Employee share schemes for early-stage companies: a short overview for employers and employees

Employee share schemes (ESS) allow businesses to provide employees an alternative approach to remuneration whereby they can offer discounted options or shares as a way to top-up an employee’s remuneration package, make a role more attractive and give an opportunity for the employee to participate in the success of their employer. However, if the rules which govern the ESS are not appropriately drafted, they can potentially lead to unfavourable tax implications for the employee, or diminish the benefits of the ESS itself.

Over the last decade, various changes to tax rules have been implemented to improve the attractiveness of implementing an ESS, including the provision of tax concessions in the form of a ‘start-up’ concession, tax-deferral arrangement, and a $1,000 assessable income reduction.

This article will provide a high-level overview of an ESS, a brief explanation of the tax concessions available and the conditions required to obtain such tax concessions

Overview of ESS and potential implications

An ESS allows a company to offer their employees options or shares in their enterprise, which are known as an “ESS interest” (ESS Interest). There are different ways a company may do this, including through seeking payment from the employee (e.g. salary sacrifice) or offering the shares at a discounted rate as a way to top-up an employee’s remuneration package.

An ESS can be particularly useful for startups and early-stage businesses wishing to attract highly-skilled employees to support the success and ambitions of the business without immediately impacting the cash flow of the business. Further, an ESS can be a useful incentive to motivate employees to drive business growth, with employees naturally wishing to increase the value of their options or shareholding in the business through the contributions they make or the length of time they spend with their employer.

There are, however, tax implications for an employee accepting an ESS Interest. Generally, if an employee accepts options or shares at a discount, the employee will be required to include the discount as part of their assessable income for that income year. This can be problematic for employees as they are required to pay tax on a financial benefit that they have not yet directly received, as either the shares have not yet been sold or the relevant options have not yet been exercised.

As this has the ability to hinder the practical utility of an ESS, various reforms and changes have been introduced to ensure ESSs remain an attractive option for employers to incentivise employees.

What ESS tax concessions are available?

There are three main ESS tax concessions available, being the:

• ‘start-up’ tax concession;
• tax-deferral arrangement; and
• $1,000 assessable income reduction.
  
  

Start-up tax concession

As noted above, an employee will generally be required to include any discount received from an ESS as part of their assessable income. However, if an employer is eligible for the ‘start-up’ concession, the employee is not required to include the discount on an ESS interest in their assessable income. Instead, the employee will only be required to report the option or shares received under an ESS as a capital gain, under the capital gains tax (CGT) regime, once the shares are sold or options are exercised. This is generally a more attractive method to assess income as the employee is only required to pay tax when they have sold their shares or exercised the option, and not when the interest is initially received (at which point those interests are usually illiquid).

Further, if the shares or options have been held for at least 12 months, a 50% CGT discount would be available.

To be eligible for the start-up concession, there are strict conditions which must be met for the employer and the employee as well as the terms of the ESS. These include:

• the employer must be an Australian resident company and the company (and its subsidiaries or holding companies) must;
• not be listed on any approved stock exchange;
• be less than 10 years old;
• not exceed $50,000,000 in annual turnover; and
• not be in the predominant business of dealing with share trading and investments;
• the employee must:
• be an employee of the company (or its subsidiaries) at the time of acquiring the ESS Interest;
• not beneficially own shares, or have a voting power, beyond 10% of the company upon acquisition of the ESS Interest; and
• hold the option or shares for at least three years (unless the employee is no longer working at the company);
• if offering shares, those shares must be:
• ordinary shares; and
• offered at no more than 15% of its market value at the date of issue; and
• at least 75% of the permanent employees who have completed at least 3 years of service and who are Australian tax residents are entitled to participate; and
• if offering options, the exercise price must be at a price that is greater than or equal to the market value of an ordinary share in the company at the date of grant.

Tax-deferral arrangement

If a business or employee is not eligible for the ‘start-up’ concession, the business may nonetheless offer shares (or options) in a manner that would allow the taxation to be deferred (i.e. so that it is taxed at a later point in time).

This is generally less useful than the ‘start-up’ tax concession as the employee may still be taxed on their shares (or options) before they have been sold (or exercised). However, it may still be preferable to the general tax regime in which the discount would be included as assessable income for the particular financial year the ESS Interest is granted.

Broadly, taxation of ESS interests may be deferred to a deferred taxing point if the following criteria are met:

• in respect of shares:
• there is a real risk of forfeiture; or
• the shares were acquired under a salary sacrifice arrangement for no consideration, the employee received no more than $5,000 worth of shares per income year and the rules of the scheme must state that deferred taxation applies to the scheme; and

• in respect of options:
• there is a real risk of forfeiture; or
• the scheme genuinely restricts the employee immediately disposing of the options and the rules of the scheme must state that deferred taxation applies to the scheme.

Whether or not an ESS interest is at real risk of forfeiture is highly dependent on the facts and circumstances of the scheme but may include where there are conditions relating to retention of the ESS interest are subject to, for example, high performance targets or forfeiture on cessation of employment.

The deferred taxing point is the earliest of (subject to a 30-day rule for the disposal of interests within 30 days of the deferred taxing point):

• for shares:
  • where there is no longer a real risk of forfeiture and no restrictions on disposal; or
  • 15 years after the employee acquired the shares; and

• for options:
  • where there is no longer a real risk of forfeiture and no restrictions on disposal;
  • 15 years after the employee acquired the options; or
  • when the employee exercises the options, and after exercising the options, there is no longer a risk of forfeiture and no restrictions of the disposal of those shares.

$1,000 assessable income reduction

Finally, under the $1,000 assessable income reduction, the employee may reduce their taxable income, as a result of their assessable income increasing due to the receipt of the ESS Interests, by $1,000, provided that:

• the employee:
• has not applied either the ‘start-up’ tax concession or tax-deferral arrangement;
• has an adjusted taxable income of less than $180,000;
• is an employee of the company (or its subsidiaries) at the time of acquiring the ESS Interest;
• does not beneficially own shares, or have a voting power, beyond 10% of the company upon acquisition; and
• holds the options or shares for at least three years (unless the employee is no longer working at the company);
• the company:
• offers the ESS (and any related loan facilities) on a non-discriminatory basis, being at least 75% of Australian resident employees (who have completed three years of service) are offered to take part in the ESS;
• is not in the predominant business of dealing with share trading and investments; and
• there is no real risk of losing the ESS Interest (other than by sale or option exercise / lapse); and
• if offering shares, the shares must be ordinary shares.

What's best for your business and employees?

There is ultimately mutual benefit for employees and employers in ensuring that any ESS offered is structured appropriately from a tax perspective. It is in the best interest of both parties, that the benefits of this form of remuneration are maximised.

If both the employer and employee are eligible, providing options or shares under the ‘start-up’ concession will provide the greatest value to an employee as it defers tax assessment until the point that the shares (or options) are sold or exercised and the employee will also be eligible for the 50% CGT discount if these are held for at least 12 months.

If an ESS is not eligible for the ‘start-up’ concession, depending on whether the ESS meets certain criteria and conditions, the employee may elect to defer their taxation or pay it upfront claiming a $1,000 reduction.

Whether a business or employee is eligible for any of the ESS tax concessions will depend on the particular circumstances for each business and/or employee.

Tax concession rules surrounding an ESS can be complex and highly dependent on the facts and circumstances surrounding each business.  Given the complexity, it is recommended  that employers seek taxation and legal advice if it is interested in offering an ESS, particularly so that it ensures the terms of its ESS are compliant with relevant tax law.

More information from Maddocks

For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Commercial team.

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