Changes to Employee Share Schemes
In June 2015, parliament passed the previously announced changes to the taxation of Employee Share Schemes (ESS). These amendments apply to employee equity offered on or after 1 July 2015 and will not apply to any employee equity issued prior to this date.
One of the main purposes for the changes was to make it easier for start-up companies to reward their staff with equity and in this respect, the new rules include a specific concession for start-ups.
Some of the other key changes to the ESS tax provisions apply to all employee share plans and include:
- the extension of the maximum tax deferral period for employees from 7 years to 15 years
- the change in the deferred taxing point for options and rights from the vesting date to the exercise date
- the removal of the need for a ‘‘real risk of forfeiture’’ to defer the taxing point on options and rights
These changes are discussed in detail below.
Whilst the potential deferral of the taxing point of qualifying employee equity for 15 years sounds attractive, it must be remembered that to achieve the tax deferral there must be a real risk of forfeiture or sale restriction over the employee equity for the whole of the 15 year period. In addition, other points to consider when looking at the deferral period include:
- The likelihood of a higher value at the taxing point – Employees are taxed on the market value of their employee equity at the deferred taxing point. Therefore, if the value of the shares climbs over the 15 years, the employee will be taxed on a higher amount than the original value of the award.
- Possible higher marginal tax rate at the time of the taxing point – If an individual’s income continues to rise over the 15 year period, employees may have a significantly higher marginal tax rate at the deferred taxing point than when the equity was granted.
- CGT versus ESS rules – Any growth in value from the time the employee equity is granted the equity until the deferred taxing point is taxed in the hands of the employee at their marginal tax rate on income account. However, any growth in value after the deferred taxing point (until sale) will generally be treated as a capital gain to the employee and may be eligible for the CGT discount.
- Eligibility for the CGT discount – For CGT purposes, the employee is generally taken to have acquired the employee equity at the deferred taxing point and the CGT cost base is based on the value at that time. The employee will need to hold the equity for an additional 12 months after the deferred taxing point to qualify for the 50% CGT discount
- Employee cessation – In practice, the introduction of the 15 year deferral period will probably mean that more employees will be taxed at the cessation of their employment if this occurs prior to the 15 year deferral period.
Change in treatment of options and rights
The ESS amendments changed the deferred taxing point for options and rights (issued after 1 July 2015) from vesting date to exercise date. This may provide employees some flexibility in planning the financial and tax implications of their equity if their plan has an extended exercise period.
This amendment also means that options that are ‘out of the money’ at the end of the exercise period will not have a deferred taxing point as it is unlikely that the employee would exercise such options.
Taxing Point of Options and Rights – Cash Flow
It is important to note that the taxing point of options and rights may not coincide with the sale of the underlying shares. As the above explains, the tax event occurs on the exercise of the option or right. This usually means that there are two outflows of cash required at a similar time. The first to exercise your right or option and purchase the underlying share, and the second, to pay the tax on the benefit you have received. It may be necessary to plan for the future outlay and you should speak to your finance professional or tax agent regarding timing strategies and cash flow management.
It should be noted that all employee share schemes vary and are unique to the company offering them and your particular circumstances. When considering the implications of an ESS, you should contact your taxation advisor or financial planner for detailed advice.
Source: Written by Tess Uncle, Associate Director of Wybenga & Partners Pty Limited, Chartered Accountants, Sydney