Tax me later – changes to employee share schemes
An employee share scheme (ESS) is a common way that companies, typically early-stage startups, attract and retain employees.
The Corporate Collective Investment Vehicle Framework and Other Planned Measures Bill 2021 (Cth) (Bill) has now passed Parliament and awaits Royal Assent.
The Bill, through tax concessions, aims to encourage entrepreneurs and founders who are considering starting new businesses.
What are employee share schemes?
An ESS is a scheme in which companies offer their employees shares or rights (e.g. options) to acquire shares (ESS Interest) in the company or one of its subsidiaries.
An ESS Interest is commonly gifted or sold to an employee at a discounted price, and may be subject to loan or salary sacrifice arrangements.
In the start-up space, ESS Interests are commonly offered as a performance bonus or in lieu of receiving a higher base salary. ESS arrangements benefit both employers and employees. Employers can attract and retain high performing staff, and employees can obtain ‘skin in the game’.
What are the current taxation arrangements?
Currently, employees are taxed when they receive an ESS Interest (a taxed-upfront scheme), or the tax is deferred to a later time under specific circumstances (a taxed-deferred scheme). To be able to defer tax, both the scheme and the employee must meet the general conditions as well as the specific conditions for each type of tax-deferred scheme.
In a “taxed-upfront scheme”, the employee is taxed on the discount they receive in comparison to the market value of the shares at the time they are acquired. The discount must be included in the employee’s assessable income for that income year, which can create a significant tax liability for the employee.
On the other hand, the taxing point in a “tax-deferred scheme” is the earliest of the following events:
when there is no real risk of forfeiture and no restriction on disposal of the ESS Interest;
when the employee ceases their relevant employment; and
15 years after the ESS interests were acquired.
Issues with the current taxation arrangements
The current legislative framework in Division 83A of the Income Tax Assessment Act 1997 (Cth) (Tax Act) generally results in a mismatch between when an employee is liable for tax, and when an employee could obtain proceeds from their ESS Interests to pay that tax liability.
As a result, departing employees may face the prospect of being forced to sell some or all of their ESS Interests to fund their tax liability. This, of course, assumes there is a market for the employee’s ESS Interest, which may not be the case.
What is changing?
Schedule 10 of the Bill amends the Tax Act to remove cessation of employment as a taxing point in a tax-deferred scheme.
Under the changes, ESS interests in a tax-deferred scheme would instead be taxed upon the earliest of the following events:
when there is no real risk of forfeiture and no restriction on disposal of the ESS Interest; or
at the end of the 15-year period following the acquisition of the ESS Interest.
What this means for you
The removal of cessation of employment as a deferred taxing point is a welcome change.
Once the Bill receives Royal Assent, as an employee, you may be able to retain your ESS Interests and not be forced to dispose of some or all of your ESS Interests when you cease employment in order to cover a tax liability. Having not being taxed at the time of cessation of your employment, cash flow may be freed up for future ventures (e.g. to start a new business).
For employers, the planned reforms would likely delay any valuation of the departing employee’s ESS Interests, particularly at a time when the value may be indeterminable or not meriting a costly valuation.
Employers and employees alike should ensure that ESS arrangements are established correctly from the beginning to ensure that interests are aligned.
Our team at Henry William Lawyers has a broad range of experience advising founders of businesses on a range of issues that arise throughout the business life cycle, from early inception through to listing on ASX.