New law gives a much need­ed boost to Employ­ee Share Schemes

What is an ESS?

An employ­ee share scheme (ESS) is a scheme under which shares or rights to acquire shares (options) in a com­pa­ny are pro­vid­ed to an employ­ee or their associates.

Why have an ESS?

An ESS is a way of attract­ing, retain­ing and moti­vat­ing staff because they align employ­ees’ inter­ests with share­hold­ers’ inter­ests. Employ­ees ben­e­fit finan­cial­ly if the com­pa­ny per­forms well. Phrased neat­ly by Mal­colm Ful­ton, invest­ment direc­tor at Starfish Ven­tures, share plans are “… key cur­ren­cy that peo­ple employ to keep high­ly tal­ent­ed peo­ple on board while con­serv­ing cash.”

This is all the more the case with start-up com­pa­nies, par­tic­u­lar­ly those in the tech­nol­o­gy sec­tor, where cash is sparse and tal­ent expen­sive. The prob­lem, how­ev­er, for the Aus­tralian start-up sec­tor before July this year was that com­plex rules and adverse tax con­se­quences ren­dered such plans, all but use­less leav­ing the Aus­tralian start-up sec­tor lan­guish­ing behind juris­dic­tions such as the US, EU and elsewhere.

What were the problems?

In essence, employ­ees who were grant­ed options or shares under an ESS would incur a tax lia­bil­i­ty, in the case of options, when the option vest­ed even if the employ­ee chose not to exer­cise the option and, in the case of shares, when the shares were no longer sub­ject to claw back. If the shares were issued at a dis­count, the tax lia­bil­i­ty of the share­hold­er would be fur­ther com­pound­ed. The amount assessed would be the mar­ket val­ue of the ESS inter­est at the deferred tax­ing point, reduced by the cost base of the interest.

On tak­ing gov­ern­ment, the Coali­tion elect­ed to redress the above and a num­ber of oth­er prob­lems asso­ci­at­ed with share plans, which had left them large­ly ignored, par­tic­u­lar­ly by the Aus­tralian start up sector.

What are the main changes for the start-up sector?

The key changes are:

  • for rights (options) — the tax­ing point will not be when the right can be exer­cised but will be deferred to the point at which the right is exer­cised and will be fur­ther deferred until the shares issued upon the exer­cise of the options are actu­al­ly sold;
  • for shares— pro­vid­ed they remain sub­ject to gen­uine restric­tions on sale for at least three years (in oth­er words, they are not able to be dis­posed of) the tax­ing point will be deferred until the shares are actu­al­ly sold.

Sig­nif­i­cant­ly, at the time of sale, Cap­i­tal Gains Tax will gen­er­al­ly apply.

In the case of shares, assum­ing they are issued at a dis­count (which can be no more than 15%) the dis­count will nev­er be taxed, as the gain for CGT pur­pos­es will be the sale price less the mar­ket val­ue of the shares when acquired.

In respect of options, the dis­count is not sub­ject to upfront tax but is effec­tive­ly deferred until the options are exer­cised and the result­ing shares dis­posed of, at which time the gain for CGT pur­pos­es will be the sale price, less the aggre­gate of the amount paid by the employ­ee to acquire the option and the exer­cise price.

Fur­ther­more, employ­ees will be enti­tled to receive 50% CGT relief if they have held the options and shares col­lec­tive­ly for at least 12 months, even when the shares they received on exer­cise have been sold by them with­in 12 months of exer­cise of their options.

Who can access the start-up concessions?

To be eli­gi­ble to access these tax con­ces­sions, the fol­low­ing require­ments must be met:

  • unlist­ed: the grantor com­pa­ny must be unlisted
  • 10-year incor­po­ra­tion: the grantor (and any oth­er com­pa­nies in the cor­po­rate group) must be incor­po­rat­ed for less than 10 years before the ESS inter­est is granted
  • $50 mil­lion turn over lim­it: the grantor must not have an aggre­gat­ed turnover of more than $50 mil­lion for the pri­or income year
  • no share trad­ing: the grantor company’s busi­ness must not involve share trading
  • ordi­nary shares: all shares that may be acquired under the ESS must be ordi­nary shares
  • Aus­tralian res­i­dent: the employ­ing com­pa­ny (which may or may not be the grantor/​issuer) must be an Aus­tralian res­i­dent taxpayer
  • 10% lim­it: no employ­ee may hold more than 10% of the shares in the com­pa­ny (includ­ing the shares that could be acquired by exer­cis­ing options/​rights held by that employee)
  • salary sac­ri­fice: the shares or rights acquired under the ESS via a salary sac­ri­fice arrange­ment (if applic­a­ble) must not exceed more than $5,000 worth of shares per income year under those arrangements
  • dis­count: in the case of shares, the dis­count pro­vid­ed must be no more than 15% of the mar­ket val­ue of the shares at the date of pur­chase — for options, they must have an exer­cise price (or strike price) equal to, or greater than, the cur­rent mar­ket val­ue of the ordi­nary shares (in oth­er words, issued at mar­ket val­ue or out of the mon­ey) in the issu­ing com­pa­ny at the time the right is acquired
  • min­i­mum hold­ing of 3 years: every acquir­er of an inter­est under the ESS must be oblig­ed to hold its inter­est for a min­i­mum of 3 years from the date of acquir­ing the option or the shares
  • 75% avail­abil­i­ty: in respect of share schemes, at least 75% of Aus­tralian res­i­dent per­ma­nent employ­ees” (with at least three years’ ser­vice) must be enti­tled to acquire ESS inter­ests in the employ­er (or hold­ing company).

These con­ces­sions are clear­ly a much need­ed boost for the start-up sec­tor and those who have dis­missed or placed on hold plans to intro­duce an ESS should now re-con­sid­er their posi­tion. The process is not com­pli­cat­ed and the ben­e­fits asso­ci­at­ed with align­ing the inter­ests of key staff with those of the share­hold­ers is some­thing not to be underestimated.