Issue #4
Something for Nothing?
Issues with issuing shares & options to employees
Hardly a new issue, but the practice of issuing shares or options to employees is back on the ATO’s radar.
What is under the spotlight?
The high-income individuals project announced in the 2007/08 ATO Compliance Program has identified the under-reporting of income arising from employee share schemes to again be a major focus. This follows on from ATO attention in the 2006/07 Compliance Program targeting the use of trust arrangements to reduce the tax on shares and rights acquired under an employee share scheme.
The ATO’s compliance focus on employee share schemes was recently highlighted in a speech by the Commissioner of Taxation Michael D’Ascenzo to the Australian Institute of Company Directors.
The full extract of the Commissioner’s speech can be viewed at ‘Employee Share Schemes‘.
Regardless of any increased ATO interest, we flag the following issues as obvious areas where the intended operation of the law in this area seems to be missing the mark:
- Is Tax Payable?
- How much tax is payable?
- When is the tax payable?
- Other issues
- On-costs
Is tax payable?
A taxpayer acquires a share or right under an employee share scheme where it is acquired in relation to any employment of the taxpayer or any services provided by the taxpayer and the share or right is acquired for less than its market value.
A discount given to an employee on such shares or options to acquire such shares is assessable income of the employee. The shares, or options to acquire shares, are almost always shares in the employing company itself or alternatively in a holding company or subsidiary of the employing company.
Unfortunately, for many employees this fact comes as a bit of a surprise. The surprise is generally due to the fact that responsibility for ascertaining any tax implications is generally transferred to the employee by way of a short sentence buried in the congratulatory letter notifying the employee of the planned allocation. Most taxpayers are also conditioned to expect that the tax implications for shares and options arise on sale not acquisition.
In addition, it is a common misconception that employee shares schemes are only an issue for employees of listed company employers. This is not the case and the measures apply equally to employees of SME companies.
Of course, there is a grey area as to whether or not the measures apply where the taxpayer receiving the shares is a family member of current shareholders and the issue of the shares to the taxpayer is part of an overall succession plan. In these circumstances it may be reasonably arguable that the shares have not been acquired due to any employment nexus but rather due to family or shareholding ties.
Of course, there are other areas of the tax law that may require consideration such as the value shifting provisions.
How much is tax payable?
The discount received by the taxpayer is included in their assessable income for the year in which the shares (or rights) are issued unless the shares (or rights) are ‘qualifying’.
Where a taxpayer acquires ‘qualifying shares or rights’ under a Division 13A employee share scheme, they can choose to include the discount given on the shares or rights in their assessable income either:
- in the income year they acquire shares or rights (‘the acquisition year’) if the taxpayer makes a section 139E election; or
- in the income year that ‘cessation time’ of the shares or rights occurs (‘the cessation year’).
There are detailed rules for calculating the discount amount, depending on whether the discount is assessable in the acquisition year or cessation year.
The valuation rules can be complex and onerous to apply, especially when applied to unlisted shares or rights. For example, in the case of unlisted shares, the valuation rules require that the employer obtain either a formal valuation from a ‘qualified person’ or by getting the ATO to approve a valuation method in writing.
A person is a qualified person for this purpose if the person is registered as a company auditor under a law of a state or territory, provided that company auditor is not:
(a) a director, secretary or employee of the company, a share in which is being valued;
(b) a partner, employer or employee of the person referred to in (a); or
(c) a partner or employee of an employee of a person so referred to.
Contrary to common misconception an employer merely advising a value of the shares or options as a basis for determining any discount is not adequate.
When is the tax payable?
The tax payable on the discount will of course be payable upon assessment of the relevant year’s income tax return. That is, in the year of issue or in the cessation year.
In the case of qualifying shares and/or rights where the employee wishes to include the discount in the acquisition year care should be taken to ensure that a valid section 139E is made. Only in limited instances will the Commissioner exercise his discretion to allow a late section 139E election regardless of whether the employee has already included any discount in assessable income.
Issues also arise where a valid section 139E election has not been made for the year in which the shares or rights were acquired and the employee is out of time to request an amended assessment . Problems may be further compounded if a section 139E election has been made in the wrong income year and the taxpayer is out of time to request an amended assessment.
Unfortunately we have seen situations where the Commissioner has assessed the taxpayer on the discount at cessation time, even though the discount has previously been included in the taxpayer’s assessable income, albeit in the incorrect income year.
Other issues
Employee share schemes are becoming increasingly important for private companies as part of staff planning. As private companies generally do not have the in-house resources available to public listed companies, they should ensure professional advice has been obtained to determine whether their employee share schemes comply with the relevant tax legislation.
Some issues arising from the application of the employee share schemes rules to private companies include:
- the 5% ownership threshold – in order to receive ‘qualifying’ status immediately after the acquisition of the share or right, the taxpayer’s legal or beneficial interest in the shares of the company cannot exceed 5%;
- the recruitment for qualifying shares to be ordinary shares – in many instances employees of private company’s are issued with dividend only shares;
- the interaction of the value shifting rules – shares issued for nil consideration to employees could result in taxing event arising to the pre-existing shareholders under the value shifting rules;
- loans and Division 7A – a loan made to a shareholder or their associate to acquire ESAS shares or rights is not taken to be the payment of a dividend for Division 7A purposes if the loan was made solely for the purpose of enabling the shareholder or their associate to acquire qualifying shares or qualifying rights.
On-costs
Employee share schemes may also impact other areas of tax, such as payroll tax and fringe benefits tax. Consideration of the application of employee share schemes to payroll tax and fringe benefits tax requires a shift in the tax burden being borne by the employee to the employer. For example, the discount on employee share schemes is generally assessed in the hands of the employee under Division 13A, but payroll tax is assessed on the employer.
In situations where Division 13A does not apply to the employee share scheme other provisions of the tax law need to be considered. This may occur where, for example, where shares or rights are acquired at full market value, or where an employee scheme involves interests that are not ‘shares or rights’ (eg. units in an associated unit trust).
The ATO in recent times has focused heavily on employee benefit trust arrangements whereby employees have received units in an investment unit trust established by the employer.
As part of the harmonisation of payroll tax in Victoria and NSW, from 1 July 2007, the Victorian payroll tax law now includes any discount on shares or options issued after that date in the definition of ‘wages’. NSW has included such amounts for shares and options issued after 1 July 2003.
Payroll tax liability attaches to year in which the shares or options vest in the employee unless the employer has included the discount in the payroll tax year the shares and options were granted.
Discounts on shares or options schemes are also legislated as ‘wages’ for payroll tax purposes in WA, NT and the ACT. The South Australian Government has announced that it will implement legislation to make employee share acquisition schemes subject to payroll tax, effective from 1 July 2008.
Compliance in this area is made doubly hard by the fact that responsibility for preparing payroll tax returns is likely to rest with the payroll department who may have little practical hope of ascertaining the details of executive remuneration plans beyond the cash salary component that hits the payroll.
Conclusion
The above discussion broadly canvasses some of the issues surrounding granting shares and options to employees.
It would seem to us that the correct tax treatment often gets overlooked when the commercial issues and negotiations occur as to whether and on what terms shares or options will issue.
This edition of ‘The Assessment’ was prepared by Jeremy Khaw & Rob Power.
If you have any comments in regards to the contents of this edition please feel free to contact Jeremy at jeremyk@webbmartinconsulting.com.au or
Rob at robp@webbmartinconsulting.com.au
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