Employee share schemes (ESS) are a great strategy for employers who want to incentivise staff without having to outlay more cash or increase salaries during cash-tight periods of growth. It’s also a wonderful way to align employee interests with the interests of shareholders and to collaboratively work towards a shared vision.
We cover off the benefits and pitfalls of employee share schemes in our comprehensive BlueRock Guide to Employee Share Schemes, but in this article, we wanted to take you through a real-life case study of how ESS start-up concessions work.
What are ESS Start-up Concessions?
ESS start-up concessions allow eligible participants to pay tax only on a share or option when they receive the financial benefits of selling the shares, rather than when they receive the shares, vest, or exercise the option.
A Case Study of ESS Start-up Concessions in Action
How does this look in real life? Let’s take a look at the fictional case of Smiley Pty Ltd using the start-up concessions to issue an employee share scheme to their employees.
- Happyco Holdings Pty Ltd is the 100% shareholder of Smiley Pty Ltd
- Smiley Pty Ltd is the employing company incorporated on 30 June 2019
- Smiley is an Australian resident company for tax purposes
Smiley Pty Ltd (the employing company) offers options to employees to acquire ordinary shares in Happyco Holdings Pty Ltd (ESS interest Issuer).
- The options are granted at a price that represents the market value of the shares at the date of granting the options.
- The expected vesting period is 36 months, subject to change by the board.
- The employee is bound by the Employee Options Plan, Terms of Offer, Constitution and Shareholders Agreement upon accepting the offer.
- The ESS will be offered to several key employees, including Tony Smith.
Assumptions Associated With this Employee Share Scheme
- On 1 July 2020, Tony Smith was granted 1,700 options which when exercised, will represent 8% ownership of the company
- Tony is required to pay $0 per option granted on the granting date.
- Options will vest on 15 June 2021 and Tony will be required to pay $2 per option to be allotted 1,700 fully paid ordinary shares.
- The market value of ordinary shares according to the safe harbour rules as at 15 June 2021 is $2 per share.
- On 30 June 2022, Tony decided to sell his shares at an agreed price of $25.00 per share to an approved party.
Tony will add $19,550 to his income tax return as a capital gain, where he will be taxed at his marginal rate for that income year.
Any discount provided to Tony from the granting and vesting of the options will be reduced to nil and not to be included as income within his income tax return. When Tony disposes of the subsequent allotted shares at a gain, he may be required to pay capital gains tax.
ESS Eligibility Requirements
To qualify for concessional tax treatment, the ESS and the employee must meet the following general conditions:
- The options/shares provided to the employees must be in Smiley Pty Ltd or the holding company (Happyco Holdings Pty Ltd)
- When the employee acquires the options/shares, the interest must relate to ordinary shares.
- Immediately after acquisition, the options/shares you provide must not result in the employee either owning more than 10% of the shareholdings or controlling over 10% of the voting rights.
- The participant must be employed by Smiley Pty Ltd.
- The predominant business of Smiley Ptd is not the acquisition, sale or holding of share, securities, or other investments (directly or indirectly).
In addition to the above general conditions, the ESS and employees of Smiley Pty Ltd must meet the following further conditions to satisfy the start-up concessions as per Subsection 83A-33:
- Smiley Pty Ltd or any of its related parties or affiliates is not listed on the Stock Exchange
- Smiley Pty Ltd must be incorporated for less than 10 years before the end of its most recent income year before it issues the interest.
- Smiley Pty Ltd has an aggregated turnover not exceeding $50 million.
- Should the Employee Share Scheme (scheme) interest be a purchase of shares, the discount must be no more than 15% of its market value when you provide it.
- Should the scheme interest be a purchase of options, the amount that must be paid to exercise the option must be greater than or equal to the market value of an ordinary share in Smiley Pty Ltd when you grant the option.
- Smiley Pty Ltd must be an Australian resident taxpayer.
- The employee meets the minimum holding period of 3 years.
Determining Market Valuation of ESS Shares
Smiley Pty Ltd anticipates that there will not be a change in control of the company within 6 months of the valuation time. If these two conditions can be met, then Smiley Pty Ltd may use the following methodologies:
- Net Tangible Assets Method (method 1 – preferred methodology)
- Comprehensive method (method 2 – if method 1 can’t be used or method 2 is chosen to be used)
ESS Reporting Obligations
Smiley Pty Ltd will provide the participating employee with an Employee Share Scheme Statement by 14 July following the tax year in which the options are granted. The statement will show the following:
- Number of options acquired
- Market value of ordinary shares on the date options acquired
- Grant price per option acquired
- Acquisition date
Smiley Pty Ltd will be required to provide to the ATO Employee Share Scheme (ESS) Annual Report, by 14 August following the tax year in which the options are granted. The annual report will provide the ATO with each employee’s ESS interests received for the financial year as per the information provided to the employees within the Employee Share Scheme Statement.
Have Questions About ESS Start-up Concessions?
If you’re keen to explore employee share schemes as a model for your business, or if you have questions about start-up concessions and other ESS tax implications, feel free to reach out to our Melbourne-based accountants from our experienced business advisory team.