Innovative start-ups often face significant challenges in the early stages of building and developing their business, in particular, attracting high calibre talent.
For many small start-ups, there simply isn't the capacity to compete with larger businesses by providing higher salaries or incentives.
As International research has shown, those employees with an ownership interest tend to be more productive than those who don't.
Employee share schemes are typically used to attract and retain the skills needed for the business's growth by offering people with the right skill sets a stake in the planned and future success of the business.
Australian business entrepreneurs have been championing reform of ESS rules and legislation for some time and have broadly welcomed the changes that were put forward by the Government in 2014.
So what is changing and how will it affect a start-up's ability to implement an Employee Share Scheme (ESS)?
The exposure draft legislation was released in January and proposes a series of amendments that would:
- Reverse some of the changes made in 2009 to the point at which rights issued as part of an employee share scheme are taxed for employees of all corporate tax entities;
- Introduce a further tax concession for employees of certain small start-up entities;
- Allow the ATO to work with industry to develop safe harbour valuation methods, supported by standard documentation that will streamline the process of establishing and maintaining an ESS for business.
The objective of the changes is to improve the tax treatment of employee share schemes, making them more accessible and attractive to business to facilitate the alignment of interests between employers and their employees.
This will also help to stimulate the growth of innovative start-ups in Australia by helping small, unlisted companies to be more competitive in the labour market.
The proposed reforms include taxing points are amended as follows:
- When there is no real risk of forfeiture of the shares and any restrictions are lifted;
- When the employee ceases employment; or
- 15 years after the shares were acquired.
- When there is no risk of forfeiting of the rights and any restrictions on the sale are lifted;
- When the employee exercises the rights (i.e. rather than when an employee can exercise the right);
- When the employee ceases employment;
- 15 years after the rights were acquired.
The changes to rights schemes means that those which do not contain a real risk of forfeiture will be able to access tax deferred treatment where:
- The scheme rules state that tax deferred treatment applies to the scheme; and
- The scheme genuinely restricts an employee from immediately disposing of the right.
The exposure draft legislation proposes that the significant ownership and voting rights can be relaxed by doubling the existing 5% test to 10%.
The Government's proposed amendments will ensure that an employee's choice not to exercise a right is also a choice that does not prevent application of the refund provisions. If an employee decides to let a right lapse and has previously paid tax as a result of acquiring the right, then the employee will be entitled to a refund.
Smaller start-ups have been included in the changes. Employees of certain start up companies receive additional concessions when acquiring certain shares or rights in their employer or a holding company:
- Shares: The discount is exempt from tax and the share - once acquired - is then subject to the CGT system with a cost base reset at market value.
- Rights: The discount is not subject to upfront taxation and the right (and resulting share once acquired) is subject to CGT with a cost base equal to the employee's cost. The resulting share, once acquired, is then subjec to CGT with a cost base equal to that of the employee's lost of aquiring the right.
There are, of course, some key eligibility criteria that start-ups need to meet to take advantage of the ESS reforms. The ESS interests need to be in a company that:
- has aggregate turnover of less than $50 million
- is not listed; and
- is incorporate for less than 10 years (including other companies within any group)
- is Australian resident taxpayer (which may, or may not, be the company issuing the ESS interest).
The employee share scheme must:
- in the case of a share, be acquired with a discount of less than 15% of the market value when it is acquired; and
- in the case of a right, have an exercise price (or strike price) that is greater than the market value of an ordinary share in the company that issues it at the time the right is acquired. This ensures that the concession only applies in situations in which the ESS interest is issued at a small discount to the employee.
One of the challenges with these reforms is the rule around a company being incorporated for less than ten years. Innovation can take a considerable amount of investment in R&D, both in time and dollars, to get a commercial product to market, with the investment often coming from joint ventures, partnerships and other investors who may well be established for more than 10 years.
While the devil will be in the detail, this is an area where advice should be sought ahead of any ESS planning.
The safe harbour market valuation methodologies will be applied from a date to be specified in by the ATO Commissioner in a legislative instrument.
As always, it's important to get professional advice when establishing an Employee Share Scheme, particularly when planning for tax and other structural needs within the start-up.
Contact us on 02 9957 4033 for guidance and to speak to one of our expert team.
Download PDF version: Reforming ESS for Start-Ups
Last updated March 2015. This factsheet is provided for information purposes only and is correct at the time of publishing. It should not be used in place of advice from your accountant. Please contact us on 02 9957 4033 to discuss your specific circumstances.