Contributed by Dennis Tomaras, Partner, Cornwalls
The COVID-19 pandemic has brought all forms of side effects to the economy and business. One such side effect has been with start-up companies. In their totally understandable desire to turn the corner on COVID-19, some start-up companies have overlooked the numerous advantages associated with employee share schemes for them and their staff.
Generally speaking, it is accepted that employees with an ownership interest in their employer (no matter how small) tend to be more committed and perform better.
The purpose of this article is to provide an overview of the advantageous tax rules for employee share (or option) schemes for qualifying start-up companies.
As we will describe below, the ATO has even provided model employee share and option plans, as well as draft offer letters, for use by start-up companies.
What is a start-up company?
The income tax rules applicable to employee share and option schemes can be very complicated, and there are nuances throughout the relevant legislation.
Recognising this, the government introduced a more straightforward regime for eligible start-up companies from 30 June 2016. (Before the introduction of these rules, it was very difficult to come up with a ‘cost effective’ share scheme for employees of start-up businesses, having regard to the complexities and the tax results within the tax employee share scheme provisions as they then stood.)
In order to qualify as a start-up company for the purposes of these simplified and, we suggest, more advantageous rules, the following criteria must be satisfied:
- The relevant company must have an aggregated turnover of less than $50 million in the income year before the year in which the share or option interests are granted
- The company must not have had any of its shares or options listed on any stock exchange in the income year before the grant of the employee share scheme.
- The company must have been incorporated for less than 10 years.
- The employing company must be an Australian resident taxpayer.
Eligible terms of the employee share scheme offer
The start-up company rules limit the eligibility criteria of the relevant share or option scheme permissible.
The rules provide that the only interests which can be acquired under the relevant start-up company share or option scheme, must be in ordinary shares or options to acquire ordinary shares in the relevant company.
Further, the share or option interest must be held for a minimum holding period of 3 years, commencing on the date when the interest was first acquired.
In the case of an option scheme, the exercise price must not be less than the market value of the shares in the start-up company at the date of the grant of the options. Typically, with most start-ups, the company’s market value in the early years will be very low. As has been demonstrated in many cases, this value can increase significantly over say, a 3 to 5 year period.
In the case of a share plan, the shares must not be offered to the employees for more than a 15% discount on the market value of the shares at the date of grant.
Advantage of an option plan to employees
In our opinion, the rules regarding an option plan for the employees of a start-up company are particularly advantageous.
These advantages can be summarised as follows:
- The employee will not be taxed on the grant, vesting or exercise of their options (provided the options are at market value of the relevant shares).
- The employee will only be taxed upon a transfer of the shares or options.
- For capital gains tax (CGT) purposes, the shares received on exercise of the options will be deemed to have been acquired on the day when the options were granted.
- Any gain or loss the employee makes on a future disposal of the shares or options will be taxed pursuant to the CGT rules and not the income tax rules.
The above rules are relatively straightforward. This is in contrast to some of the income tax rules applicable to employee share and option schemes for companies that do not qualify as a ‘start-up’.
Advantages of a share scheme to employees
The advantages of a share scheme plan for employees of a start-up company can be summarised as follows:
- Provided the discount is no more than 15% on the market value of the shares, the employee will not be taxed on acquisition of the shares.
- The employee will only be taxed upon a future transfer of the shares.
- For CGT purposes, any future gain or loss the employee makes on disposal of the shares will be taxable under the CGT rules. In other words, if the employee holds the shares for at least 12 months prior to disposing of them, then the employee will be entitled to apply the 50% CGT discount to any capital gain made.
ATO model plans
Believe it or not, the ATO has conveniently provided start-up companies with both an eligible option plan and an eligible share plan. Copies of these are available on the ATO website.
In addition, the ATO has provided start-up companies with an offer letter to use along with the model share or option plan.
Quite simply, eligible start-up companies can use the ATO model plans and either accept them completely (provided that they are in accordance with the company’s wishes), or alternatively, modify them as required. The point is that the ATO has done a lot of the work for you.
In the case of option schemes for start-up companies, the ATO has even provided an instruction guide that covers both the income tax and Corporations Law rules. We suggest this shows how serious the ATO is in assisting start-up companies with employee share or option plans for their employees.
In summary, the position for start-up companies and employee share or option plans can be described as follows:
- The rules for such employee share and option schemes for start-up companies are deliberately simpler and more advantageous for employees of the company.
- Generally speaking, provided the issue price of the options or shares, as the case may be, meets the relevant rules herein, discounts are not taxed upfront to the employee.
- Moreover, if the share or option scheme is an eligible start-up company plan, then the CGT rules will be applicable to the employees. In addition, an employee in an option scheme will be deemed to have acquired their start-up company shares at the earlier date when the options were first acquired, as compared with the future conversion to shares date.
- Amazingly, the ATO has even prepared model share and offer plans and offer letter documents for start-up companies to use, or at least modify as they see fit.
- As stated at the outset of this article, start-up companies are generously defined under these rules. These rules will be applicable to eligible start-up companies with a turnover of up to $50 million in the financial year before the implementation of the share or option plan.
In our opinion, as companies are now coming out of COVID-19, such schemes should be revisited, so as to both:
- provide employees with an ownership interest in the start-up, and
- issue shares (or options) in the start-up at a time when perhaps, the company’s market value has been suppressed.
The bottom line is that eligible start-up companies should be very carefully looking at these rules, because they remain advantageous to both the company and the employee.
Disclaimer: This information and the contents of this publication, current as at the date of publication, is general in nature to offer assistance to Cornwalls’ clients, prospective clients and stakeholders, and is for reference purposes only. It does not constitute legal or financial advice. If you are concerned about any topic covered, we recommend that you seek your own specific legal and financial advice before taking any action.
Source: This article was originally published on the Cornwalls website, 27 July 2021, and has been reproduced with permission.