Changes to the taxation treatment of employee share schemes

New laws have recently been passed in relation to the taxation treatment of employee share schemes. The new laws give rise to significant taxation changes to the way employee share schemes are taxed and also create new compliance obligations for companies offering participation in the schemes. The new laws apply from 1 July 2009.

DibbsBarker can assist companies offering share and option benefits to their employees under existing schemes to ensure that there are no unintended and unexpected taxation triggers under the scheme. DibbsBarker is also able to assist companies wishing to implement new employee share schemes to ensure that the design of the scheme provides for the most tax effective result for the company and its employees under the new laws.

The new laws are set out in Division 83A of the Income Tax Assessment Act 1997 and apply to shares or rights (referred to in the Act as an “ESS Interest”) that are acquired on or after 1 July 2009 by an employee under an employee share scheme. The former provisions in Division 13A of the Income Tax Assessment Act 1936 will continue to apply to all shares and rights that were acquired before 1 July 2009.

The key features of the changes to the law are summarised below.

Structure of scheme to drive its taxation treatment

The structure of the employee share scheme will now determine its taxation treatment. The default position is that the tax on the discount (or value of the benefit given to the employee) for shares and rights that are acquired under an employee share scheme will now be paid at the date of grant unless under the conditions of the scheme:

• the benefits provided are at a “real risk” of forfeiture; or
• they are provided through a “salary sacrifice arrangement” (which relates to shares not rights) offering no more than $5,000 worth of benefits to an employee per income year per employment relationship; and

where the scheme and the employee meet certain other conditions.

Real risk of forfeiture

• The term “real risk” of forfeiture is not defined in Division 83A and a “reasonable” person test is to be applied. Something is not a “real risk” if a reasonable person would disregard the risk as highly unlikely to occur or as nothing more than a rare eventuality or possibility.
• In order to defer tax under the “real risk” of forfeiture test the conditions of the employee share scheme must provide:
  • in the case of a share, for a real risk that the employee will forfeit the share, or lose it other than by disposing of it; and
  • in the case of a right to acquire a beneficial interest in a share:
    • there must be a real risk that the employee will forfeit the right, lose it other than by disposing of it, exercising it or letting it lapse; or
    • there must be a real risk that if the employee exercises the right to get a beneficial interest in a share, they will forfeit the beneficial interest in the share, or lose it other than by disposing of it.
• A “real risk” includes situations in which a share or right is subject to meaningful performance hurdles or the securities will be forfeited if a minimum term of employment is not completed. There is no “real risk” of forfeiture in circumstances where:
  • there is a condition that merely restricts an employee from disposing of a share or right for a specified time; or
  • shares or rights are forfeited if the employee is dismissed for fraud or gross misconduct.

When is the deferred taxing point?

In schemes where the tax is deferred, the taxing point is now the earliest of:

• when there is no risk of forfeiture of the benefits and any restrictions on the sale or exercise are lifted;
• when the employment in respect of which the interest was acquired ceases; or 
• 7 years (previously 10 years) after the shares or rights were acquired,

unless the employee disposes of the share or option within 30 days after the time worked out above, in which case, the deferred taxing point is the disposal date.

$1,000 tax exempt plans

$1,000 per employee tax exempt plans continue to operate essentially in the same manner. The only additional test being that the participant’s adjusted taxable income for the relevant income year must not exceed A$180,000.

Tax refund rules

• The tax refund rules are now extended to cover forfeited shares. However, the most significant and adverse change in the law provides that the tax refund rules will not apply if the extinguishment, forfeiture or inability to vest occurs as the result of a choice the taxpayer makes (including choosing not to exercise a right for example, where the exercise price is higher than the market value of the underlying security) except a choice to leave employment. A refund of tax will be denied if the decision to forfeit is related more directly to the loss in the market value of the security.
• The practical result of this change in the law is demonstrated where an employee acquires an option under an employee share scheme which is subject to a “real risk” of forfeiture. In this instance, the employee will generally be subject to tax at vesting and not exercise (i.e. before the employee generates any cash from the option). If the option is underwater and the employee never exercises it, the employee can not claim a refund for the tax that was paid on vesting of the option. The employee will be able to claim a capital loss equal to the cost base of the forfeited security.

Trusts

Employees with a beneficial interest in shares in an employee share trust will now be taxed as though they were the legal owners of those shares. This change in law means that the tax liability of the employees cannot be reduced, delayed or avoided by interposing a trust.

Market value

The general principles of “market value” will apply in determining the market value of listed and unlisted securities. The Board of Taxation has been asked to review the existing valuation rules and as an interim measure the existing valuation rules for unlisted rights will be replicated in the regulations. The Board of Taxation’s report is due in February 2010.

New annual reporting requirements for employers

• The changes to the law also include new annual reporting requirements for the provider of ESS interests. Under the new laws, a provider must give a statement to the Commissioner and to the employee if:
  • the provider provided ESS interests to the employee during the year which were taxed under the employee share scheme tax rules; or
  • the provider has provided ESS deferred tax interests to the employee (during that income year or a previous income year) and the ESS deferred taxing point for the ESS interests occurred during the year.
•  The statement must be in a form approved by the Commissioner and provided to the employee no later than 14 July after the end of the financial year and to the Commissioner no later than 14 August after the end of the financial year.

Limited form of withholding tax

The new law also provides for a limited form of TFN withholding tax if a company provides ESS interests to an individual during an income year and that individual fails to provide their employer with a TFN or ABN at the taxing point.

To discuss how these changes affect your business, please contact Peter Burden on +617 3100 5020.