Focus: Sensible changes proposed to the Australian taxation of ESS interests
27 March 2015
In brief: Improvements to the Australian taxation of employee share schemes (ESS) have been proposed in new tax legislation before Parliament. One of the important changes is that Australia will be moving back to rights to acquire shares generally being taxed on exercise of those rights. Partner Sarah Bernhardt and Senior Associate Shaun Cartoon, members of Allens' Head Office & Governance team, report on the proposed ESS tax changes and how they may potentially impact on the design of employee share plans from 1 July 2015.
How does it affect you?
- The proposed ESS tax changes in the Tax and Superannuation Laws Amendment (Employee Share Schemes) Bill 2015 (the Bill) may potentially impact on the design of employee share plans from 1 July 2015. In particular:
- employers should no longer view the Australian tax implications for an option holder as being a disincentive from granting employees options with an exercise price;
- employers granting performance rights may like to consider including an exercise period post vesting of those rights; and
- in appropriate circumstances, a portion of fixed remuneration may now be able to be granted as equity awards on which the taxing time for the employee is deferred.
- Special concessions for employees of small startup companies are also proposed in the Bill, which are discussed in Focus: Startups rev your engines: proposed ESS tax concessions to benefit the startup sector.
Before the 2009 changes to the taxation of ESS interests, employees could choose to have qualifying ESS interests taxed on grant or at a deferred taxing point (subject to certain conditions). Tax deferred rights to acquire shares such as options were usually taxed on exercise.
The 2009 changes introduced the concept of a 'real risk of forfeiture' as one of the gateways to deferred taxation of ESS interests. Under those changes, if there was a real risk of forfeiture on grant of rights to acquire shares such as options, the taxing point was generally deferred to the point at which those rights were first able to be exercised (rather than when the employee decided to exercise, as was previously the case). Further, under the 2009 tax changes, no refund of the tax payable is generally available if vested rights to acquire shares later lapse.
Not surprisingly, the 2009 tax changes largely resulted in companies ceasing to grant options with an exercise price to Australian employees. Employers generally regarded having tax payable on options prior to exercise, on a taxable value which can be significantly higher than the difference between the market value of the share at the taxing time and the exercise price (including tax on under-water options), with generally no refund of that tax if the options later lapse, as an unreasonable and unacceptable outcome for their employees. It was also completely out of step with the 'global norm' of options being taxed on exercise. It is this perverse tax outcome for employee options that is at the heart of the proposed changes in the Bill (which are generally intended to apply to awards granted from 1 July 2015).
An alternative gateway to deferred taxation of rights
Under the proposed changes in the Bill, rights to acquire shares granted from 1 July 2015 will be eligible to access deferred tax treatment where there is no real risk of forfeiture on grant, provided that:
- the scheme genuinely restricts the employee from immediately disposing of those rights;
- the scheme rules expressly state that the scheme is subject to deferred taxation; and
- the other general eligibility conditions for ESS interests to access tax deferral are satisfied (excluding the real risk of forfeiture test).
This proposed change will mean that a company should be able to ensure that deferred tax treatment will be available for employees, regardless of whether the real risk of forfeiture test is satisfied, by expressly stating in the plan documentation that the scheme is subject to deferred taxation. The Explanatory Memorandum to the Bill helpfully clarifies that a statement in the offer documents will be sufficient to satisfy this requirement (ie it should not be necessary to amend the plan rules).
This change will also mean that, if a company wants to provide employees with equity awards as part of their fixed remuneration (which, by definition, is not generally subject to a real risk of forfeiture), that may now be possible. However, the equity award must be granted as a 'right to acquire shares' before becoming a beneficial interest in shares, there must be restrictions on the disposal of the rights and the plan documents must make it clear that deferred taxation will apply.
Taxing point deferred to exercise of rights
The deferred taxing point for a right to acquire shares which is granted from 1 July 2015 is proposed to generally be when an employee exercises the right (rather than when the employee can exercise the right). The Explanatory Memorandum to the Bill makes it clear that 'exercise' of a right will include situations in which the right is automatically exercised without the employee needing to take any positive action. As with current law:
- if the shares acquired on exercise of the rights are subject to a genuine disposal restriction (or a real risk of forfeiture), then the taxing point will continue to be deferred until the first day on which the shares are not subject to the disposal restriction (or real risk); and
- the deferred taxing point will occur earlier if the employee ceases employment (unfortunately, this rule is not being fixed), if the rights are transferrable, or if the period of 15 years from grant passes.
This proposed change, together with the change to the refund rules and new valuation tables referred to below, may result in a re-emergence of employee options with an exercise price into the Australian remuneration landscape from 1 July 2015.The change may also result in a re-emergence of exercise periods on vested performance rights. However, before a company chooses to add a significant exercise period to rights granted from 1 July 2015, it should first consider other potential flow-on implications of adding such an exercise period, such as whether dividend equivalents should be provided on vested rights and whether adding an exercise period will add to the employer costs of operating the plan (especially where it is proposed that shares to satisfy the vested rights will be sourced from on-market purchases).
As there are no proposed transitional rules in relation to this change (ie the change will not apply to rights granted before 1 July 2015) companies wanting to make use of the new rules should be careful not to create rights in employees before 1 July 2015 to be granted rights to acquire shares on or after 1 July 2015. This is because, depending on the particular circumstances, the indeterminate right rule contained in the ESS tax provisions may apply to deem the date of grant of such rights to be the date on which the promise to grant was made (which, if before 1 July 2015, may prevent the application of the new rules).
Broadening the refund rules for rights
One of the changes made in 2009 was to deny a refund of tax paid on rights to acquire shares which vested but then later lapsed. For example, if options with an exercise price were taxable on vesting, but were never exercised, no refund of the tax paid on vesting would be available, notwithstanding the fact that the employee would not have benefited from the options. Instead, a capital loss would be available on lapse of the options.
It is now proposed that the refund rule will change so that a refund of tax paid on rights to acquire shares will be available where those rights lapse or are cancelled after the taxing point. However, this change is likely to be of limited practical application as it will only apply to rights to acquire shares granted from 1 July 2015 (which will generally only be taxable on exercise other than for good leavers, or where the rights are transferrable or where tax on grant applies).
New tax valuation tables for options
The taxable value of unlisted options with an exercise price which have a taxing point prior to exercise is generally calculated in accordance with safe harbor valuation tables contained in the tax provisions. New regulations are proposed to update these valuation tables.
Very generally, the new valuation tables are likely to produce a lower taxable value of options than under the previous tables. As the taxing point for options granted from 1 July 2015 is generally expected to revert to when those options are exercised, the new tables may only have limited application in practice (eg where options are taxable on grant or for good leavers or where the options are transferrable). However we understand that Treasury may be considering a special transitional rule for the new valuation tables to the effect that the tables may be applied to any options which have a taxing point from 1 July 2015, even if the options were granted before that date.
Premium priced options
Under current law, if an option has a nil taxable value on grant under the tax valuation tables (eg has an exercise price significantly greater than the market value of a share on grant of the option), the ESS tax provisions do not apply to the option. Instead, if that option had a 'real' market value (notwithstanding its nil value under the tax valuation tables), there is a technical risk that fringe benefits tax could apply on the grant of the option.
It is proposed that such options will now be brought within the ESS tax provisions. Unlike with the other changes, this proposed change is intended to apply retrospectively from the 2011-12 income year onwards.
The net effect of the proposed amendments is that options which have a nil taxable value on grant under the tax valuation tables (but have a market value on grant greater than nil) will now technically be taxable on grant, but on a nil taxable value (even where there is a real risk of forfeiture on grant). After that, only capital gains tax should generally apply. This change, in conjunction with the new valuation tables (refer above), may see an increase in the grant of premium priced options.
Maximum period for tax deferral extended to 15 years
It is proposed that the maximum tax deferral period will be increased from 7 years to 15 years for tax deferred ESS interests. This change will apply both to awards granted in the form of rights to acquire shares and to awards granted in the form of beneficial interests in shares.
Changes to maximum ownership and voting rights limits
Under current law, one of the eligibility requirements for deferred taxation on ESS interests is that the employee must not have greater than 5 per cent ownership or voting rights in the company in which the ESS interests are granted. Importantly, the current test is unlikely to take into account unvested rights to acquire shares (and, depending on the circumstances, may not take into account vested rights), and only includes interests held by associates to the extent that those interests were acquired by the associate in relation to the employee's employment.
The Bill proposes that the maximum ownership and voting rights limits will be doubled from 5 per cent to 10 per cent for awards granted from 1 July 2015. However, the new test will include vested rights to acquire shares held by the employee and may also include unvested rights. It will also include interests held by associates, regardless of how the associates came to acquire their interests. We would therefore expect that, in some circumstances, the increased threshold percentage may be outweighed by the broadened net of interests that will now be counted in the test. This may result in this amendment operating as a restriction (not a concession) for employees in such circumstances.
The proposed ESS reforms are a sensible refinement to the 2009 changes and may lead to some changes in remuneration strategies from 1 July 2015.
We are very happy to discuss these proposed changes with you and we will keep you updated on further developments in this area.
You can leave a comment on this publication below. Please note, we are not able to provide specific legal advice in this forum. If you would like advice relating to this topic, contact one of the authors directly. Please do not include links to websites or your comment may not be published.