Start-ups and SMEs can encounter difficulties in attracting and retaining key hires.
Under the employee share scheme legislation, start-up employee share schemes and employee share option plans are a great way to attract, retain and incentivise key hires in a simple, tax-effective manner (and often at a significant discount to “real” market value).
Employee Share Schemes Introduction
Company employee share schemes and employee share option plans are a common way for start-ups and SMEs to attract, retain and incentivise key hires.
Employee share schemes and employee share option plans also seek to compensate key hires who could command significantly higher salaries with more established employers.
Australia’s ESS/ESOP Tax Rules
The employee share scheme legislation (General Tax Rules) operates to tax employee participants (Participants) on any discount they receive to the market value of any shares or options granted to them under an employee share scheme or employee share option plan.
Participants are taxed either:
in the income year in which the shares or options are granted based on the discount as at the grant date; or
subject to meeting certain criteria, at the earlier of various employee share scheme “deferred taxing points” in the future (e.g., vesting or exercise), based on the discount as at the date of the relevant taxing point.
Employee Share Scheme Tax Implications
The problem for Participants is the employee share scheme tax treatment as the General Tax Rules:
are not very tax-effective (Participants are taxed on the relevant discount at their marginal tax rate); and
assume liquidity (i.e., that the Participants can sell-down or sell-out of their shares in order to pay their tax bill).
However, Participants in an employee share scheme/employee share option plan of a small private company with highly illiquid shares (i.e., no ready market for them) can incur significant cash flow problems as a real tax liability must be met with funds from other sources.
This is especially problematic where the start-up or SME is raising capital at a high valuation.
It is possible to structure an employee share option plan to push the deferred taxing point back to the exercise of an option, so as to give Participants the power to decide when they will be taxed (i.e., by choosing when to exercise). However, the downside is that any increase in the value of the options (based on the growth in the underlying shares) between the grant date and the exercise date is taxed as ordinary income at the Participant’s marginal tax rate (currently up to 45% excluding levies) rather than a capital gain.
The benefit of deriving a capital gain, compared with ordinary income, is that Participants may be able to access the general 50% CGT discount on a capital gain, allowing them to take the first half of the capital gain completely tax-free, and only pay tax on the remaining half.
In order to access the general 50% CGT discount, eligible taxpayers (including individuals) must, among other things, hold the CGT asset for at least 12 months prior to disposal.
Ordinarily, an option must be exercised, and the underlying share held for at least 12 months in order to access the general 50% CGT discount on its subsequent disposal.
This may be depicted as follows:
As you can see, the options in the diagram above must be exercised as soon as they vest, and the underlying shares held for at least 12 months, in order for a Participant to satisfy the “12-month rule” as soon as possible.
This creates a tension between:
having to exercise the option in order to start-the-clock on the “12-month rule”; and
wanting to delay exercise so as to avoid having to pay the exercise price as long as possible.
Further, this can be problematic in a start-up context where an exit may occur at any time.
The start-up employee share schemes/employee share option plan rules were introduced to address the structural deficiencies of a “one-size-fits-all” approach.
Start-up employee share schemes and employee share option plans are subject to a minimum 3-year holding period within which options or shares cannot be disposed of, except in limited circumstances approved by the ATO (e.g., the disposal of all the shares in the company to a third-party purchaser).
A start-up employee share scheme allows eligible start-ups to issue shares at a discount of up to 15% to their market value.
The downside of a start-up employee share scheme is that Participants are shareholders from the grant date and, potentially, prior to kicking the goals the company needs in order to justify the Participant holding equity.
Further, if the shares are subject to vesting conditions, they are generally bought back by the company. An employee share scheme buy-back, like all share buy-backs can give rise to complex tax issues that can have serious tax consequences for outgoing Participants.
A start-up employee share option plan allows eligible start-ups to issue options with an exercise price at least equal to the market value of the underlying share on the grant date.
The options may be subject to vesting conditions such as:
minimum employment periods;
employee or company-specific KPIs; or
any combination of the above.
Unlike the position under the general tax law, where a Participant exercises options granted under a start-up employee share option plan, the holding period of the options does count towards the holding period of the underlying share for the purposes of the “12-month rule”. This means that, provided the options were held for at least 12 months, the Participant could exercise the options immediately prior to an exit and still access the general 50% CGT discount in relation to the disposal of the shares (assuming all other conditions are satisfied).
As outlined above,
the maximum discount for shares issued under a start-up employee share scheme is 15% of the market value of the shares on the grant date; and
the minimum exercise price of options granted under a start-up employee share option plan is the market value of the underlying share on the grant date.
In this context, “market value” means either:
ordinary market value; or
subject to meeting the relevant conditions – the ‘Start-Up Safe Harbour Value’.
There are 2 Safe Harbour Valuation methodologies potentially available, that is:
Method 1 – an adjusted net tangible assets valuation (NTA Valuation);
Method 2– a director-approved valuation (Director-Approved Valuation).
The NTA Valuation is based on the relevant company’s financial statements and excludes often valuable intangible assets such as intellectual property and goodwill. It does, however, include cash, therefore, start-ups may choose to implement an employee share scheme or employee share option plan and issue shares or options to Participants:
prior to raising capital; or
between capital raises (when perhaps cash has been used in developing excluded intangible assets for NTA Valuation purposes.
Under an NTA Valuation, it is common for start-ups raising at high valuations to issue options with an exercise price at a fraction of that “real” market value such that the options are significantly “in-the-money” from the outset.
The Director-Approved Valuation requires that the company is valued by its Chief Financial Officer or a person having the knowledge, experience, and training to perform such valuations based on designated criteria and endorsed in a written resolution by the directors.
Employee Share Scheme Reporting
The employee share scheme legislation mandates that employers are subject to employee share scheme reporting, that is, employers are required to notify:
participating employees by way of an ‘ESS Statement’ for the income year in which the ESS interests are either:
issued to those employees (for start-up employee share schemes/employee share option plans); or
assessable to those employees (i.e., the grant year for taxed upfront plans or the deferred taxing point year for deferred tax plans); and
the ATO by way of an ‘ESS Annual Report’ detailing all the ESS interests either:
issued by the company during an income year (for start-up employee share schemes/employee share option plans); or
assessable to employees for an income year (whether under taxed upfront or deferred tax plans).
Start-up employee share schemes and employee share option plans are a great way to attract, retain and incentivise key hires in a simple, tax-effective manner (and often at a significant discount to “real” market value if the company wishes to do so). However, you need to carefully confirm eligibility and implement the plan within the scope of the concessional regime, in order to deliver the desired tax benefits and avoid nasty surprises.