Contributed by Brett Feltham, Partner, Gadens
As part of the 2021–2022 Federal Budget, the Federal Government has announced reforms to employee share ownership in Australia, with those changes designed to make it easier for businesses to offer their employees participation in employee share schemes (ESS) and to help businesses attract and retain the talent they need to compete on a global stage.
Cessation of employment as a taxing point
Employers use ESS to attract, retain and motivate staff by issuing interests such as shares, rights (including options) or other financial products to their employees, usually at a discount to their market value. There are many types of ESS, but generally the type of scheme determines the tax treatment that applies.
Under current tax laws, if ESS interests are granted to an employee at a discount and defined conditions are met, then concessional tax treatment may apply. To qualify for concessional tax treatment the following general conditions must be met:
- the ESS interests must be in the employing company or its holding company
- at the time that the employee acquires the interest, all ESS interests available for acquisition under the scheme must relate to ordinary shares, and
- immediately after acquiring the ESS interests, an employee (and their associates) must not hold or control more than 10% ownership and voting rights in that company.
Further conditions must then be met depending on the type of scheme and the specific tax concessions that may apply (such as the start-up tax concession rules).
Commonly ESS interests are structured so as to allow an employee to defer paying income tax in relation to their ESS interests until the income year in which the “deferred taxing point occurs”, instead of paying tax in the year the ESS interests are acquired. This means that an employee may defer having any liability to pay tax until such time that they have realised some value from the ESS interests and can sell or dispose of some or all of those interests to cover their tax liability.
Currently, under a tax-deferred ESS, the deferred taxing point is the earliest of:
- cessation of employment
- in the case of shares, when there is no risk of forfeiture and there are no genuine restrictions on disposal
- in the case of options, when the employee exercises the option and there is no risk of forfeiting the resulting share and there are no genuine restrictions on disposal, and
- the maximum period of deferral of 15 years.
The taxation of ESS interests which continued to be held by an employee when they ceased employment has been a major area of concern for most stakeholders, and there has been concerted lobbying by interest groups and others for its removal for a number of years.
The change announced by the Federal Government will now result in tax being deferred until the earliest of the remaining taxing points. This is a significant and welcome change, particularly in the context of the following matters:
- from the start of the COVID-19 pandemic, many employees have seen their employment terminated by reason of redundancy. Often such employees are treated as “good leavers” and retain some or all of their ESS interests as a result. That “good leaver” treatment triggered a taxing event on their ESS interests due to cessation of employment. This resulted in those employees being required to pay tax on those ESS interests, at a time when they had yet to realise any value from those interests, and created a potential cash flow issue
- those employees who were made redundant, and others who ceased employment prior to the COVID-19 pandemic, may have paid tax on their ESS interests when they ceased employment at a significantly higher share price or value, than those shares are now worth, an
- as a result of the current tax rules, there has often been a practical limit or a reluctance to provide that unvested ESS interests can continue to be held by an employee after they cease employment. This has meant that either ESS interests were vested on cessation (to allow an employee to realise value to meet their tax liability) or forfeited (to remove any tax liability for those interests). This change removes that limitation.
Companies will, however, need to reconsider the design of their ESS going forward in light of the changes, including considering what conditions should apply to ESS interests which continue to be held by an ex-employee post-termination. Further tax deferral will only be possible if there remains a risk of forfeiture or a genuine disposal restrictions on ESS interests held by those ex-employees. If there is no risk of forfeiture or genuine disposal restrictions post-employment, then the change to remove cessation of employment as a taxing point will provide no benefit to those employees.
This change will apply to ESS interests issued from the first income year after the relevant legislation is passed, which hopefully may apply to ESS participation from 1 July 2021 onwards (but which will depend upon when relevant amending legislation is passed).
Removing red tape particularly for unlisted companies
The Federal Government has also announced that it will remove “red tape” to ensure that employee participation in ESS is made easier.
An offer by an employer to an employee to receive shares, options or some other form of equity under an ESS triggers a range of obligations under the Corporations Act 2001 (Cth), including the need to provide the employee with a prospectus or disclosure document unless an exemption applies.
Prior to the release by the Australian Securities and Investments Commission of ASIC Class Order 14/1001 (CO 14/1001), many unlisted companies relied on specific exemptions under the Corporations Act, such as the senior manager and/or small scale offerings exemptions, in order to avoid the need to prepare and lodge a disclosure document. Those exemptions do not, however, deal with ancillary securities law obligations such as those relating to secondary sale offers, licensing, hawking and advertising restrictions.
While the release of CO 14/1001 was an attempt to make it easier for unlisted companies to offer participation in ESS and to provide a broader range of relief, unfortunately many unlisted companies have been unable to rely on these exemptions. This has been largely as a result of the requirement under CO 14/1001 that the value of any offer to an employee in any 12 month period could not exceed $5,000. In some cases companies have been required to limit the breadth and value of employee participation and/or undertake the expensive and time consuming task of preparing a disclosure document.
While it is not yet clear how the Federal Government intends on implementing these changes, it has indicated that it will reduce “red tape” for ESS by:
- removing regulatory requirements for ESS, where employers offer ESS interests to their employees for no cost and do not provide a loan to the employees to whom they offer ESS – this may be achieved by ASIC re-interpreting the “no consideration” exemption in the Corporations Act to cover this situation, or alternatively amending CO 14/1001, and
- where unlisted companies offer ESS interests to their employees at some cost and/or do provide a loan to employees, streamlining the requirements for those companies making ESS offers that are valued at up to $30,000 per employee per year – this is most likely to be achieved by amending CO 14/1001 and raising the limit from $5,000 to $30,000.
Both of these changes should lessen the compliance burden and the costs associated with unlisted companies offering ESS interests to their employees.