Recent and ongoing changes to the taxation treatment of employee share and option schemes have fundamentally altered the optimum structuring of such schemes.
The Federal Budget on 12 May 2009 announced substantial amendments to the income tax treatment of future participants in employee share and option schemes.
As part of the Government’s policy to cut back certain business related tax incentives, the major tax concessions applying to such schemes were removed or narrowed.
In response to widespread concerns that the reforms had the effect of nullifying the benefits of nearly all employee share and option incentive schemes operating in Australia, the Federal Government released a Consultation Paper on 5 June 2009, proposing that the reforms be modified to have less impact on legitimate tax incentives for such schemes. This has been followed up in a Press Release and Policy Statement by the Assistant Treasurer. The Policy Statement takes immediate effect and sets out the final position for the taxation of employee share and option schemes.
Prior to the reforms, employee share and options schemes structured as ‘qualifying schemes’ and fulfilling certain prescribed criteria, enabled participating employees to qualify for one of two tax concessions available under Division 13A of the Income Tax Assessment Act 1936.
Broadly, the discount in relation to the shares or options acquired by a taxpayer was included in the taxpayer's assessable income. Generally, the discount was calculated as the difference between the market value of the security and the consideration paid to acquire it.
The discount was assessed as follows:
- The employee could make an election to be assessed in the income year the securities were acquired but with a reduction of tax payable on the discount up to $1,000; or
- If no election was made, taxation was deferred on the discount for up to 10 years, so it would be included in the employee's assessable income in a later year of income (such as when the employee disposed of the share).
In the Budget proposals, the first concession was restricted to only apply to employees with adjusted taxable incomes of less than $60,000 and the second was abolished. This proposal has since been amended by the subsequent Policy Statement followed by an Exposure Draft of legislation, which applies to all securities issued on or after 1 July 2009.
Under the Policy Statement the two alternative concessions referred to above have been retained but modified as follows:
Upfront tax exemption
The upfront tax exemption of $1,000 will be available to taxpayers with an adjusted taxable income of less than $180,000. This threshold was chosen to align with the top marginal tax rate threshold and to address the concern that the measures announced in the Budget would have a broader crippling effect on the viability of many legitimate employee share and option schemes, including those servicing middle income earners.
Tax deferral concession
‘Real Risk of Forfeiture’
The tax deferral concession has been narrowed to apply only where there is a real risk that the shares or options may be forfeited (for example, due to performance hurdles or employment conditions). Taxpayers receiving benefits under these schemes will not be able to pay tax upfront and the scheme’s rules must distinguish these schemes from those eligible for the upfront tax exemption.
Taxpayers with interests up to a value of $5,000 in certain salary sacrifice based schemes can also defer taxation where there is no real forfeiture risk.
The Deferred Taxing Point
The point to which taxation can be deferred has been moved. For shares, the taxation point is deferred until the risk of the taxpayer losing the share is minimal and no restriction prevents disposal (such as escrow). For options the same test applies, but if there is a real risk of forfeiture or restrictions on disposal in relation to the shares issued on exercise of the options, the taxation point is deferred until after those conditions cease.
The existing law requiring that employees be taxed when their employment ceases continues to apply. However, from 1 July 2009, the maximum deferral period has been reduced from 10 to 7 years.
The Policy Statement established a mechanism for further industry consultation and review by the Board of Taxation to address outstanding reform issues, including:
- how to determine the market value of scheme benefits;
- whether shares and options provided by start-up, R&D and speculative companies should be subject to a tax deferral arrangement, despite not being subject to a real risk of forfeiture; and
- an Exposure Draft of the legislation.
On 24 July 2009, Assistant Treasurer, Senator Nick Sherry gave a press release setting out the timeline for final industry and Board of Taxation consultation on outstanding reform issues. The timetable included:
- a two-week consultation period on the draft Exposure Bill;
- a Board of Taxation consultation on technical issues to report to the Assistant Treasurer within approximately one month of the release of the draft Exposure Bill; and
- a comprehensive Board of Taxation review on two further substantive issues to report to the Assistant Treasurer by 28 February 2010.
The Government intends to consider the legislation to implement these amendments during the Spring sittings of Parliament, which commenced on 11 August 2009.
The draft Exposure Bill for the proposed legislation was released on Friday, 14 August 2009. The closing date for submissions on the exposure draft was Monday, 31 August 2009.
- All existing employee share and option schemes should be reviewed to ascertain whether they are still appropriate given the changes.
- Employees who hold shares or options under existing schemes should be advised that the changes will not affect them. Employees should be advised of the implications for new shares or options being issued in schemes under the new rules.
- The Policy Statement reforms reduce the risk that potential participants will opt out of schemes due to their inability to afford upfront tax on securities from which no income can be generated until subsequent years, if at all.
- A concern remains over the uncertainty of the upfront tax exemption, where employees cannot ascertain at the time of acquiring securities whether their adjusted taxable income will be below the threshold.
- Terms of employee share and option schemes should be clear in distinguishing between schemes which are eligible for the upfront tax exemption and those which qualify for tax deferral.
- For all schemes the question of how to value the market value of scheme benefits will be important to enable employees to properly understand their potential liability for tax.
Lavan Legal has substantial experience in structuring and advising on employee share and option schemes.