Setting up an employee share scheme (ESS) or employee stock option plan (ESOP) to attract, retain and incentivise staff is valuable to many Australian businesses. It’s also beneficial to the numerous international businesses that expand their operations into Australia and employ members of our highly skilled workforce. Here we explore the tax implications of establishing an effective ESS or ESOP that aligns company and employee interests.
Basic ESS and ESOP tax provisions
Broadly, an employee is taxed up front on the discount to market value they receive on options or shares issued to them under an ESOP. For example, if an employee is given options with a market value of $100k for no consideration, that employee will usually be required to include that $100k in their assessable income. In Australia, the highest individual marginal tax rate is currently 47% (inclusive of all levies).
Employees that receive shares in a listed company can usually fund their tax liability by selling a portion of those shares. However, this is much more difficult in non-listed company settings as there is usually no tradeable market for those securities which means that being taxed upfront on an illiquid asset is generally quite undesirable. In these situations, tax should be a key consideration when setting up the employee stock option plan in order to defer the taxing point until a later point in time, such as a liquidity event.
Importantly, from an Australian income tax perspective, where options are issued to employees with an exercise price or strike price equal to the market value of the underlying share on grant date (e.g., as used in many 409A valuations), this can still constitute a discount to market value and be subject to Australia’s income tax provisions.
The ‘startup concession’ was introduced in 2015 to overcome the hurdle of the taxing point not being aligned with a liquidity event. Under the concession, Australian employees are only taxed on the options or shares they receive under an ESOP upon a sale or disposal of those options or shares.
Further, any gain on sale of those options or shares would be on capital account, meaning that provided the employee held the options or shares for more than 12 months, the 50% Capital Gains Tax discount would generally be available to halve the amount of the taxable gain.
There are various conditions that must be satisfied for the options or shares to qualify for the startup concession and a discussion of these is outside the scope of this article. However, one condition multinationals should keep in mind is that the Australian staff must be employed by an Australian company (i.e., those individuals cannot be employed or contracted directly by the overseas company).
Where the startup concession is not available, in many cases the business would look at setting up an ESOP that qualifies for ‘tax deferral’. Broadly, this means that instead of the employee being taxed on the issue of the options or shares upfront, taxing is deferred until a later point in time, and will usually occur when the options or shares vest, the employee exercises the options to acquire shares or the employee sells the options or shares.
Importantly, under a tax deferral employee stock option plan, the employee would include in their assessable income the discount to market value of the options or shares at the deferred taxing point, not the discount to market value at grant date.
Further, the tax deferral provisions are broad in their application, and it is crucial that businesses obtain the proper tax advice to ensure the ESOP is not set up in a way that inadvertently ‘crystallises’ a taxing point for their employees. For example, the following could result in a taxing event:
- An employee transfers their options or shares to a related party, such as a spouse or family trust.
- An employee exercises their options and acquires shares.
- A trading window that allows employees to dispose of their options or shares.
The mere existence of any of the above provisions could result in a taxing point for the employee, even if the employee does not actually take any of these actions to dispose of their shares.
Other types of employee share schemes
We have touched on two of the more common types of employee share schemes – the startup concession and tax deferred – but there are various other types of arrangements that could be implemented, each with its own merits. The most suitable arrangement will depend on the key drivers for your business. Please contact William Buck or your tax advisor for more information on the other types of ESS or ESOP.
At the outset it was noted that tax is often a key driver in setting up an effective ESOP due to the potential cashflow burden on employees arising from the mismatch in timing between a liquidity event and taxing point.
Besides tax, there are various commercial drivers that will impact how the ESOP is structured. For example:
- How much of the company’s capital table should be set aside for the ESOP?
- Which employees should participate in the ESOP?
- How many shares should each employee receive?
- What about contractors and other advisors to the business?
- What are the vesting conditions and exercise periods for options?
- What rights should be attached to the shares?
- When can employees sell their options or shares?
- What happens in an exit event?
- What happens to the options or shares if an employee leaves the business?
The answers to these questions will be different for each business and so implementing an ESOP is generally a three-way conversation between the company board, the tax advisor and the lawyer. The company will communicate its ideal parameters, the tax advisor will structure the scheme, having regard to commercial and tax considerations, and the lawyer prepares the documents and advises on any Corporations Act disclosures and reporting obligations.
Finally, businesses should be aware that there are various other issues that require consideration before implementing an employee share scheme, for example:
- Choosing an appropriate valuation methodology (e.g., professional valuation, recent capital raise, Black-Scholes model)
- Annual reporting requirements with the Australian Taxation Office
- Payroll tax reporting requirements
- Workers’ Compensation reporting requirements
- Accounting implications, especially if preparing General Purpose Financial Statements
- Deductibility of intercompany charges and management fees in relation to the ESOP, and
- Corporations Act disclosures and reporting obligations.
There is no one-size-fits-all approach to setting up an ESOP. Each business has its own unique requirements and commercial drivers, and an ESOP needs to cater for those. Tax implications should be considered when establishing any ESOP that is effective and aligns company and employee interests. Contact your local William Buck tax advisor to find out more about how to establish a tax effective employee share scheme in Australia that aligns with your business.