Podcast transcript
Therese Raft
Welcome to Navigating the New Normal – Grant Thornton’s podcast exploring trends in business and the marketplace.
Today I am joined by Peter Hills, Partner and National Head of Remuneration Taxes. Today we're talking about employees share schemes and why this particular employment model could be a win-win for business owners and their employees.
So welcome Peter!
Peter Hills
Thanks, Therese.
Therese Raft
Now, Peter, I hear that employees share schemes are becoming a more popular tool to remunerate employees. But let's start with the basics. What exactly is an employee share scheme?
Peter Hills
Well, I simply describe an employee share plan, or scheme, as the provision of shares or options to employees for services provided by that employee. And so, that difference between providing that non-cash item, compared to cash salary, is probably the main difference. It's interesting, though, when we go out into the marketplace, a lot of people don't realise that the employees share scheme tax rules also apply to directors and individual contractors. And what I mean by individual contractors, is people contracting as an individual and not through a company or trust.
Therese Raft
Would you mind giving us an example off an employee share scheme in action?
Peter Hills
I’ll probably answer that in what I refer to as trends that have been seeing over the last year. When COVID came about in March or April last year, what we saw is a lot of people wanting to conserve cash, and so instead of providing salary in wages, they provided some type of employee share scheme. And typically at that stage, we saw a lot of companies provide Performance Rights. It's interesting how the world changed, too. So, you know, at the moment what we're seeing is a lot of companies wanting to list, and we're seeing a lot of companies come to us to implement employees share plans for those companies. And through that we're implementing either option plans or Performance Rights plans. But then at the same time, what we're also seeing at the moment is the so called start-up companies. And with those start-up companies, you know, they’re wanting to attract people. You know, there's a tight market out there for good people and so therefore, we're seeing a lot of start-up companies implementing employee option plans for their people. But you know, I should note, a lot of employee share plans are actually taxable under the Employees Share Plan rules, which treats the gain as essentially salary wage income, so it's taxable at the employee’s marginal tax rates. Alternatively, there's also a number of employee share plans that are designed to be outside those employees share plan rules, tax rules, I should say. And in those circumstances, those particular plans are taxable under the capital gains tax rules. And I'm sure there's a lot of people out there that know the benefits of the capital gains tax rules, that in certain circumstances and in particular when you satisfy the 12 month rule, and also holding it as an individual or through a trust, you can access the 50% CGT discount.
Therese Raft
Now, industrial relations and jobs have certainly been a major theme during COVID-19. So all last year we've heard plenty about changes to awards, and hours being cut and then reinstated. But we haven't heard a lot about employee share schemes. Why is that the case?
Peter Hills
Yeah, it's interesting. And it's interesting that you say that because from my side, living and breathing employee share schemes day in, day out, you know, I seem to be getting questions constantly through the week on existing plans, or new plans. I suggest that there's certain pockets that employee share schemes are very popular, and there's certain pockets that they're not as well known. And you know, I described it in this way for listed companies, especially at the senior management and above level, I would suggest that there's probably not a company on the ASX that hasn't got some type of employee share plan. But for listed companies, general population, I suggest that the number of employee share plans for the general population is probably far less. And you know, I sit here and I question why. I must admit I don't have the answer for that. And potentially, it could be looked at more often. In the private side, the trend has changed. When I first started doing employee share plans about 20 years ago, the tax rules weren’t as friendly, and it's probably fair to say that a lot of private companies in those days were more orientated towards family groups and transitioning the business through the family. And now we've got new tax rules in July of 2015, that are more encouraging for private companies. But also at the same time, we seem to have this trend that a lot of companies are setting themselves up and through that, introducing new IP, technologies, concepts, with the view of exiting at some point, whether or not it's through an IPO or trade sale, which does lend itself to the employee share concept and implementing an employee share plan for them.
Therese Raft
Now, you also have a really lovely example that you shared with me before about a company that you worked with, that implemented an employee share scheme when their company's share price was quite low.
Peter Hills
Yeah. It was December 2018. I had this mining company, or exploration company, come to me and at that particular point of time, their share price was 15 cents. And we implemented an option plan – a so-called ‘Premium Priced’ Option plan. And the share price is now $8.20. And so you know, that's a really good example off value that can be provided to an employee and then through that process, giving the employee an uplift in remuneration that wouldn't otherwise be able to get through cash salary. I should highlight, you know, at the same time, there's these success stories. And there's many a person that likes to tell you how many times that one at the TAB and the like, but they don't necessarily tell you how many times that they've lost. There are a number of examples, and especially when the market was going the opposite way, where options or the like, was provided to employees and share price went down, and they did become out of the money and potentially at no fault of their own. So it does work both ways.
Therese Raft
Well, that's a very interesting point that you make there. And in an important one. You mentioned, you're getting a lot of queries from existing companies. Why are they in particular interested in this is the future remuneration model?
Peter Hills
You know, I suggest where we're at with the labour market at the moment, for a number of companies is probably highlighting the reasoning why employees share plans, and in particular, how they’re designed, is becoming more important and prevalent. We are tax people, and we engage with remuneration consultants to essentially assist with the design of the underlying KPI’s and the goals that need to be put in place to drive that behaviour. But then also at the same time, to assist in so called benchmarking, determining the amount of award that should be provided to these employees or directors or management.
Therese Raft
So we've outlined some really interesting trends that have led up to this point. And obviously there's more than one way you can structure an employee share scheme or employee share plan. Could you maybe explain a little bit about what a Performance Right is?
Peter Hills
Okay, maybe before I go into that and describe a Performance Right, I'll just discuss why we use Performance Rights, and Options and the like. We rarely see companies implement an employee share plan that provides an employee a share up front. We typically see the instrument being used and granted first, as either a Performance Right or the option. I'm sure you ask me the question about the options later, and it does depend on a number of factors. So how I describe a Performance Right is simply a non-exercise price option. And what I'm meaning by that is that you grant this option to an employee for no cost, and then at the same time, the employee has the ability to exercise this right to acquire a share off the company for no cost as well. And so essentially, it’s a free share. If you said, where do we see it, typically? I see it typically in companies that have got stable growth, and high dividend yield. We typically see quite stringent performance criteria on them, because you’re giving something away for free, and at the same time, you might have some type of time based hurdles on there as well. Now, I see it in both the listed and the unlisted marketplace. I do note in unlisted, we tend to go towards some so-called ESOP start up options, if they're available. But for companies that ESOP start up options aren’t available, in the private space, we would use the Performance Rights. Let me give you a quick example. Bear with me for a tick. So sitting here. We've got a company that's got a share price off a dollar, and we’re saying that in the next 2-3 years, its growth opportunity may be $2 or $3, and so that's a so called stable growth. So how the tax rules work for these Performance Rights, is that in the future, when the employee exercises in the market value is $2, the employees will be assessed, at that point of exercise, typically, and I do say typically, are assessed on that $2 at their ordinary marginal tax rates. And so it does highlight that particular example. You know, the person getting a substantial reward, but then also it highlights the taxing and how the Performance Rights is taxed.
Therese Raft
Now, Peter, there's also another version, of an employee share scheme, and that's called a Premium Priced Option. How is that different to what we've just been discussing?
Peter Hills
Yeah, Premium Price – and maybe I should just highlight – Premium Price is a concept and a name that the industries probably created, and it's simply described as essentially the exercise price being a premium to the market price. But then, at the same time, that premium being high enough, so that the value at grant is nil. And there's a particular reason why you're doing that… is it's pushing you outside the employee share plan rules, and into the capital gains tax rules. And, you know, as I mentioned before, the capital gains tax rules potentially give you that access of 50% CGT discount. Let me go through an example, and we'll use the dollar market value to get a nil value under the employees share plan tax rules. You would have to have an exercise price of a $1.45 or more, for a four year option. And so you can see the premium that's been calculated and how much it has to be priced to be, essentially have no value under the tax rules. So you're sitting here, comparing it to the Performance Rights. And, you know, with a Performance Right, the employee is going to get value at all points because you don't have to pay anything for it. But for a Premium Priced Option, they have to essentially have a share price is greater than $1.45 before they get in value. So let’s use that example that we had before. We sell it for $2, the employee makes a 55 cent gain, compared to the example that I've said for Performance Rights. You know, there can be a substantial difference in return, because of essentially the exercise price. Alternatively, you know, let's look at if the share price went to $10 and they're able to access the 50% CGT rule, because they've held the share for greater than 12 months after exercise.
In that example, they would make $8.55 gain, and only half of that gain would be assessed. And what will happen is that essentially the tax saving will start to outweigh the cost of essentially buying that share, and knowing the tax outcomes between the Performance Rights plan and the Premium Price plan, but then also knowing and having an understanding of potential growth factors can assist the company in deciding which instrument makes sense for their employees. And it helps decide what type of instrument that's used. You know, there's a number of other things that need to be taken into account. There's accounting impacts, payroll tax impacts and dilution impacts that companies have to go through when deciding which instrument to use.
Therese Raft
So both those options sound like they are more for established companies, and there's a lot of work that's clearly going on the back end to match the instrument to the unique requirements of the company. But I also understand there's an option, or another way of doing an employee share scheme, which is the ESS start-up concession?
Peter Hills
Yeah, it's become popular, really, really popular for the tech start up market, and for companies that are starting up. The best way of describing whether or not you're a start-up company, and there's a number of tests, I won't go through them it would take too long. But the best way describe it is that essentially, the company’s not listed, but then, secondly, the company has been incorporated for less than 10 years, and there's also turnover tests in there as well. If you are able to satisfy those tests and others, the ability to provide very concessional options or shares to employees under these start-up rules is attractive. And the reason why I say that, is that the rules allow you to essentially push the employee into the capital gains tax rules that I've discussed a few times already and in particular the 50% CGT concession. But also the rules allow concessional valuation, as far as pricing, that exercise price, I talked about before that the exercise price had to be a premium to the market value. Under these start-up rules, they have to be a price that’s essentially equal to, or more than the market value. But then also in certain circumstances, you could use some safe harbour valuation rules that can give a very low exercise price. And so what you're seeing is that these start-up companies being able to provide a good package, and we typically provide options to employees that are priced very concessional and are subject to the CGT rules. And in the future, if they're around for that so called exit event, only having half of that gain subject to the CGT rules. So it is very, very attractive. And, you know, we're seeing a number of enquiries around these rules. I want to highlight one thing. The ATO and the government tried to make these rules simple and provide a number of support documents to assist the process of implementing. Interestingly enough, the technicalities and the number of different tests that have to be satisfied, are numerous. And so therefore it does require a number of things that need to be satisfied before they can be applied correctly.
Therese Raft
So there were some changes in the May 2021 budget around employee share schemes. Has that helped at all to simplify things or make employees share schemes more attractive or accessible?
Peter Hills
You would have hoped. And the reason why I hesitated in how I was going to answer that question, there was a number of inquiries that were conducted prior to these recent changes, and unfortunately, they didn't go far enough. So the two changes, and I should highlight that before I go on any further. The two changes where essentially stopping the taxation of employees when they cease employment and that was in certain types of plans and the so called ‘tax deferred’ plans. And then the other one was around the corporation law requirements of providing options and shares to employees and the one that I can advise on is the tax changes. And, you know, what we found is that it doesn't apply to all plans. We've talked about Premium Priced Option plans, and we talked about ESO start-up plans. That particular change doesn't apply to that. It does apply to the so called Performance Rights plan, and in the situation where a person was a good leaver and you wanted them to essentially be able to keep those Performance Rights, and, you know, nine times out of 10, you wouldn't allow them to be kept upon ceasing employment. Now, probably the typical times was when someone was made redundant, or alternatively retirement or some type of good leaver provision, and you did want them to be able to keep it, and it has worked for them. I think that that's a really good outcome, but it would have been great that we saw some more changes, making the rules a little bit more simple. And at the moment there's so many different variations. It would have been great that maybe they, for example, just made all employees share plans taxable under CGT rules only. And that could have created a completely different motivation and incentive for employees if you simplified it that way.
Therese Raft
Now you've already mentioned that the government has had a few inquiries. The ESS start-up concession was introduced in 2015, obviously there was some tinkering just a couple of weeks ago. So is the government actively encouraging companies to use this as a mechanism?
Peter Hills
There has been this recognition from the government that there should be more employee share plans used, and you know, I think that it was highlighted again in this latest budget, even though that these tax changes weren't necessarily as far as what we hoped, it was highlighted that we need to attract and retain good people in Australia. And to do that you need a couple of things in your tool bag to essentially assist with that process, and one of them is a good designed employee share plan. And so I do believe that the government has got some motivation. And, you know, I think they were watch these recent changes on it. Maybe more around the corporation law side and the disclosure requirements that are required to implement an employee share plan, and just to to see how that assists increasing the process off increasing the uptake around employee share plans.
Therese Raft
Finally, Peter, I'll be honest the way that you kind of describe some of the tests, the requirements that go into being able to set up an employee share scheme. It sounds quite complex. In the end, and fundamentally, is it worth the effort?
Peter Hills
Yeah, that's a really good question. I think that the best way that I answer that is the number of enquiries that I get on a weekly basis, I suggest that we have about a 90-95% take up. And so, we go through at a high level, what employee share plans are about, and go through the tax side and steer them towards the lawyers for the legal side, and rem consultants for the design of the underlying remuneration package. And the take up is still high after we've gone through all that discussion, and our reason to myself and the take up is high because people are realising they need – as I've said before – something that essentially assists with remunerated employees and motivating and cash salary is not going to achieve that. So they persevere. So I, you know, I think that that's overriding driver, and through that driver they're going to get a far greater return on that cost than what they would have otherwise done if they hadn’t done anything. The IPO market is definitely keeping interest up in this marketplace at the moment, for providing employee share plan advice. And you said before the marketplace, to attract people and retain people in the start-up space is very prevalent. And I do believe that things are trends, and I do believe that people talk at the pub, so to speak or in so called investment or support groups, and I suggest that the trend is going to be there for a while yet, and anything becomes stronger over the coming years.
Therese Raft
Well, Peter, it sounds like there's a lot of moving pieces that go into making up this is an option, and clearly very popular one. Thank you so much for your time and explaining some of the mechanics behind it.
Peter Hills
Thanks, Therese,
Therese Raft
And people can find a little bit more information on some of those different options on our website. And Peter are you happy for people to reach out to you on LinkedIn and on email to perhaps discuss employees share schemes and their individual circumstances in more detail?
Peter Hills
Yes, please do. And obviously also could be searched up on our Grant Thornton website as well.
Therese Raft
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