News From Australia - Employee Shares

Article written by Sue Prestney for 'Charter', the magazine of the Australian Chartered Accountant Sue Prestney is a Senior Partner with MGI Melboune.

Article reprinted with the permission of the Institute of Chartered Accountants in Australia, www.icaa.com.au

Employee share plans have been much in the news this year, as the Government’s proposal to tighten the tax treatment of ESPs has relaxed into the latest version of draft legislation, differing little fundamentally from the current provisions of Division 13A of ITAA36. The situation is still, basically, that employees are taxed upfront on any discount in relation to the issue of shares, with some minor concessions for non-discriminatory plans (ie plans offered to at least 75% of employees). There are tax deferral arrangements for salary-sacrificed share discounts up to a maximum of $5,000 pa and for discounts on shares and options which are genuinely subject to forfeiture. However the only deferral available for discriminatory plans is for options.

As always, when it comes to employee share plans, the focus has been on the big end of town; large organisations which have the resources to deal with non- discriminatory plans, whose shares are listed and therefore capable of being converted into cash once vesting conditions have been met. There is little to assist SMEs who often have a pressing need to provide equity to key employees in order to retain skills that are otherwise difficult to attract (in competition with large businesses) and/or to provide a succession plan for the current operators.

It seems ludicrous that an employee who is provided with shares in a private company as a gift or at a discount to market value (whatever that is) is required to pay tax on that discount up front despite the fact that, even if those shares are vested, they are, practically, unable to turn them into cash. Under most employee share plans for private companies there are provisions for employee shares to be compulsorily bought back by the company, or by other shareholders, in the event of termination of employment, death or disability. There may be an opportunity for voluntary disposal in restricted circumstances. But there is no ready market for these shares. Try asking a financier to lend you money on the security of a minority interest in a private company.

Loans from a private company employer to allow the shares to be issued at market value, and avoid the application of Division 13A (or the proposed Division 83A of ITAA97), have to be subject to annual payments of interest and principal to avoid falling foul of the Division 7A deemed dividend provisions (and FBT). These commitments may be able to be funded from annual dividends but, to many SME owners, such arrangements are too difficult to understand and messy to administer. The employees are often daunted by the prospect of incurring a debt in relation to an asset of dubious realisable value, even if the loan is non-recourse.

There really needs to be an easier way. There is and it is simple. Have special tax deferral provisions for the issue of discounted minority shareholdings to employees of private companies. The deferral could extend until the shares are disposed of or until the end of a specified term, eg 7 years, if this is earlier. This at least would give the employee the opportunity to accumulate some dividends over the 7 year period to fund the tax payment.

Tax would be payable on the value of the shares at that time in the same way as other deferral arrangements would operate under Division 83A of ITAA97. If the shares were disposed of, the taxable value would be determined as their disposal price with no need to go into valuation issues which are always a vexed question in private companies. (Obviously the valuation question would still arise if the deferral ceased at the end of the 7 year period, prior to disposal.)

An anti-avoidance mechanism could be built in to prevent employees from disposing of their shares for a nominal amount just before the end of the 7 year period and reacquiring another parcel of shares soon after, to start another 7 year deferral. The mechanism could simply be that a person is only entitled to one deferral period for each shareholding.

Such a deferral arrangement would not be without penalty for the employee. As for other deferral arrangements, the value of the shares at the end of the deferral period would be taxed as ordinary income, not capital gains, thereby excluding the application of the CGT discount (and other CGT concessions) on the growth in value of the shares to that point.

This proposal is predicated on the assumption that it is desirable to encourage employee equity participation in private companies and that it is appropriate to encourage key employee equity participation as much as general employee participation.

My firm belief is that these assumptions are valid. As the baby boomers seek to successfully transition their businesses on retirement, they need to retain those key employees with the experience and skills to keep the business going, either for new owners or as new owners themselves. Providing equity as a ‘golden handcuff’ leading up to this event is one of the most effective ways of keeping those key people in the business. It is not something that is ‘nice’ to do for the employees. It is something that must be done for the welfare of the business.

MGI Melbourne is a member of MGI Australasia

Chartered Accountants Institute, Australia

2009-11-11