ESS Tax Inquiry: an opportunity to encourage employee share scheme participation in Australia - Corporate Tax

The Australian Government is in the midst of an inquiry into employee share schemes. The inquiry presents an important opportunity for government to examine the overall effectiveness, impact and shortcomings of Australia's employee share scheme tax rules.

Employee share schemes, including employee share plans and option plans, allow employees to participate in the success of the company they work in. However, they can also be an important part of the remuneration structure for employers with cash flow pressures. As such, many employers may start to contemplate such arrangements, not just because of the inquiry but in light of the current challenging environment created by COVID-19.

Background to the inquiry

The government introduced changes in 2015 which were designed to improve the employee share ownership model to help incentivise employees and give them a sense of co-ownership.

As part of this, the government also sought to improve the model to bring option tax treatment more in line with global practice, including to ensure there was no up-front taxation of options. It increased the maximum deferral period—the taxing point—to 15 years. Taxation for options was changed so that the taxing point was generally limited to the time that the employee has exercised the option and any disposal restrictions have been lifted.

Those changes were designed to ensure that employees only have to pay tax when they actually have some value that they can realise.

Five years later, the House of Representatives Committee on Tax and Revenue will consider the impact of the 2015 changes and what other jurisdictions are doing.

Overview of Australia's ESS tax regime

Unlike schemes in other countries, Australia's rules generally do not allow for qualifying plans to be taxed at rates lower than regular employment income. Australia's ESS tax rules only provide tax rate reductions for Australian 'start-up' companies. These are narrowly defined to include companies which are not listed on any stock exchange, have been incorporated for less than 10 years and have an annual turnover of less than $50 million (the start-up rules are discussed further below).

Outside of the start-up concessions, Australia's rules create timing problems, unnecessary valuation requirements and discrepancies that can result in prohibitive complexity for employers. The result is a tax model that can lead to a positive disincentive on using employee schemes to incentivise employees.

Tax timing and rates

The legislation generally seeks to align the time of taxation to the time at which the employee exercises the options or rights and any disposal restrictions have been lifted.

Where the shares are relatively liquid, employees often need to sell some of those shares to pay the tax. Having to sell shares to pay tax is contrary to the stated objective of trying to align the interests of employees and shareholders.

If an employee ceases employment at an earlier time, and does not forfeit the options or rights, he or she will generally be taxed at the time of cessation of employment.

Employees can be taxed even if the plan relates to illiquid shares in an unlisted private company. This can result in cash flow issues for employees when funding the tax liability and valuation requirements for employers for determining the amount subject to tax.

At the taxing point, the employee is generally subject to taxation on the market value of the discount received on options or rights, and at the same marginal rates that apply to employment income. Subsequently, the employee may be liable for capital gains tax on and increase in share value. Only this latter component of the gain is eligible for a 50% capital gains tax discount, and only if the shares have been held for at least 12 months after exercise of option or rights (which is a timing requirement that may not be satisfied if the employee must sell shares to fund a tax liability).

Start-up company concessions

Share plans and option plans offered by start-up companies are not subject to separate taxation under ESS rules but are subject to capital gains tax, and only upon sale of underlying shares (i.e. not on grant or exercise). This means that the total discount and any further uplift in share value is generally taxed at a lower effective rate as the employee is likely to be eligible for a 50% CGT discount if the award is held for at least 12 months after grant.

One of the impediments to widespread use of the start-up concession is that it does not apply to individuals that own 10% or more of the shares in the company. This means that the founders of most start-up companies are not granted concessions, and are subject to tax upfront at the time that an option or share award is granted. In addition, there are rules about the permitted issue price or exercise price and a minimum three year holding period unless employment ceases earlier.

International competitiveness and simplicity

Over the past several years, there has been an internationally competitive environment for talent and there is every indication that this will return once economic conditions stabilise. Many jurisdictions offer concessionary qualifying share or option plans but these locations are not tax havens, they are mainstream OECD members with more favourable regimes than in Australia.

The Australian rationale for limiting tax-favoured status to certain employees of local start-ups is not clear, particularly since Australian employers face other challenges in retaining people with advanced technical abilities and talents from a global market for that type of talent.

In our experience the existing model leads to many companies introducing more complex structures, such as plans which include limited-recourse loan arrangements to deal with some of the cash flow issues described earlier. However, given their complexity, these arrangements are often only made available to a small number of senior and financially sophisticated employees.

Where to from here?

If the Government's objective is to encourage wider participation in share and option incentives, the tax regime should permit a broad range of employees of a company to participate in plans which have simple plan terms and simple tax consequences, and which achieve competitive tax outcomes comparable to international jurisdictions. The existing start-up concessions go a long way towards achieving this, so there would be merit in extending universally the treatment that currently only applies to Australian start-up companies.

The inquiry is currently seeking submissions from the public. Corrs is interested in hearing feedback in relation to the current Australian employee share scheme tax rules, including your company's thoughts and experiences with the tax regime and how it compares with rules in other jurisdictions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.