By Peter Feros, Andrew Sharp and Mack Wan
On Wednesday 14 January 2015, the Minister for Small Business announced the release of Exposure Draft legislation and regulations containing amendments to the taxation arrangements of Employee Share Schemes (ESS) previously announced in October 2014.
The stated aim of this proposed law is to support innovative start-up companies in Australia, and to improve the taxation arrangements for ESS to be more internationally competitive. The existing rules, introduced by the then Rudd Government in 2009, have been criticised for taxing participants on value often well in advance of the possibility of that value being realised.
As a package, the exposure draft legislation is broadly in line with Treasury’s announcements on the rules, with key amendments included as part of the new exposure draft legislation being:
Options taxed on exercise, not vesting
Perhaps the most significant amendment to ESS rules (and one with potential application to all option plans, not just those implemented by start-ups) is that employees issued with options at a discount to market value will generally be expected to have their taxing point deferred until they exercise the option (rather than when there is no real risk of forfeiture of the option, as is the case under current law). This is a welcome change, as it alleviates the current problem of unrealised gains for employees, who can be taxed well in advance of liquidity of their investment.
However, except in the case of start-ups (discussed below), the ESS rules will continue to tax participants on value at their marginal tax rates, which is often double the effective tax rate that an equity holder can expect on a gain they make on their equity when taxed under the capital gains tax (CGT) rules.
The maximum deferral point for taxation of the discount for both shares and options will also be increased from 7 to 15 years.
Further tax concessions for employees of certain start-up companies
Employees of Australian start-up companies that receive certain shares or rights at a small discount to market value under an ESS will have their equity taxed under the CGT rules (with potential discount capital gains treatment), rather than have the discount included in their assessable income. For shares acquired under such a plan the employee's cost base in their shares will be set at market value, whereas for rights, the employee's cost base will be equal to the employee’s cost of acquiring these rights.
Broadly, the following conditions must be satisfied in order for the tax concession for start-up companies to apply:
- The discount provided on a share must be less than 15% of the market value of the share when acquired, and in the case of a right, its exercise/strike price must be greater than or equal to the market value of an ordinary share at the time the right is acquired.
- The company must be unlisted.
- The company must have been incorporated less than 10 years before the share/right was acquired. Further, all companies in the corporate group also need to have been incorporated less than 10 years before the acquisition date.
- The company is required to have an aggregated turnover not exceeding $50m for the income year prior to the income year in which the ESS was acquired.
- The employing company (which may or may not be the issuing company) must be an Australian resident taxpayer.
- The existing minimum holding period and broad availability conditions must be satisfied.
While these are welcome changes for start-up companies, not all start-ups will be in a position to impart the benefits of these rules to their employees. Specifically, start-ups that have received sponsorship from venture capital may find that their aggregated turnover exceeds $50m when calculated by reference to other portfolio companies of the same venture capital fund. From a policy perspective, it would appear that there should be no reason to prevent start-ups that have received sponsorship funds (including from, for example, sponsors within the early-stage venture capital limited partnership regime) from relying on these concessions, and industry participants are urged to make a submission to Treasury on this issue.
Relaxing the significant ownership and voting rights limitation
The significant ownership and voting rights limitation, pursuant to which an employee who holds a significant stake in the issuer of the equity is ineligible for tax deferral, will be relaxed from 5 per cent to 10 per cent of the effective ownership or maximum voting rights of the employer. In determining the employee’s effective ownership and voting rights, the holdings the employee could obtain by exercising rights they have over shares in their employer (regardless of whether those rights are ESS interests acquired under an ESS or not) and the holdings of their associates must be taken into account. Under current law, such rights are not taken into account.
Amending rules on refund of income tax for forfeited shares and rights
The new ESS rules will entitle an employee who was taxed upfront on the discount on their interest, in circumstances where the employee had no choice but to forfeit their interest (except when that choice was to cease employment) and where the conditions of the scheme were not constructed to protect the employee from market risk to apply for a refund of the tax suffered up front.
Introducing new powers for the Commissioner to approve safe harbour valuation methods to improve certainty and reduce compliance costs in maintaining an ESS
Under the proposed rules, the Commissioner has been granted new powers to approve a method for determining the market value of an asset or non-cash benefit for income tax purposes. The Explanatory Memoranda provides that the ATO will "work with industry to develop and approve safe harbour valuation methods to improve certainty and reduce compliance costs in maintaining an ESS".
Updating the tax valuation tables which are used to determine the value of options for tax purpose
In order to reflect current market conditions, the safe harbour option valuation tables in the regulations (currently based on a modified Black-Scholes calculation) will be amended. Also, as part of the Board of Taxation’s recommendation in 2009-10, the following assumptions used to update the tables have also been inserted:
- Risk-free interest rate – 4%
- Dividend yield – 4%
- Volatility – 12%
Written submissions to the Federal Treasury for the Exposure Draft legislation closes on 6 February 2015, with the expectation that the proposed amendments will have application for ESS interests issued on and from 1 July 2015.