In our October 2014 Tax Alert we highlighted the announcement by the Federal Government (as part of its Industry and Competitiveness Agenda) to change Australia’s Employee Share Scheme (ESS) tax laws. The Government has now released draft legislation to reform the ESS rules, primarily designed to bring them more in line with international standards to assist Australian business attract, retain and incentivise employees in an international labour market. If these changes become law they will apply to ESS shares and rights acquired on or after 1 July 2015.
Broadly, the new rules reverse a number of unpopular changes which were made to the ESS tax laws with effect from 1 July 2009, particularly in respect of rights (e.g. options), make other improvements to the taxation of ESS interests, introduce additional tax concessions for employees of eligible ‘start-up’ companies and allow for the Commissioner of Taxation (Commissioner) to approve different methodologies for valuing ESS interests. The Government is also proposing to update the safe harbour valuation tables contained in taxation regulations which are used to value unlisted rights, to ensure they reflect current market conditions.
Revisions and proposed improvements to the 2009 ESS tax law changes
Under the new rules, the following changes will potentially impact employees of all companies:
- Where tax is deferred on ESS shares or rights, the maximum deferral period will be extended from seven to 15 years.
- Employees granted ESS rights which are not subject to a real risk of forfeiture will now be eligible to claim a tax deferral on the rights, provided they are subject to a disposal restriction from the grant date and the governing rules for the ESS expressly provides for the deferral of tax on these rights.
- The deferred taxing point relating to the exercise of ESS rights will be extended from when the rights become exercisable until when they are actually exercised (subject to a further tax deferral if the underlying shares are subject to a real risk of forfeiture or disposal restrictions).
- The existing limit of 5% in the ownership interest or voting power which an employee is permitted to have in the provider company in order to potentially access the ESS concessions (i.e. the ‘upfront’ $1,000 reduction or tax deferral) will be increased to 10%. To determine whether the 10% limit is exceeded, an employee will need to account for the shares which they could obtain on exercising rights they have over shares in the company (whether ESS rights or not).
- Employees will now be eligible for a refund of tax paid on discounted ESS rights where they choose not to exercise the rights and let them lapse (unless the ESS is designed to protect the employee from downside market risk).
Eligible start up concessions
The new rules introduce the following additional tax concessions for employees (including temporary residents) provided with ESS interests in start-up companies at a small discount, subject to certain eligibility conditions being satisfied:
- in the case of a share, the ESS discount will be exempt from tax and the share will be subject to the Capital Gains Tax (CGT) rules from acquisition and will have an opening CGT cost base equal to its market value at this time; and
- in the case of a right, the ESS discount will not be taxed upfront on the grant date but will effectively be taxed (under the CGT rules) at the time the right (or underlying share, in the event the right is exercised) is disposed of
The above tax concessions will only be available for ESS shares acquired at a discount of less than 15% and for ESS rights which are ‘at, or out of, the money’ on the grant date, where the employer entity is an Australian tax resident and the particular ESS and the relevant provider entity exhibit the following characteristics:
- the general conditions which presently apply to all existing ESS concessions (incorporating the revised 10% ownership/voting power limit noted above) must be satisfied, together with the existing (three year) holding rule and the ‘broad availability’ test (i.e. the ESS (or an earlier ESS) is open to at least 75% of the employer entity’s Australian-resident, permanent employees with at least three years of service); and
- the provider company must be unlisted, have an aggregated turnover of $50 million or less for the preceding income year and be incorporated for less than 10 years (as must each entity in a corporate group of which the provider company is a member).
Changes to ESS valuation methodology and the valuation tables for unlisted rights
Generally, the current ESS rules adopt the ordinary meaning of market value in relation to ESS interests and do not prescribe a particular valuation method. The new rules provide the Commissioner with the power to conditionally approve market valuation methodologies that can be used to determine the market value of all assets or non-cash benefits (not just ESS interests) for income tax purposes. However, the Explanatory Memorandum to the draft legislation indicates that it is likely the Commissioner will initially only exercise this power to assist eligible start-up entities in valuing their ESS interests.
Currently, it is open to an employee in receipt of unlisted rights to utilise the safe harbour valuation tables contained in taxation regulations to value the rights for ESS tax purposes. The draft legislation also contains amendments to these valuation rules which are designed to reflect current market conditions and to explain the assumptions underlying the tables (in terms of the applicable interest rate, dividend yield and volatility measure). If enacted, these revised valuation tables will apply from 1 July 2015 and will generally result in a lower valuation than under the existing tables.
Grant Thornton comment
In introducing these new ESS rules, the Government acknowledges that the existing rules are problematic and confusing for employers and employees alike and have the potential to create unintended and unfair results. We consider the changes to the existing tax laws, particularly in respect of the timing of tax deferral and the refund eligibility entitlements for rights, will effectively address these concerns.
In particular, extending the deferred taxing point of ESS rights from when the rights become exercisable until when they are actually exercised will generally address the risk of employees being taxed on a higher value of the right at vesting than when it is exercised. Options are expected to gain popularity as an attractive way to incentivise employees.
Further, we welcome the additional start-up concessions. However, we fail to see why these concessions should be limited to unlisted companies, particularly given that many ‘small cap’ listed companies clearly meet the other eligibility criteria for being considered a ‘start-up’.
The adjustment of the ESS valuation tables to reflect prevailing market conditions and the disclosure of their underlying assumptions is also seen as a positive step. It will remain to be seen how frequently the assumptions are updated for changing market conditions.
With regard to the ability of the Commissioner to approve valuation methods (which are expected to initially only have application to start-up entities), it will be interesting to see whether they are concessional as this is likely to heavily influence whether they are adopted.
Submissions Submissions in relation to the draft legislation are due by 6 February 2015. Grant Thornton is currently canvassing the views of affected clients on this matter. Please contact us should you wish to contribute your views.