Over the past 12 months the appetite of mid-size businesses for ESS arrangements has been extremely high and continues to steadily increase for a range of reasons, including:
- improving the company’s bottom line by increased productivity and profitability, attributable in part to reduced employment and recruitment costs
- improving staff morale and developing a business performance-orientated culture
- motivating and incentivising employees by enabling them to directly participate in the company’s growth and increased value; and
- aiding the founders of closely-held companies with their retirement and succession planning by transitioning ownership to family and or non-family employees in a managed way, while ensuring the business remains independent and thriving
Last year’s changes to the ESS tax laws have been a key factor in this increased demand. They not only introduced the very attractive ESS ‘start-up’ concessions directed at the employees of relatively young, emerging unlisted companies and groups, but also:
- removed many of the problem areas which had tended to cause bad tax outcomes for ESS participants (particularly involving options); and
- provided enhanced scope and flexibility in the commercial design and structuring of ESS arrangements
The optimum ESS arrangement for a company depends on the specific circumstances, requirements and commercial drivers of the company and participating employees. This should include tax considerations.
This is making the ESS ‘start-up’ concessions highly attractive to both employers and employees as they:
- allow eligible (unlisted) companies to provide free market-priced options to employees without the need for expensive independent share valuations; and
- enable recipient employees to be taxed concessionally on their options under the Capital Gains Tax rules (rather than the more prohibitive ESS tax rules) from day one
For companies and employees that cannot access the ESS ‘start-up’ concessions, traditional options, performance rights (ie nil exercise price options) and various types of share plans are often being used.
Options and performance rights are typically being used to give employees access to gains on some type of exit event such as a trade sale or IPO. The advantage of options and performance rights is that they can restrict ownership until the exit event. This assists in retaining the employee to the future event and avoids complications if the employee leaves early or doesn’t live up to performance expectations, as it is very simple to cancel the options or performance rights.
Where access to dividends is a driver for the implementation of the ESS a variety of different types of plans are being implemented. A number of companies are still using options or performance rights but are allowing employees to exercise their option or right to receive the underlying shares and dividends. We are also seeing shares issued directly, for example through a loan share plan. The issue of shares directly and use of loans does raise a number of tax risks and the ESS tax rules are more restrictive for shares than they are to performance rights and options. In addition, consideration of the deemed dividend rules under Division 7A need to be carefully considered when funding the acquisition of shares through loans.