What is a premium priced option plan and when are they useful?
A premium priced option plan (PPOP) is not a legislative term, rather, it is a term used to describe an employee share option plan where the exercise price of the options is sufficiently above the market value of the underlying shares on the grant to deliver a nil market value for tax purposes such that:
there is no discount provided in relation to the grant of the options; and, therefore
there is no amount assessable to the employee participant under Division 83A of the Income Tax Assessment Act 1997 (General ESS Tax Rules).
They can also be used to deliver a nominal or low value for tax purposes.
The General ESS Tax Rules operate to tax employee participants on any discount they receive on the grant of an ESS interest (e.g., shares or options) and this discount is the difference between:
the market value of the relevant ESS interest at the applicable taxing point; and
the consideration paid or payable for the ESS interest.
In relation to options, ordinary market value methodologies include the Black Scholes option pricing formula (as modified by Subdivision 960-S of the Income Tax Assessment Act 1997). However, the General ESS Tax Rules allow employee participants to adopt the market value under the tax regulations in this regard (where applicable).
The Income Tax Assessment (1997 Act) Regulations 2021 (Regs) provide that an ESS interest that is an unlisted right (including an option) that must be exercised within 15 years of the grant date is, at the choice of the employee, either:
the ordinary market value of the right; or
the value worked out in the Regs (Regs Value).
In turn, the Regs Value is the higher of:
the market value of the underlying share on the grant date less the lowest exercise price payable to exercise the right (Simple Value); and
the value determined in accordance with the valuation tables in the Regs (Table Value).
The Table Value uses various inputs to determine an option value for tax purposes and, for example, other things being equal:
the higher the exercise price above the market value of the underlying share on the grant date, the lower the option value and vice versa; and
the longer the exercise period, the higher the option value (as there is a longer runway for the option to increase in value) and vice versa.
As outlined above, in these circumstances the rights (including options) must be exercised within 15 years of the grant date, however, even if we take the maximum exercise period, the Regs specifically state that where the exercise price is more than 2x the market value of the underlying shares on the grant date, the rights have a nil value for tax purposes.
Further, if we wish to reduce the exercise price, we can perform a scenario analysis to determine the impact on the exercise price of reducing the exercise period in determining the Table Value, for example:
if the exercise period were 4 years with an exercise price of $0.015 per option – the Table Value of the options is nil; and
if the exercise period were 5 years with an exercise price of $0.015 per option – the Table Value of the options is just $0.000015 per option.
It is important to recognise that outside the special concessional rules for eligible start-up companies (Start-Up ESS Rules), the holding period of an option does not count towards the holding period of the underlying share for the purposes of accessing the general 50% CGT discount.
This means that a participating employee under a PPOP will have to exercise their options and hold the underlying shares for at least 12 months after the exercise date in order to access the general 50% CGT discount (assuming all other conditions are satisfied) and this can be difficult where an unexpected exit occurs, however, there is always the possibility of:
negotiating with a purchaser to acquire vested but unexercised options for the relevant option premium (triggering CGT event A1 for the option holder and preventing them from ‘restarting the clock’ on the 12-month rule in relation to the underlying shares); or
the company cancelling the options for the relevant option premium (triggering CGT event C2 for the option holder and preventing them from ‘restarting the clock’ on the 12-month rule in relation to the underlying shares).
PPOPs are a great idea where the Start-Up ESS Rules are not available, and you are looking to deliver a nil or nominal option value for tax purposes.
If you would like to discuss how you and your business could benefit from a PPOP, contact Mosaic Tax Legal at firstname.lastname@example.org or 1300 115 841.