issued at a discount. An equity interest that is issued for market value is excluded from the operation of ESS.
In that context, options to overcome the operation of Employee Share Scheme provisions are:
- Issue of shares at market value, combined with a suitable funding arrangement. The funding arrangement must address other tax issues, including Division 7A and FBT.
- Premium priced options which are drafted in such a manner that there is considered to be no discount on the issue of the option.
Changes for Start Ups
On 14 October 2014, the government announced changes to Employee Share Scheme provisions to benefit Start Ups. The announcement included:
“The Government will reform the tax treatment of Employee Share Schemes to bolster entrepreneurship in Australia and support innovative start-up companies.
Employee Share Schemes give employees a financial share of the company’s potential success. As such, they help start-up companies to attract and retain high-quality staff.”
The Tax and Superannuation Laws Amendment (Employee Share Schemes) Act 2015 gives effect to the government announcement providing the following concessions to start ups:
- Discounts on the issue of shares will not be included in assessable income if the discount is less than 15%. In the example above, the discount will not be included in assessable income if the equity interest of $200,000 is issued at a price of $170,000;
- An issue of options at an exercise price equal to current market value will not be subject to ESS;
- Where the issue of the interest satisfies the concessions for start-ups, there is no tax under Employee Share Scheme provisions on issue of the interest and gains on realisation are taxed under the CGT regime.
In the writer’s view, the broad availability condition is an obstacle to the utility of an Employee Share Scheme for Start Ups and SMEs. The philosophy behind the broad availability condition is outlined in the Explanatory Memorandum for the Start Ups concession at paragraph 1.59 as follows:
… this acts as an integrity rule that prevents employees from misapplying the concession in order to buy a business or indirectly access company profits through the ESS rules.
The writer considers these concerns are dealt with by the restriction that concessions under the Employee Share Scheme provisions require the interest acquired to not exceed 10%.
Importantly, the Start Ups concession for shares is subject to the broad availability condition, which is unlikely to be satisfactory for most Start Ups. However, the concession for options is not subject to this broad availability condition and therefore provides opportunities to allow the issue of equity in a manner that the key employee will benefit from future capital growth.
With the exception of the broad availability condition applying to the issue of shares, the Start Ups concession satisfies the objectives of the founder set out in the second paragraph of this article.
Other Conditions
Whilst the provisions are stated to be for Start Ups, the conditions are not so restrictive. The other key conditions are:
- The company, any holding company and any subsidiary of the group must not be listed on a stock exchange;
- Each of the companies in the group have been existence for less than 10 years;
- Aggregated turnover does not exceed $50 million;
- Employee Share Scheme relates to ordinary shares;
- There is a minimum holding period requirement of three years or the cessation of employment;
- Issue of equity interest of less than 10% interest.
Many SMEs that have been in existence for less than 10 years will be able to satisfy these conditions.
Partly Paid Shares
Some consider the use of partly paid shares as a means of addressing the Employee Share Scheme taxation issue.
Taking the facts set out in the Example above, an outline of the terms of issue of the partly paid shares that has been suggested is – Issue price of $200,000; $1 payable upon issue; the balance payable out of the whole or part of the dividends declared on the partly paid shares; entitled to dividends in proportion to number of shares held (rather than the standard under most constitutions – in proportion to the amount paid up on such shares).
The argument is the market value of fully paid shares is $200,000, the obligation of the employee is to pay $200,000 ($1 upon issue and the balance out of dividends declared), and therefore the employee is paying market value for the shares. The analysis suggests the market value of the partly paid shares on issue is $1, because there is an obligation to pay a further $199,999 respect of shares that have a fully paid value of $200,000.
The writer suggests the above technical analysis is flawed. The key question is: What is the market value of the interest issued? Utilising the basic definition of market value (the price agreed between a willing but not anxious buyer and a willing but not anxious seller), and assuming the company pays dividends at the rate of 10%, partly paid shares with an amount payable on issue of $1 and an entitlement to dividends of $20,000 per annum are considered to have a market value well above the amount of $1 payable on issue.
Key Points
- Employee Share Scheme causes adverse tax consequences for the issue of equity to key employees.
- Concessions in Employee Share Scheme provisions generally require that they be offered to at least 75% of permanent employees. This is not suitable to most SMEs.
- To overcome these adverse tax consequences, it is necessary to implement the equity issue in a manner that falls outside ESS.
- The proposed concessions for Start Ups provide an opportunity for SMEs in respect of the issue of options.