Employee share schemes (ESS) are a great concept. They aim to align the interests of employees with the interests of shareholders, producing better outcomes for both.
At one end of the business spectrum, employee share schemes are commonly utilised by listed companies. There is broad participation by employees, although the largest financial benefits do tend to fall to the most senior management.
At the other end of the spectrum are startups. Anyone in the startup space knows the concept of “sweat equity” and using shares or options to attract employees to a business without the cash to pay significant salaries.
The tax laws generally (but not always) work quite well in both these cases, aligning when a tax liability crystallises with when the employee realises a real financial benefit.
What about established private businesses?
Unfortunately there continue to be a number of significant impediments to implementing employee share schemes in private companies, and despite promises in the Federal Budget that “[t]he Government will make it easier for businesses to offer employee share schemes to provide more Australians with a share in the economic value they create through their hard work”, the situation is unlikely to change any time soon.
Why is this the case?
There are two key drivers of this issue – the private nature of these businesses, and tax.
As private businesses, there is no established market for the shares. So, unlike in a public company where shares can be sold through the ASX or equivalent, an employee in a private company has limited opportunity to sell the shares that they hold. This means they can’t realise the capital value that they help build.
Some industries are different. In professional services businesses there is often an established culture of management having ownership in the business, so new management level employees may be available to buy out shareholders who want to exit. More broadly across private businesses, this is unusual.
In most private businesses it falls to a major shareholder, often the founder, to bankroll the exit of employee shareholders. For good reason, most major shareholders are reluctant to do this.
The lack of an established market can also be overcome where a private business is building towards a liquidity event, such as a sale, as the liquidity event establishes the market. This is also what many start-ups are targeting.
Even if the issue of a lack of an established market can be overcome, there is still the issue of tax.
The tax policy underlying the employee share scheme provisions is that the employee has received property (shares or options) in consideration for performing their services as an employee, so the employee should be taxed on the value that they receive. The default taxing point is when the shares or options are issued to the employee, as it is from this point that they (theoretically at least) hold valuable property and derive benefits from it.
This is great in theory, but problematic in practice.
Dividend payments in private businesses tend to be inconsistent, and without an established market there is no ability to realise the capital value of the share. The employee may hold valuable property, but they may not derive any value from it for some time.
What are the potential solutions?
The ESS provisions provide for a deferred taxing point in some cases. However, designing an ESS to achieve this deferred taxing point, which is based on the design of the scheme and not an election by the employee, comes at a cost. All the capital growth up to the deferred taxing point is taxed as income rather than as a capital gain.
Another alternative is “loan-based plans”. Under this style of ESS, the employee receives a loan (usually from the company, but sometimes from a major shareholder or a bank) and uses the funds to subscribe for shares at market value. As the shares are acquired at market value, no amount becomes taxable under the ESS rules. Whether this type of plan will work for a private company depends on the circumstances. There are Corporations Law issues to manage, as well as Division 7A implications and FBT.
A further alternative is a “flowering share” arrangement. The employee is issued with a special class of shares that have limited rights, and so limited value. This arrangement deals with the up-front tax cost triggered in standard employee share schemes. Over time, usually based on different conditions being satisfied, rights progressively accrue on the share such that after a period it has the desired dividend, capital and voting rights. These arrangements can be complex to implement, and you need to be careful that in solving the tax issues you don’t take away the commerciality of the arrangement.
For many private businesses, implementing an effective ESS becomes too hard, so they settle on bonus style arrangements instead. This also presents an opportunity. So called “phantom share plans” are sophisticated bonus arrangements that provide a return to employees that mirrors what they would have received as a shareholder. The employee gets dividends and the capital uplift (really, the cash equivalent), but they don’t legally hold an equity interest in the business.
In the end, the right arrangement for a particular business will depend on the commercial objectives of that business. For private businesses that are prepared to invest the time and effort, an effective ESS is possible. However, for many private businesses a well-designed bonus arrangement will likely be a better approach.