ESS/ESOPs and the general 50% CGT discount
The general tax rules relating to the taxation of an employee share scheme (ESS), or an employee share option plan (ESOP) are outlined in Division 83A of the Income Tax Assessment Act 1997 (General ESS Tax Rules).
The General ESS Tax Rules are aimed at taxing participating employees on any discount they receive on the grant of an ESS interest (including shares or options in a company) either:
- upfront – in the income year of the grant; or
- subject to meeting certain conditions – at the earlier of various future events, for example:
- exercise; or
- the 15th anniversary of the or cessation of the employment to which the ESS interests relate (known as the deferred taxing point).
However, if the actual disposal date of the ESS interests occurs within 30 days of any of the above, the deferred taxing point is postponed until the actual disposal date (30-day rule).
Notwithstanding the General ESS Tax Rules, Australia has a concessional tax regime for eligible start-up companies and employees for both ESS and ESOP (Start-Up ESS Tax Rules).
For more information on the General ESS Tax Rules and the Start-Up ESS Tax Rules – see here or check out our Start-Up ESOP Explainer Video here.
Where the General ESS Tax Rules apply (that is, the Start-Up ESS Tax Rules do not apply), it is important to understand how any eventual capital gain will be taxed.
General ESS Tax Rules and the general 50% CGT discount
The General ESS Tax Rules are aimed at taxing participating employees on any discount they receive on the grant of an ESS interest.
Once the General ESS Tax Rules have done their work and brought to tax the relevant discount either upfront or at the relevant deferred taxing point:
- for ESS interests subject to upfront taxation – the ESS interests are taken to have been acquired for their market value on the grant date; and
- for ESS interests subject to deferred taxation – the ESS interests are taken to have been acquired immediately after the deferred taxing point for their market value unless the 30-Day Rule applied (in which case, the General ESS Tax Rules to the exclusion of the CGT regime).
The market values of the ESS interests at the relevant taxing point under the General ESS Tax Rules forms part of the cost base of the shares or options in the hands of the participating employee in calculating the eventual capital gain (or loss) on those interests.
In relation to options granted under an ESOP, any exercise price paid will also form part of the cost base of the underlying share, for example:
Annabelle receives 10,000 options in A Co with an exercise price of $1.00 per share (Options).
The Options were issued for no consideration and are valued at $0.10 each.
As the Options were acquired at a discount, they fall within the General ESS Tax Rules and, as the Options are subject to vesting conditions and all other conditions are satisfied, the Options are subject to deferred taxation.
The Options vest in equal tranches over 4 years, however, the terms of the ESOP are such that the deferred taxing point is the exercise of the Options.
Annabelle decides to exercise the Options as soon as each tranche vests and her assessable income (under the General ESS Tax Rules) and her cost base for CGT purposes are summarised as follows:
|Tranche||No. of Options||Market Value of Options/Discount for ESS Purposes (Per Option)||Exercise Price (Per Option)||Cost Base (Per Option)||Total Cost Base|
It is important to note that employee participants must hold their underlying shares for at least 12 months after the exercise of their options in order to qualify for the general 50% CGT discount in relation to the shares (12 Month Rule), as well as satisfy all other eligibility criteria in this regard.
The holding period of an option does not count towards the holding period of the underlying shares from which they derive.
Returning to the example above:
Assume that Annabelle sold all of her shares 3 years after Tranche 4 vested (and the final tranche was immediately exercised).
The sale price per share was $30.
Annabelle’s capital gain is determined as follows:
|Shares||Cost Base Per Option||Total Cost Base||Sale Price Per Share||Total Sale Price||Capital Gain||50% CGT Discount||Discount Capital Gain|
Start-Up ESS Tax Rules and the general 50% CGT discount
Where the Start-Up Tax Rules apply, no amount is taxed under the General ESS Tax Rules, and the participating employee will generally only be taxed:
- on any dividends received (that is, on shares issued under a Start-Up ESS or following the exercise of options issued under a Start-Up ESOP); and
- any eventual capital gains.
One of the critical differences between the General ESS Tax Rules and the Start-Up ESS Tax Rules is how they interact with the general CGT regime, that is:
- where an option is granted under the General ESS Tax Rules – the holding period of the option does not count towards the holding period of the underlying share following its exercise; however,
- where an option is granted under the Start-Up ESS Rules – the holding period of the option does count towards the holding period of the underlying share following its exercise.
This means, for example, that in the context of an unexpected exit, provided that a participating employee has held their options for at least 12 months they could exercise their options and immediately sell them and still satisfy the 12 Month Rule for the purposes of accessing the general 50% CGT discount.
However, the wording of the relevant legislation is such that in our opinion, unless the employee participant participates in the Start-Up ESOP personally (rather than indirectly through an entity such as a discretionary trust):
- this concession will not apply; and
- the general rules will apply such that the options must be exercised, and the underlying shares held for at least 12 months before satisfying the 12-month rule.
If you would like to discuss how you or your employees will be taxed under an ESS/ESOP, or design and implement your ESS/ESOP to maximize CGT treatment and eligibility for the general 50% CGT discount, contact Mosaic Tax Legal at email@example.com or 1300 115 841