Employee Share Option Plans (ESOP) are a long standing remuneration practice among many businesses in various jurisdictions around the world. For Australian tax purposes, an ESOP is referred to as an employee share scheme (ESS). Broadly, an ESS involves offering shares, rights, or options in a company to employees generally as an incentive to align the goals of owners and employees and to introduce a shared sense of ownership in the business.
ESS themselves have been an effective means for companies to attract, retain and motivate key employees for many years. However, the Australian tax laws governing ESS have constantly changed and morphed over the last decade, resulting in both favourable and unfavourable outcomes for Australian taxpayers. The ESS tax rules have been convoluted, inconsistent in their application and a constant source of uncertainty for both Australian and foreign taxpayers. In more recent years, these tax rules have been revised yet again.
This article is not intended to cover all aspects of the new ESS rules, but rather to focus on the generous new tax concessions offered to eligible start-up businesses from 1 July 2015. These tax concessions could include deferral of taxing point and generous capital gains tax treatment which may qualify for the CGT discount.
Generally speaking, ESS interests (i.e. shares, rights or options) issued to employees at a ‘discount’ to their market value are taxed up-front as income unless they meet the requirements for deferred taxation. However, if employees of certain small to medium enterprise (SME) start-ups are eligible for the new ESS start-up concessions, the employee will not be taxed on grant or vesting of the ESS. Furthermore, in the case of options there is no taxing point on exercise either. Instead, the first taxing point will be on ultimate disposal of the shares which is taxed on capital account and which may also attract the CGT discount.
We provide an outline of the concessions and requisite conditions below:
What are the ESS start-up concessions?
For shares to which the concession applies:
- The discount is exempt from tax; and
- Shares will be subject to the capital gains tax (CGT) rules with a cost base equal to the market value at the time of acquisition.
For rights to which the concession applies:
- The discount is no longer subject to up-front taxation; and
- The share received upon exercise of the right are subject to the CGT rules. The cost base of the shares will be equal to the employee’s cost of acquiring the right.
What conditions must be satisfied?
For the ESS start-up concessions to apply, the following conditions must be satisfied by the company (the test company):
- The test company (including any holding companies or subsidiary of a holding company) must not be listed on a stock exchange at the end of the most recent income year before the ESS interest is acquired;
- The test company (including any holding companies or subsidiary of a holding company) was incorporated by or under an Australian law or foreign law less than 10 years before the end of the most recent income year before the ESS interest is acquired;
- The test company has an aggregated turnover of less than AU$50 million for the income year before the year in which the employee acquired the ESS interest;
- Where the ESS interest is a share – the discount is less than 15% of its market value at the time the employee acquired the interest;
- Where the ESS interest is a right – the exercise price of the right is greater than or equal to the market value of an ordinary share in the company at the time the employee acquired the interest;
- The employer of the employee must be an Australian resident;
- The employee is an employee of the test company or a subsidiary of the test company when they acquire the ESS interest;
- All the ESS interests available for acquisition under the scheme relate to ordinary shares;
- The employee is not permitted to dispose of the ESS interest for a period of 3 years starting from when the ESS interest was acquired (there are limited exceptions to the 3 year rule);
- At least 75% of the Australian resident permanent employees of the employer, with at least 3 years of service are, or have at some time been entitled to acquire ESS or ESS interests under the scheme (however, we note that options do not need to satisfy this requirement) and;
- The employee must not hold a beneficial interest or voting power of more than 10% in the test company immediately after acquiring the ESS interest.
Some key takeaways from the above are as follows:
- Due diligence must be undertaken on the test company’s shareholders and their investments to determine whether the listing, 10 year incorporation and AU$50m aggregated turnover requirements are satisfied; but
- Provided that each of these three requirements are satisfied as at the end of an income year, it is possible to still be eligible for the ESS start-up concessions in the next income year even if those requirements are failed in that next income year.
Eligibility of ESS start-up concessions for foreign companies?
As outlined above, a condition of the ESS start-up concessions is that the employer must be an Australian resident. However, this condition does not require that the entity issuing the ESS interests must be an Australian resident. In other words, a foreign company will qualify for the ESS start-up concessions if it has a subsidiary that is both the employer and an Australian resident provided all other conditions are satisfied.
How are ESS interests taxed under the start-up provisions:
For ease of reference, the table below outlines how the ESS interests are taxed under the ESS start-up provisions:
|No upfront taxing point||Yes||
|The ESS deferred taxing points do not apply (this means no taxing on cessation of employment, exercise of the option or lifting of any sale restrictions on the shares).
|No CGT event on exercise of options
|CGT cost base||
Cost base will equal market value at grant date. That is, if the shares have a market value of $1.00 and are acquired for $0.50, the cost base is $1.00.
Cost base of the shares acquired on exercise of the options will equal the exercise price.
Generally when shares are sold.
Generally when shares acquired on exercise are sold or the options themselves are sold.
Available if shares sold more than 12 months from date of grant.
Provided that the option or share is sold more than 12 months from when the option was granted, the participant should be eligible for the CGT discount.
Other key considerations
When considering implementing an ESS start-up plan, it is important to also consider:
- Whether an exit event is likely within 3 years in which case the ESS start-up concessions may be lost to the employees (there are exceptions);
- The type of ESS interest (i.e. shares, rights or options) that should be granted under the ESOP. This will vary depending on the company’s individual circumstances and objectives; and
- The various legal issues involved with ESOPs, including ensuring that the Australian corporations law disclosure requirements or disclosure exemptions have been satisfied.
In summary, the introduction of the new ESS start-up concessions are a welcome change for Australian SME businesses. However, the Australian ESS tax rules are complex and there are various traps and pitfalls that companies need be wary of. Whether your client is a start-up company looking to implement an ESOP to attract the best and brightest talent, or you are a recipient of ESS interests, we can assist with the setup of an effective ESOP to take advantage of the ESS start-up concessions.