By Stuart Kollmorgen, Shane Bilardi and Andrew Spalding - Norton Rose Australia

Australian company employment remuneration and incentives can now be allocated tax effectively between cash and share acquisition schemes to more closely match United States and other overseas benefits policies.

Changes to the Australian employee share scheme (ESS) taxation regime, which took effect from 1 July 2015, allow taxing points to be deferred for longer and introduce a significant new concession for "start-ups".

For most of the last decade, taxation at time of vesting (rather than exercise) and limits on tax deferral had made most share acquisition plans unattractive to employees.

Agency theory

Students of "agency theory" will understand a fundamental problem that exists in companies -- self-interested behaviour. A corporation's managers and employees may have personal goals that compete with the shareholders' goals of maximising shareholder wealth. Since the shareholders authorise managers to administer the firm's assets, a potential conflict of interest exists between the two groups.

A potential solution is for managers and employees to be encouraged to act in the shareholders' best interests through incentives, constraints and punishments. Share acquisition schemes provide an opportunity to align goals based on the market value of shares.

Tax deferral period

The maximum period of tax deferral increases from 7 years to 15 years. This permits longer term alignment between the company and employee interests.

Changes to deferred taxing point

The deferred taxing point for options (and for other rights, such as performance rights) broadly moves from vesting to exercise.

This largely removes the risk of employees being hit with an unfunded tax liability.

Extending deferred taxation

Deferred taxation is no longer restricted to options (and other rights) issued subject to a "real risk of forfeiture" (RROF). Deferred taxation will now also be available if:

1. there is a genuine disposal restriction preventing the immediate disposal of the options (or other rights); and
2. the plan rules expressly state that the plan is subject to deferred taxation (there is particular wording that the plan needs to contain for this purpose).

Many employers will of course still wish to retain performance or service conditions for commercial reasons (that is, to incentivise and retain employees) but this change allows greater flexibility in plan design and eliminates uncertainty around what constitutes a RROF.

Concessions for "start-ups"

Who are eligible "start-ups"?

Eligible start-ups:

• are Australian resident companies (which may cause overseas groups to incorporate an Australian entity);
• are unlisted companies (as are any subsidiaries, the holding company and any subsidiaries of the holding company);
• are incorporated for less than 10, and cannot be part of a corporate group in which any other company has been incorporated for more than 10 years; and
• have an aggregated turnover (including overseas holding company) of $50 million or less.

Application of "start-up" concession

In order for the "start-up" concession to apply:

• shares must be issued at a discount of no more than 15% to market value; and
• options must have an exercise price equal to or greater than the current market value of a share.

The discount on shares or options issued by an eligible "start-up" is not taxed to the employee under the ESS provisions. Instead, the employee is taxed under the capital gains tax rules, paying tax only on an eventual disposal of the shares or options.

In the case of shares, the cost base for the purposes of calculating the gain is the market value at the time of issue (not the discounted price paid). In the case of options, the cost base is generally the exercise price.

Employees who acquire shares that qualify for the start-up concession will benefit from the 50% CGT discount when they sell their shares. Employees will no longer be required to hold their shares received on exercise of their options for at least 12 months to access the discount.

Effect

The changes will apply to ESS interests (that is, shares, options and similar rights) acquired on or after 1 July 2015. The changes will not affect interests issued before this date.

What does this mean for you?

It is now tax-effective to incorporate share acquisition schemes as a genuine benefit within employee remuneration. This permits you to supplement employee earnings with non-cash benefits without cash outlays by the company. This permits goal alignment as between managers/employees and shareholders to be facilitated, in order to maximise shareholder wealth.

For multi-national corporations, it is easier for Australian plans to replicate or match the schemes of US and other overseas parent company schemes. While variations for Australian rules and plans may be required, these are more easily manageable and more attractive to Australian employees.

Option plans are likely to come back into favour.

Existing plans

For existing plans, every company should review their existing employee incentive arrangements to assess whether they are still optimal under the new law.

Companies that choose to retain their existing plans should still review them and consider making amendments to provide employees with access to the full benefits of the new law. Considerations include:

• whether the plan contains the necessary terms to allow options to be taxed on exercise rather than on vesting;
• whether the plan allows employees to benefit from the full 15 year maximum tax deferral period; and
• whether the plan includes the prescribed wording to ensure access to tax deferral if there is no RROF.

Note: Originally published in Employment Law Bulletin, August 2015, Volume 21 No 6