Employee Share Schemes – it’s that time of year again

In a dynamic employment market, a well designed and implemented ESS plan can provide the necessary edge for private and public companies to attract and retain key employees. However, having a plan that is not fit for purpose can be as demotivating as not having one at all.  

Do I have an ESS reporting obligation?

A company is required to provide an ESS Statement to its employees by 14 July, and lodge an ESS Annual Report with the ATO by 14 August following the end of the tax year in which any of the below occurs:

• ESS options, rights or shares (awards) were issued to employees at a discount on their grant date, and the awards either had an up-front taxing point at the grant date or the deferred taxing point for an award granted in a past tax year occurred during the current tax year; 
• The company issued ESS options or shares under an ESS Start-up scheme during the current tax year; or
• The company issued shares under the $1,000 tax exempt rules.

Below is a brief overview of the common types of awards under Australian ESS Plans, factors to consider for the ongoing tax effectiveness of these awards, when you should consider a revision to a plan or a complete replacement and common ESS taxing points that require ESS reporting. 

Performance Rights Plan

General overview

• A performance right is a share option with a nil exercise price.
• The rights are normally subject to performance based vesting conditions.
• If conditions are met, the employee can obtain the underlying share on exercise of the right for nil consideration.

Typical ESS taxing points

• For public companies, we typically see the tax point for Performance Rights being on exercise of the rights, as the employee is usually free to sell the shares received on exercise of the rights. However, if at the original grant time a restriction was imposed on the shares received on exercise of the rights, the taxing point will be deferred until the restriction is first lifted (e.g. an imposed sales restriction, a restriction imposed by the company’s share trading policy, or insider trading knowledge).
• For private companies, due to the lack of liquidity, we generally see a sales restriction being imposed on the rights and the shares received on exercise of the rights as part of the grant process, until a future liquidity event such as a trade sale or IPO.  As a result, the taxing point for Performance Rights issued by a private company is often when the shares are free to sell.
• However, in the above scenarios, if the sale of the shares is within 30 days of the lifting of the taxing point, the taxing point will be reset to the sale date.
• From 1 July 2022, the taxing point that previously occurred on the cessation of employment if a person retained rights or shares that had not previously had their ESS taxing point is no longer applicable. This is a welcome change as in the past it has caused issues for ceasing employees.

Should I update or replace my plan?

• As mentioned, particularly for private companies, the intent is generally to have the taxing point deferred until the employee has exercised the award and is free to sell the shares. Having a genuine sale restriction is therefore critical in achieving this tax outcome. The ATO has issued guidance on when, in their opinion, a restriction on the sale of rights and the shares received on exercise of the rights, is genuine and therefore capable of deferring the taxing point.
  
  For instance, the ATO have taken the view that if an ESS Plan has a general discretion for the Board to lift the sales restriction, and if this discretion is routinely lifted, or potentially if there is no documented support to indicate when this discretion might be exercised, the restriction might not be accepted by the ATO as being genuine. To mitigate the risk that the sales restriction is not viewed as being genuine, it may be prudent to review existing plan rules and other relevant documents such as Board papers to determine if action needs to be taken to ensure the deferred taxing point is not unintentionally brought forward for employees. The opinions expressed by the ATO in their recent Tax Determination should also be considered when designing a new plan.
  
  
• Prior to the removal of the cessation of employment taxing point, some plans were designed to ensure that an employee did not have a tax debt due to an ESS taxing point on cessation of employment, and plans were generally designed that ‘Good Leaver’ employees could not keep their ESS awards. The removal of the cessation of employment taxing point could provide an opportunity for ceasing employees to retain the performance rights. In this case, companies should review their plan rules to confirm prior treatment and update for future awards if appropriate.
  
  
• For Performance Rights that were structured to defer the taxing point to a proposed future exit event, and that event has not occurred and is unlikely to occur, consider if future awards should be structured differently. For example, the plan could permit the exercise of the rights to receive the shares and place a genuine restriction on the sale of the shares to defer the taxing point until a liquidity event, and receive dividends on the underlying shares.

Option Plan 

• A right to acquire a share within a designated expiry period at an exercise price specified at grant.
• Generally issued for nil consideration with the exercise price equal to the market value of the company’s shares at grant or at a premium.
• Can be issued by eligible start-up companies under the concessional ESS Start-up Rules.
• Generally, options will be issued with vesting conditions and if met, the employee can acquire the shares upon payment of the exercise price.

Typical ESS taxing points

• Options issued at a discount on their grant date (e.g. market value exercise price options) – for these types of options, we typically see the same taxing points as those outlined above for Performance Rights.
• Options not issued at a discount on their grant date (e.g. premium exercise priced options) – as these options have not been issued at a discount under the ESS rules, they will not have an ESS taxing point and instead they will generally be subject to tax under the capital gains tax (CGT) rules.
• ESS Start-up Options – while employees are not taxable on any ESS discount, the company needs to submit the ESS Annual Report to the ATO for that year.

Should I update or replace my plan?

• In addition to the comments above for Performance Rights, review if having an exercise price – while viewed as being more tax effective than say performance rights – may not actually deliver the reward. For example, companies that issued Premium Exercise Priced Options that were outside the ESS rules and subject to the CGT rules only, may not have achieved the beneficial tax outcome they were wanting to achieve as the company’s share may not have grown as high as expected.
• Where the above situation applies, it may be worth considering if an additional award of performance rights is beneficial to achieve the company’s retention and reward objectives.

Loan Share Plan

• In a Loan Share Plan, shares in the company are generally issued at their market value with the company providing the employee with a loan to fund the purchase of shares.
• The loan is normally a limited recourse loan so that if the value of shares is less than the loan outstanding at forfeiture or an exit event. No further amounts are repayable by the employee.
• The employee usually has access to the benefits of share ownership, including dividend yield, from the grant date of the shares.

Typical ESS taxing points

• As employees are normally expected to pay market value for shares issued under a Loan Share Plan, the shares are not generally issued at a discount under the ESS rules and therefore they do not have an ESS taxing point. This means that the company generally has no ESS reporting obligation with respect to shares issued under a Loan Share Plan.

Should I update or replace my plan?

• From a tax perspective, this plan can be more complex as both the plan rules and the loan agreement need to be very specific to ensure that events like the grant and ultimate close out of the loan do not inadvertently cause issues with shareholder loan provisions in Division 7A, FBT on the loan benefit, or the share buy-back provisions. 
  
  For example, it is important from a tax perspective that the loan is extended to the employee before they are a shareholder in the company, and only employees – as opposed to their associates – participate in the plan. 

• To mitigate risk, consider return of the shares in satisfaction of the loan where the price of the shares is below the then value of the loan, as this is aligned with the ATO guidance on this matter.  
  
  
• When implementing a new plan, consider the following:
  • While the plan may achieve the goal of being subject to the CGT rules rather than the ESS rules, where the company is intending to list on a stock exchange at some stage, consider whether a Loan Share Plan is appropriate. These plans are often viewed as not being ‘corporate governance friendly’ by public company shareholders. 
  • For private companies, the ability to offer additional shares is problematic due to the Division 7A issues.
  • If the shares are to be forfeited or purchased back by the company, consider the tax implications under the share buyback and Division 7A (private companies) provisions.  

Key take aways 

• Employee share schemes are a good reward and retention tool, but they need to be properly designed, monitored, and adjusted to ensure their ongoing success.  
• In recent years, we have seen companies contemplate providing a mix of both Performance Rights and Options plans, particularly Premium Exercise Priced Options. This provides a mix of high tax cost ESS interests (e.g. performance rights) and low tax cost ESS interests (e.g. potentially premium priced options) to balance out the risk of the company’s shares not growing in value.
• Review your ESS reporting obligations and ensure that if you issued ESS Start-up awards during the tax year, or if any other types of awards had an ESS taxing point during the year, you provide an ESS Statement to the relevant employees by 14 July and lodge an ESS Annual report with the ATO by 14 August. 
• Recently there have been Corporation Law changes to the legal requirements that need to be satisfied to issue ESS interests to employees. We recommend that you contact your lawyer to discuss these changes.
• For best results, don’t just set and forget.

The above is not intended to be taxation, legal or financial advice and before implementing or adjusting any ESS Plan, you need to seek specific advice for your circumstances.

As the above comments with respect to ESS taxing points are general in nature and the taxing point is very fact dependant, a review of the plan rules and related documentation is needed to determine the actual taxing points for awards issued under a particular plan to employees.