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Tax Implications of Employee Share Scheme (ESS) Arrangements

Employee share schemes are a fantastic incentive for high-performing staff to work together as part of a high-performing company. In this article, we provide a clear summary of the tax implications of ESS.

Employee share schemes are a fantastic incentive for high-performing staff to work together as part of a high-performing company. If you’re the business owner of a start-up or high-growth company with tight cash flow, you’ll likely find employee share schemes a particularly useful growth tool. But there are tax obligations to be considered, of course, and the tax implications of employee share schemes are not always simple.

The main considerations are the agreed market value, vesting period, and treatment of capital gains tax. We do a deep dive into employee share schemes in our downloadable e-book, a BlueRock Guide to Employee Share Schemes. But in this article, we wanted to focus on providing a clear summary of the tax implications of employee share schemes.

Let's start by exploring start-up concessions.

Start-up Concessions

Start-up concessions allow eligible participants to pay tax on shares or an option only when they receive the financial benefits of those shares (e.g. they sell them), rather than when they receive the shares, vest, or exercise the option.  

The benefit to an employee of any discount on the market value of shares in the employer’s company (or subsidiary) is assessable income in the year of acquisition, unless the issue of the shares qualifies for concessional tax treatment.

The concession is intended to enable start-ups to set aside more cash for developing the business, which may have been previously used to remunerate key employees, ultimately with the intention of making Australia’s tax arrangement more attractive to innovative start-ups.  Read our case study on start-up concessions to see how this might look in real life.

Note that companies that are eligible for the start-up concession can’t access the $1,000 up-front concession.  

Benefits of Start-up Concessions

When shares are issued

  • The discount on shares offered to employees is not subject to income tax. 
  • For capital gains tax purposes, the cost base is the market value on acquisition. 

When the rights to acquire shares are issued

  • For rights, the discount is not taxed upfront under the start-up concession. The rights are subject to the capital gains tax (CGT) rules and have a cost base equal to an employee’s cost of acquiring them. 
  • There is no CGT when the employee exercises the rights and acquires the resulting shares; however, the exercise price will be included in the cost base of the resulting shares along with the amount paid for the option. 
  • A capital gain is recognised on the disposal of the resultant shares. 

Primary Requirements of Start-up Concessions

  • The company issuing the ESS interest must not have its “equity interests” listed on certain stock exchanges. 
  • The issuing company must have been incorporated for less than 10 years. 
  • The aggregate turnover of the issuing company, together with other group companies, must not exceed $50m. 
  • If the ESS interest relates to an issue of shares, the discount must not be more than 15% of the market value of the share at the time of issue. 
  • If the ESS interest relates to an issue of rights to shares (options), the exercise price must not be less than the market value of the share at the time the right was granted. 
  • The employer must be an Australian resident .
  • The recipient must be “employed” by the company that issued the ESS interest or its subsidiary. 
  • ESS interests that employees may acquire under the employee share scheme must only relate to “ordinary” shares. 
  • The employee share scheme must satisfy an integrity rule designed to prevent contrived schemes that provide employees with shares in unrelated companies. 
  • ESS interests acquired under the employee share scheme must satisfy the minimum holding period, which is generally three years (subject to some exceptions), before they may be disposed. 
  • After acquiring their ESS interest in the company, the employee must not beneficially own shares in the company, or control its voting power, beyond a 10% limit 
  • ESS interests must be broadly available to at least 75% of the Australian resident, permanent employees who have completed at least three years of service 

$1,000 Exemption on Upfront Taxation

The starting taxation point for discounts on shares or rights to acquire shares is to include the discount in the employee’s income tax return as assessable income. The amount included as assessable income can be reduced by $1,000 if the following conditions are met:

  • The sum of the employee’s taxable income, reportable fringe benefits total, reportable superannuation contributions and total net investment losses for the income year does not exceed $180,000
  • The recipient is employed by the company (or a subsidiary) offering the share or right
  • The scheme is offered to at least 75% of permanent employees with at least three years of service
  • The ESS interest relates to ordinary shares that cannot be sold within three years of the date of acquisition (unless the employee ceases to be employed by the company) and cannot be at risk of being forfeited, and
  • The employee does not, after acquisition of the shares own or control more than 10% of the company.

Deferred Taxation

When there is a real chance that shares may not vest in a person’s name, such as when a condition exists that the company must achieve particular revenue targets then there is a real ‘risk of forfeiture’.  

When this occurs, the discount on the share or right entitled under the employee share scheme is subject to income tax at the earliest of when there is no risk of forfeiture of the shares, when employment is terminated or 15 years after the date of acquisition.

Salary Sacrifice Arrangements

Deferral of the taxation of the discount is available where an employee acquires a beneficial interest in an ordinary share under a salary sacrifice arrangement. The discount must equal the market value of the beneficial interest at the time of acquisition. The share plan rules must specifically state that Subdiv 83A-C ITAA 97 applies, and the salary sacrificed amount cannot exceed $5,000.

The discount on shares is subject to income tax at the earlier of the date when the employee is able to choose to sell the shares, employment is terminated or seven years after the date of acquisition of the ESS interest.

Have Questions About Employee Share Scheme Tax Implications?

If you’re keen to explore employee share schemes as a model for your business, or if you have questions about ESS tax implications, feel free to reach out to our Melbourne-based accountants from our experienced business advisory team.

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