Should you give your employees shares in your company?
There has been a lot of discussion happening about changes to the employee share schemes in recent weeks as reforms before the Parliament are due to make ESS more attractive for start-ups and growth businesses.
Changes include some common sense approaches to how they are taxed and special incentives to share the rewards of growth with the people inside the business who've contributed to it. The reforms are - to apply to shares and options from 1 July 2015.
Employers looking to take advantage of the changes are advised to hold off issuing new shares or options until after this date, otherwise employees will be caught under the current, more onerous rules.
As we discussed last month, employee share schemes allow businesses operating under a company structure to provide employees with an ownership stake and share in the growth of the company, an incentive to align the interests of employers and employees during the embryonic phase of business growth.
Employees can be incentivized through shares and / or options. Shares provide an ownership stake whereas options provide them with a right to acquire shares at a later stage at a discount to the market value of the shares or rights.
Typically these shares or rights are subject to certain conditions that determine when and how employees can access the shares, such as a minimum employment period or performance targets. The intent of these conditions is to reduce staff turnover, keep productivity levels high and provide employees with motivation to continue to contribute to the company's goals.
If the employee leaves or doesn't meet the agreed conditions, then they generally forfeit the shares. A shareholder's agreement may also be put in place to control when, how and who the shares can be sold to once the employee is able to exercise the rights.
The reforms before Parliament address how and when employees are taxed on those shares and the regulation of share schemes.
When an employee received shares or rights under an ESS scheme, they are taxed on the discount they have received, in a similar way that they are taxed for salary or wages. The discount is generally accepted to be the difference between the market value and the amount paid by the employee to acquire the shares or rights. .
The structure of an ESS is important, because it may allow the employee to defer the point of taxation until a later time, with concessions available to reduce the amount that may be taxable.
Under the new rules, it will still be necessary to work through a number of conditions to determine whether the employee can defer the taxation on shares or rights they have received. The taxing point will be the earlier of
- When the employee leaves the employer;
- 15 years after the shares were acquired; or
- The point where the employee can sell the shares without restriction.
If the conditions are met and the employee has been provided with options to acquire shares then the taxing point will be the earlier of the following:
- The employee leaving the employer;
- 15 years after the right was acquired;
- The point where the employee can sell the rights without restriction; or
- The right is exercised and there is no real risk of the employee forfeiting the resulting shares and there are no restrictions on the employee selling the shares.
In general, the new rules enable the taxing point to be deferred for a longer period of time until the point at which it becomes clear that the employee will actually derive some economic benefit from the shares or options they have received.
There are some extra incentives for start-up companies as a result of rule changes. A start-up is considered to be:
- Unlisted that have been incorporated for less than 10 years
- Have an aggregated turnover of $50m or less in he income year before the share scheme's introduction
- If the start-up is part of a corporate group, all companies in the group must meet these requirements
There are some exceptions for certain venture capital funds from the turnover test and 10 year incorporation rule.
One of the concessions for start-up companies is that small discounts received in relation to shares or rights are not taxable at all under the ESS rules, provided that:
- The discount for shares is not more than 15% of the market value
- For rights, the strike price must be equal or greater than the market value of ordinary shares in the company at the time rights are acquired.
If the relevant conditions are met the discount should not be taxed but it will still be necessary to deal with the capital gains tax implications on eventual disposal of the shares or rights.
The new rules also tidy up the interaction with the capital gains tax (CGT) system for employees of start-up companies to make it easier for them to access the 50% CGT discount.
Normally, when someone exercises an option to acquire shares, the 12 month holding period rule is reset, which means the shares need to be held for another 12 months to access the CGT discount on sale. Under the new rules, the 12-month period will be measured from when the rights were acquired.
Share schemes are typically used to retain and attract highly skilled team members that can be particularly helpful in supporting the business through a start-up phase, particularly when there isn't cash in the business to offer higher salaries.
The value of the shares can't be realised for an agreed period of time, so an ESS locks them in for the duration of that time or the employee will lose any benefit. It can be a powerful incentive that goes beyond the 'golden handcuffs'. Offering employees the ability to invest their talent in a tangible growth asset rather than just a salary can prove highly motivating.
It's important that there are strong rules and documentation around how share schemes are managed to avoid putting the company at unnecessary risk, such as how and who shares or rights can be disposed of.
For example, if an employee holds shares acquired through an ESS but then leaves the company, can they sell the shares to anyone or will they be restricted to selling the shares back to the company or existing shareholders based on an agreed valuation formula?
Structuring an ESS is up to the company and its current owners to determine, however it is worth seeking professional guidance on setting up an employee share scheme. Taking to taxation specialists will ensure that the ESS is tax-effective and aligned with business objectives. You will need professional support including commercially aware legal advice and documentation, tax advice and business structuring advice.
The added benefit of professional guidance is avoiding the worst pitfalls of an ESS. For example, to access any of the conditions that are available under the rules, there are some common conditions that must be met:
- The scheme should not result in any one employee holding more than 10% of the shareholding or controlling more than 10% of the voting power of the company;
- The shares offered under the scheme need to be ordinary shares;
- The company's main business must not be share trading; and
- The individual needs to be employed by the company issuing the shares or one of its subsidiaries.
Before implementing an employee share scheme it is important to ensure that both the commercial and tax issues have been fully considered.
Generally a valuation of the business would also need to be undertaken to establish the discount that is being offered. There is no one size fits all method.
The Australian Tax Office is working on standard employee share scheme documentation and valuation safe harbours. While companies do not have to rely on these documents they will go some way to standardising how these schemes are implemented and the minimum requirements and standards.
This article is provided for information purposes only and correct at the time of publication. It should not be used in place of advice from your accountant. Please contact us on 02 9957 4033 to discuss your specific circumstances.