Employee share schemes are expected to become more ‘business friendly’ under proposed changes recently announced by the Federal Government as part of its Innovation and Competitiveness Agenda.The changes follow sustained lobbying within the industry, including a submission to Treasury made by William Buck, which called for a number of actions including the repeal of earlier changes made in 2009.
Legislation enacted in 2009 has hindered the ability for start-ups and SMEs to use employee share schemes to attract and retain key talent. The most recent announcement proposes to revoke these controversial changes and is expected to significantly reduce the cost and administrative burden on SMEs and better support start-ups
The question remains, however, as to whether further reformation is required.
The 2009 changes – current taxation of employee share schemes
Prior to 2009, employee share schemes provided an effective tool for start-ups and SME’s to compete for top talent. For those businesses that couldn’t afford the larger salaries paid by big businesses, an employee share scheme offered an opportunity to reward key employees with a stake in the business’ future.
The tax rules enacted in 2009, have prevented many SME’s from offering an employee share scheme. The current rules tax the employee on the value of the shares either when they are issued (upfront taxed plans) or at a specific time in future (deferred tax plans) with the maximum deferral being seven years.
This can often result in an unfunded tax liability, where tax is payable on the value of the shares, even though the shares can’t be sold and the employee hasn’t received any cash. For start-ups this can pose a significant problem, where it is not until a ‘liquidity event’ like a trade sale, IPO or commercialisation of a product occurs that the shares have a realisable value.
Often, the employee is expected to pay tax on their shares before they can actually sell them (and may not have the funds to do so). This type of scenario can undermine any motivational benefits that an employee share scheme could achieve.
On the 14th of October 2014 the Government announced a number of key changes to the tax treatment of employee share schemes which include:
- Shares and options issued by start-ups will only be taxed at the time the shares are sold which means that employees only have to pay tax when they actually receive value
- Eligible start-up businesses will be allowed to issue shares to employees at a small discount and issue options under advantageous conditions
- Shares and options that are issued by start-ups at a discount will no longer be subject to up-front taxation, so long as they are held by the employee for at least three years
- The maximum time for tax deferral will be extended from seven years from acquisition of interests to 15 years, allowing more time for the start-up to succeed
- Employees in start-ups will have their gains on the Options and Shares taxed as a capital gain and not income (thereby accessing lower effective tax rates).
The reforms which apply from 1 July 2015 come as a relief for SMEs and start-ups and are expected to further enhance Australia’s competitiveness in the search for qualified talent.
Back to the future?
While the unwinding of the 2009 changes is welcomed, it should be acknowledged that the pre-2009 rules were not perfect. There is a concern that by simply reversing the rules, the Government is failing to take the opportunity for meaningful tax reform in this area.
A number of the proposed changes outlined above could continue to restrict some businesses. For example, for employees in private businesses, taxing discounted options when they are converted to shares rather than when they are issued is merely moving the issue.
Shares and options in privately owned businesses are not readily convertible to cash. There is no market for shares in private companies, as opposed to public companies where the shares can be traded on the applicable exchange.
The concession should defer the taxing point until the employee share is sold. This would overcome the unfunded tax liability issue, which is the primary issue impeding the implementation of employee share arrangements by private companies.
While the Government’s proposed changes put Employee Share Schemes back on the table for SMEs careful consideration needs to be given to their structure to ensure that they are tax effective for both the business and the employee. For assistance in the assessment and design of an employee share scheme for your business please contact your local William Buck advisor.