A growing business will often identify one or more key employees as instrumental in driving the business. These key employees will be a minority in number. In order to retain and provide incentives to these key employees, the founder may wish to provide an equity interest in the business. In doing so, a significant issue can be providing this equity in a tax effective manner.
Employee Share Scheme provisions – Current Law
When faced with this issue, the usual starting point is the specific Employee Share Scheme provisions, currently contained in Division 83A of the Income Tax Assessment Act 1997 (ESS). The main thrust of these provisions is to include in assessable income the discount to market value of the issue price of the interest (shares or options), as demonstrated in the following example.
Jim is the founder of Start-Up Pty Ltd, a company that has been in existence and trading for two years in the IT industry (the same principles apply for businesses in other industries – retail, manufacturing, distribution, professional services, biotechnology). The business has a current market value of $2 million. Jim has identified Peter as a key employee who has been instrumental in doubling the markets of the business in the last six months. Jim would like to issue a 10% equity interest in the business to Peter. His preference is to issue this equity for no consideration. He anticipates the business will be worth in excess of $6 million in five years’ time.
In this case, a 10% interest has a value of $200,000 with a preferred issue price of nil or $1. ESS operates to include the discount ($200,000) in Peter’s assessable income at the time of the interest’s issue. This is the case regardless of whether the interest is issued directly to Peter or to an associate.
It might be considered that a means of overcoming this issue would be to consider options with an exercise price equal to the current market value. This becomes beneficial to Peter where the value of the option grows with the value of the business. When the business grows to a value of $600,000, the option (subject to an exercise price payment of $200,000) would have a value of $400,000.
That said, the ESS applies complicated valuation methods to options. Where these methods are applied, an option issued with an exercise price equal to current market value, although not payable for a number of years, is considered to be issued at a discount.
In either case, the tax result is unsatisfactory to an SME. There is a triggering of a tax liability payable by the key employee for the year of issue of the interest.
Some advisers look at the ESS to provide a tax advantage, but the concessions are limited to:
- a discount of $1000 being excluded from assessable income; and
- deferral of the taxing event.
In addition, concessions are only available where the scheme is offered to at least 75% of permanent employees (referred to as the broad availability condition). This is a condition that is unsatisfactory to SMEs looking to benefit key employees (who are the minority in number).
Alternatives to overcome the Current Law
The ESS only applies where the equity interest is issued at a discount. An equity interest that is issued for market value is excluded from the operation of ESS. In that context, options to overcome the operation of ESS are:
- the Issue of shares at market value, combined with a suitable funding arrangement. The funding arrangement must address other tax issues, including Division 7A and FBT; and
- premium priced options drafted in such a manner that there is considered to be no discount on the issue of the option. The advantage is the employee will receive the benefit of capital growth above the premium.
Changes for Startups
On 14 October 2014, the government announced changes to ESS to benefit startups. The announcement included:
The Government will reform the tax treatment of Employee Share Schemes to bolster entrepreneurship in Australia and support innovative start-up companies.
Employee Share Schemes give employees a financial share of the company’s potential success. As such, they help start-up companies to attract and retain high-quality staff.
The Tax and Superannuation Laws Amendment (Employee Share Schemes) Bill 2015 (Cth) has now been introduced which provides the following concessions to start ups:
- Discounts will not be included in assessable income if less than 15%. In the example above, the discount will not be included in assessable income if the equity interest of $200,000 is issued at a price of $170,000;
- An issue of options at an exercise price equal to current market value will not be considered an issue of a discount and therefore will be excluded from the operation of ESS.
Importantly, the Startup concession for shares is subject to the broad availability condition, which is unlikely to be satisfactory for most Startups. However, the concession for options is not subject to this broad availability condition and therefore provides opportunities to allow the issue of equity in a manner that the key employee will benefit from future capital growth.
Whilst the provisions are stated to be for startups, the conditions are not so restrictive. The other key conditions are:
- the company, any holding company and any subsidiary of the group must not be listed on a stock exchange;
- each of the companies in the group have been existence for less than 10 years;
- aggregated turnover does not exceed $50 million;
- ESS relates to ordinary shares;
- there is a minimum holding period requirement of three years or the cessation of employment; and
- issue of equity interest of less than 10% interest.