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Employee Share Schemes Explained

Overview

An employee share scheme (ESS), for the purposes of Australian income tax laws, is where an employee receives shares (or options to acquire shares) in their employer at a discount.

Companies, particularly early stage start-ups, use employee share schemes (also known as employee stock option plans, or “ESOPs”) to attract, retain and incentivise top talent.

Income Tax Assessment Act 1997, Division 83A

Division 83A of the Income Tax Assessment Act 1997 (Cth) will apply where an employee acquires shares or options at a discount.

The purpose of the Australian ESS laws is to:

  1. clarify that discounts received by employees under employee share schemes are subject to income tax at the employees’ marginal tax rates (instead of being subject to fringe benefits tax); and
  2. encourage lower and middle income earners to acquire shares under employee share schemes by providing participating employees with tax concessions; and
  3. increase the number of new entrepreneurial companies in Australia by assisting them to attract and retain employees by providing participating employees with tax concessions.

The ESS laws will not apply where the employee did not acquire the relevant ESS interests at a discount.

The default position is that an individual must include the discount received in relation to an ESS interest in the income tax year in which the ESS interest was acquired. The “discount” is the difference between the market value of the ESS interest and the amount for which it was acquired.

The ESS laws, however, provide concessions and deferral rules to some employees in recognition that they may only be able to pay the applicable income tax once they sell their shares in the company.

Tax concessions for start-ups

The tax concession for start-ups allows employees who otherwise would have to include the amount of a discount in their assessable income to disregard that amount where all of the following conditions are met:

  1. The company (or any of its related entities) must not be listed on an approved stock exchange.
  2. The company (or any of its related entities) must have been incorporated for less than 10 years.
  3.  The company must not have an aggregated turnover exceeding $50 million.
  4. The company must be an Australian tax resident.
  5. In the case of shares, the discount was must be no more than 15% of their market value when they were acquired.
  6. In the case of options, the exercise price must be equal to, or greater than, the market value of an ordinary share in the company when the options were acquired.
  7. The ESS interests must only relate to ordinary shares.
  8. Every acquirer of an ESS interest under the scheme must not be permitted to dispose of the ESS interests (or the ordinary shares eventually acquired) during a three-year minimum holding period (or when the participant ceases being employed by the company).
  9. A participant must not acquire more than 10% of the shares in the company.
  10. Participation in the ESS must be open to at least 75% of permanent employees who have completed at least three years’ service (whether continuous or non-continuous) with the company and who are Australian tax residents.

Where the start-up concession does not apply, a concession of up to $1,000 may be available to participants whose adjusted taxable income does not exceed $180,000.

ESS deferred taxing point

The default position for employee share schemes is that a participating employee will have to pay tax on the discount in the income year the employee acquired the shares or options.

This taxing point can be deferred if all of the following conditions are met:

  1. The tax concession for start-ups does not apply.
  2. The shares are ordinary shares (or, in the case of options, the shares underlying the options are ordinary shares).
  3. A participant does not acquire more than 10% of the shares in the company.
  4. Participation in the ESS must be open to at least 75% of permanent employees who have completed at least three years’ service (whether continuous or non-continuous) with the company and who are Australian tax residents.
  5. There is a real risk that, under the conditions of the scheme, the participant will forfeit or lose the interest (other than by disposing of it) OR the participant acquired the ESS interests as part of a salary sacrifice arrangement, the discount equals the market value total value of the ESS interests and the ESS interest do not exceed $5,000.
  6. In the case of options, the scheme rules restrict immediate disposal of the options and the scheme rules state that Subdivision 83A-C of the Income Tax Assessment Act 1997 (Cth) applies.

The deferred taxing points for shares are:

  1. when there is no real risk that, under the conditions of the ESS, the employee will forfeit or lose the ESS interests (other than by disposing of it) AND if the scheme restricted the employee from disposing of their ESS interests, the scheme no longer so restricts the employee;
  2. when the employee’s employment in the company ends; or
  3. the end of the 15-year period starting when the employee acquired the ESS interests.

The deferred taxing points for options are:

  1. when the employee has not exercised their options AND there is no real risk that, under the conditions of the ESS, the employee will forfeit or lose the ESS interests (other than by disposing of them, or exercising the right or letting it lapse) AND if the scheme restricted the employee from disposing of their ESS interests, the scheme no longer so restricts the employee;
  2. when the employee’s employment in the company ends;
  3. the end of the 15-year period starting when the employee acquired the ESS interests; or
  4. the employee exercises their options AND there is no real risk that, under the conditions of the ESS, the employee will forfeit or lose the underlying shares (other than by disposing of it) AND if the scheme restricted the employee from disposing of their shares, the scheme no longer so restricts the employee.

Tax deduction for employers

The Australian ESS laws allow employers to claim tax deductions in relation to:

  1. amounts provided by the employer to the employee under the ESOP (provided that the employer’s deduction will be equal to the reduction the employee receives); and
  2. financial assistance provided by the company to enable an employee to acquire the shares or options (provided the company defers this deduction until the employee actually acquires the shares).

Extensions to the ESS laws

Two important extensions to the ESS laws to be mindful of are:

  1. an employee will be taxed under the ESS laws even if the ESS interests are acquired by an associate of the employee; and
  2. the ESS laws extend to relationships similar to employment, such as where an individual provides services to the company as an independent contractor or external service provider.

Bottom line

It is important to note that these concessions and deferral rules do not always apply, so it is important to keep them in mind when structuring an ESOP.

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