Companies that are the targets of  mergers and acquisitions activity often make payments to employees to cancel their entitlements under employee share and option schemes.  The Federal Court in Clough Limited v Commissioner of Taxation [2021] FCA 108 recently ruled that these payments are not deductible to the payer.  Buyers and targets alike may need to adopt other ways to deal with such employee entitlements.

Clough Limited v Commissioner of Taxation - The background

The taxpayer (Clough) had implemented an option plan (Option Plan) in 2009 and an incentive plan involving performance rights (Incentive Scheme) in 2012.  Clough’s majority shareholder, Murray & Roberts, acquired all of Clough by way of a scheme of arrangement in 2013.

The Option Plan and the Incentive Scheme broadly provided that, in the event of a change in control, the Board had a discretion to allow the options to vest immediately (in the case of the Option Plan) or participating employees were entitled to be issued with shares (or cash equivalent) (in the case of the Incentive Scheme).

To facilitate the acquisition, Clough cancelled employees’ entitlements under the Option Plan and Incentive Scheme and paid them cancellation amounts.

Clough claimed that the amounts were deductible in full in the year ended 30 June 2014, when they were paid.  The Commissioner, on the other hand, allowed the deductions over 5 years under section 40-880 of the Income Tax Assessment Act 1997 (Cth) (the blackhole deduction).  The dispute in the case was one as to timing.  However, whether the Commissioner’s approach was correct remains open as the Court did not have to decide this.

The decision by Colvin J

In a blow to Clough, the Court held that the payments were neither:

• Incurred “in gaining or producing assessable income”; nor
• Necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

These are the so called “positive limbs” of the test for deductibility of a loss or outgoing.

The Court held that the amounts were paid to fulfil an obligation that arose upon the change of control in Clough.  Relevant to the Court’s decision were:

• There was no evidence that the amounts were paid for past performance of employees.  Instead, the payments were calculated on the basis of the value of the accrued rights taking into account the prevailing share price and without any assessment of the value of past performance.
• The evidence indicated that it was considered there was an obligation to pay out the accrued entitlements of the employees even though neither the Option Plan nor the Incentive Scheme required options and performance rights to be paid out in full on a change of control.
• Clough intended to establish new incentive schemes for its employees following the change in control, supporting the conclusion that the payments were not made to retain or incentivise employees for the future.
• It was difficult to see how the unconditional termination of the Option Plan and Incentive Scheme by making large cash payments to employees would incentivise them to remain in the employment of Clough.  Instead, employees would be freed to decide as to whether or not to stay with Clough following the change in control.

Section 40-880 and other considerations

Section 40-880 allows a deduction over 5 years for capital expenditure associated with a taxpayer’s business.

The Court did not have to consider the application of section 40-880 given the Commissioner had already accepted that it applied.  The Court also did not need to consider whether the payments were capital in nature (one of the negative limbs of the test for deductibility, but a necessary element for section 40-880 to apply).

Different tax outcomes arise for the payer depending on the way the options and performance rights are dealt with:

• If the options and performance rights had been allowed to vest and shares issued to employees, with those shares then being acquired under the scheme by Murray & Roberts, the payments by Murray & Roberts would have been capital in nature and not deductible under section 40-880.  Instead, they would have formed part of the cost base of Murray & Roberts’ shares in Clough.
• If the options and performance rights had been allowed to lapse, employees may not have suffered any adverse tax consequences and no payments would have been made by either Clough or Murray & Roberts, with no tax implications for them.
• If the options and performance rights had been replaced by similar interests by Murray & Roberts (as seems to have been in contemplation), employees may not have had a taxing event and no payments would have been made by either Clough or Murray & Roberts, with no tax implications for them.

Key takeaways

Option cancellation payments are not the only way to deal with options and performance rights in a mergers and acquisitions transaction.  Different commercial and tax outcomes arise for both payers and employees.  Both targets and acquirers should determine what strategy is in their and their employees’ best interests.