ESS Act set to remove red tape 10 min read
The recently passed Treasury Laws Amendment (Costs of Living Support and Other Measures) Act 2022 – Schedule 4 (the ESS Act) is set to significantly decrease red tape for startups that issue options or shares to employees, contractors or directors as part of an employee share scheme (ESS).
These major reforms are poised to remove a number of impediments for proprietary companies seeking to attract and retain talent – something the startup community has, for many years, been calling for to help keep Australian talent onshore. This Insight analyses the key features of the new legislation and the associated benefits for eligible startups and other proprietary companies.
Key takeaways
- The ESS Act has now been passed by both Houses of Parliament. Royal Assent was received on 31 March 2022 and the new laws will come into force on 1 October 2022.
- Until the ESS Act comes into effect, a startup offering options or shares to all or most new starters may find itself running up against the 20 non-exempt offers limit, and unable to utilise an exemption from the requirement to produce a disclosure document. Under the ESS Act, relief will be available to companies that implement an eligible scheme.
- To access regulatory relief, an ESS must meet certain criteria. The requirements differ depending on whether or not the participant is required to pay for their securities (including upon exercise of an option).
- The ESS Act is the second stage of an overhaul of ESS arrangements for Australian companies. The first stage addressed issues with the taxing of certain ESS interests. Under the ESS Tax Act, cessation of employment will no longer be a taxing point when it occurs on or after 1 July 2022.
Current disclosure obligations
Before the introduction of the ESS Act (and until it becomes effective), unless a relevant exemption applies, offers of shares or options to investors or employees in Australia required preparation of a disclosure document (such as a prospectus or offer information statement), which must be lodged with ASIC.
To date, to avoid the application of the requirement to produce a disclosure document, the most commonly relied upon exemptions for offers made to employees have been, at a high level, as follows:
- that the offer is made to an employee who is also a 'senior manager' (ie a senior executive in a corporation who is concerned with its overall management); or
- the small scale offering exemption, which requires that, in any 12-month period:
(i) in relation to offers received in Australia (excluding other exempt offers) there are no more than 20 acceptances; and
(ii) the amount raised (in relation to those offers) does not exceed $2 million in total.
In limited circumstances, a proprietary company has also been able to rely on ASIC class order relief when issuing shares or options to employees (Class Order 14/1001). However, for unlisted companies, this relief has had very restrictive application (among other things, it is limited to offers made that exceed no more than A$5,000 in value per participant per year).
A fast-growing startup that offers options to all or most new starters as part of its employee incentive structure may quickly find itself running up against the 20 non-exempt offers limit each year, and without the ability to utilise an exemption from the requirement to produce a disclosure document (preparation of which is often not feasible for a startup).
Relief under the ESS Act
At a high level, if the requirements under the ESS Act are met, the following regulatory relief is available to companies that implement an eligible scheme:
- the existing disclosure requirements (eg the requirement to produce a prospectus) under the Act do not apply to offers under the scheme;
- the scheme can be operated without an Australian financial services licence;
- general financial advice can be provided in relation to the scheme without an Australian financial services licence;
- the restrictions on advertising and hawking securities and financial products in the Corporations Act 2001 (Cth) (the Act) do not apply to the scheme; and
- the design and distribution obligations do not apply to the issue, sale or transfer of interests under the scheme.
The fact that a company makes an offer for an ESS interest under these new laws does not prevent it from also making an offer that complies with the existing (and still in force) disclosure requirement exemptions under the Act.
ESS tax overhaul
The ESS Act is the second stage of an overhaul of ESS arrangements for Australian companies. The first stage of amendments addressed issues with the taxing of certain ESS interests and was passed on 10 February 2022 (the ESS Tax Act). Currently, if an employee holds an ESS interest that is subject to tax on a deferred basis (but not including an ESS that satisfies the criteria for the startup tax concessions) and they leave their employment before those interests have otherwise been taxed, they will have to pay tax on their ESS interests. This is problematic for many companies that can't access the startup tax concessions, as employees who leave the business and retain their ESS interests have a tax liability even though their ESS interests are not able to be monetised (eg because there's no associated sale event).
However, cessation of employment will no longer be a taxing point where the relevant cessation of employment event occurs on or after 1 July 2022. Instead, that employee will have to pay tax at the next relevant taxing time (which usually coincides with the vesting or exercise of the interest, or the lifting of disposal restrictions).
ESS Act – high-level summary
1. Application to offers or grants of ESS interests that do not require a participant to pay for their securities (including upon exercise of an option – ie no exercise price)
An offer under an ESS must be for the issue, sale or transfer of ESS interests of a company or registered scheme to ESS participants.
ESS interests for an unlisted company are:
- a fully paid share; or
- a unit in, an incentive right, or an option to acquire, a fully paid share.
ESS participants are a director, employee or service provider of the company.
The offer must not require the ESS participant to provide monetary consideration for the issue or transfer of the interests to qualify for regulatory relief as a 'no payment to participate' ESS.
If the offer is for options or incentive rights, no monetary consideration is to be provided on the exercise of the options or rights.
An offer document must be provided at the point of offer for an offer of options or incentive rights.
The offer must be expressed to be made under Division 1A of Part 7.12 of the Act.
There are also specific requirements for trusts issuing or transferring ESS interests that need to be complied with.
These include:
- the activities of the trustee must be limited to managing employee share schemes of the company;
- the trustee must not charge fees for administering the trust, other than reasonable disbursements or amounts charged to the company or responsible entity;
- where the trustee is an associated entity, the trustee may only exercise voting rights associated with ESS interests in accordance with the instructions of the holder of the interests; and
- the trust must contain terms that meet any prescribed regulatory requirements.
2. Application to offers or grants of ESS interests that do require a participant to pay for their securities (including upon exercise of an option)
An offer under an ESS must be for the issue, sale or transfer of ESS interests of a company or registered scheme to ESS participants (further details as set out above).
The ESS interests must be offered for issue or sale in return for monetary consideration, and the interests will be acquired by the ESS participant who pays for the interests.
The offer must comply with the issue cap.
An offer complies with the issue cap if the sum of the two below numbers do not exceed the specified percentage of interests actually issued by the body:
- the number of interests that may be issued, directly or indirectly, as a result of the offer; and
- the number of interests that have been issued, or could be issued as a result of previous offers, in connection with an employee share scheme made during the previous three years.
The specified percentage is:
- 5% for listed companies; and
- 20% for unlisted companies,
(unless otherwise specified by the regulations or the company's constitution).
For an unlisted company, the offer must comply with the monetary cap.
- The monetary cap only allows an ESS participant to outlay up to $30,000 on offers over a 12-month period, plus an additional amount equal to 70% of any dividends and 70% of cash bonuses received in that year (and subject to the regulations prescribing an alternate amount).
- When calculating such amounts, amounts payable on the exercise of options or incentive rights are included. However, amounts that only become payable during a liquidity period for the ESS interests are excluded.
- The first 12-month period applies from the day the participant accepts the offer under an employee share scheme.
An offer document must be provided at the point of offer for an offer of options or incentive rights.
The offer must be expressed to be made under Division 1A of Part 7.12 of the Act (further details as set out above).
For an unlisted company, the participant must be provided with disclosure documents (which are less onerous than the existing disclosure requirements):
- 14 days before making an offer; and
- (where the ESS interest is an option or incentive right) before the ESS interest can be exercised.*
*We anticipate this to be an administratively burdensome requirement for startups that issue ESS interests where options become exercisable on the meeting of regular vesting milestones. In order to reduce this burden, companies may need to consider varying the terms of their ESS plans, to limit the frequency at which options can become exercisable.
Different disclosure documents are required for different types of ESS interests. For an unlisted company, the participant must be provided with, among other things:
- certain financial information about the body making the offer (including a balance sheet and profit and loss statement prepared in compliance with the Australian or international accounting standards);
- a valuation of the interests being offered; and
- a statement that the body making the offer is solvent.
There are also specific requirements for trusts issuing or transferring ESS interests that need to be complied with (further details as set out above).
For a loan-funded employee share scheme to be eligible for relief:
- the loan must have no interest or fees payable;
- in the event of non-payment of the loan, the rights against the participant are limited to forfeiture of the interests acquired using the loan; and
- if the loan is by an unlisted company, it cannot be provided to an existing shareholder.
Similarly, if the ESS involves a contribution plan, the plan must meet certain requirements.