Changes to taxation of employee share schemes from 1 July 2009

The new law in relation to taxation of employee share schemes is contained in Division 83A of the Income Tax Assessment Act 1997.  The new law has the effect that any discount on a share or a right (being an ESS interest) issued or granted on or after 1 July 2009 will be taxable in the year in which the share or right is issued or granted other than in limited circumstances where a deferral of taxation occurs being where either there is a real risk of forfeiture or the ESS interest is in the form of shares acquired under certain salary sacrifice arrangements with a maximum value of $5,000.00 per annum.  The $1,000.00 tax exemption on any discount continues where the scheme meets certain conditions.

After much deliberation the legislation introducing an amendment to the taxation of employee share schemes, being the insertion of Division 83A into the Income Tax Assessment Act 1997, has been passed with effect from 1 July 2009.  The new legislation introduces a new concept known as an “ESS interest” which is defined as a beneficial interest in a share in a company and Division 83A applies to ESS interest acquired on or after 1 July 2009.

As far as taxation concessions are concerned, the $1,000 tax exemption continues and taxpayers participating in an employee share scheme will pay tax when they acquire the share or right on the amount of discount in excess of $1,000, if they have taxable income of $180,000 p.a or less and if the employee and the scheme meets certain conditions.  These conditions are essentially the same conditions as those which are applied under the previous legislation in respect of “qualifying shares” or “qualifying rights”.

The legislation provides that shares and rights are taxable on the basis of the market value of the ESS interest at the time when the interest is acquired.  As far as unlisted interests are concerned including rights or options, the previous methodology for the valuation of such interests will be replicated in Regulations yet to be issued but there is a proposal that when the Board of Taxation completes its review as to how best to determine the market value of ESS interests, taxpayers will be able to ultimately use the general market valuation rules to value such interest if they so choose.  This means, for example, taxpayers will no longer be oblige to use an auditor if they can determine and sufficiently justify the market value appropriately without using an auditor. 

As far as deferral of taxation is concerned this is only available either if the ESS interest are at a real risk for forfeiture or where the ESS interests are acquired under certain salary sacrifice arrangements with a maximum value of $5,000 per annum.  The legislation deals with the definition of “real risk of forfeiture” having regard to what a reasonable person would consider is a real risk that the employee would lose or forfeit the interest or never receive it other than by selling or exercising it, or through the market value of the ESS interest falling to nil.  Explanatory materials with the legislation state that the notion of a “real risk” is a risk which is more than mere possibility.

In order to qualify for deferral of taxation other conditions must also be satisfied being that the shares or rights must relate to ordinary shares rather than any other types of shares such as preference shares, the scheme (in relation to shares only) must be non-discriminatory which means that the employer must offer a scheme or schemes that apply to 75% of the permanent employees of the company and the interest must not result in an employee having effective ownership or voting rights of greater than 5% of the employer.  For an ESS interest provided through a salary sacrifice scheme the interest must be provided because the employee agrees to acquire the interest in return for a reduction in salary or wages or is a part of remuneration package where it is reasonable to conclude that the employee’s salary or wages would be greater if the interest was not part of that package

The taxing point for a deferred ESS interest is:

• For shares – the earliest time when there is no real risk that the employee will forfeit the share or lose it other than disposing of it and there are no general restrictions on its disposal or where the employee ceases employment or seven years after the employee acquires the shares;

• For rights/options – the earliest time when the employee ceases the employment in respect of which the employee acquired the shares, seven years after the employee acquired the shares or other times specified as being where there are no restrictions on the disposal of the right or disposal of the share acquired by exercising the right.   

This legislation is likely to have significant implications for the design of employee share schemes.  For example it is unlikely that option or rights schemes will continue to be widely utilised given that the circumstances where deferral of taxation can apply have been significantly limited and because there is a new methodology proposed for the valuation of the rights or options when they are granted.

It follows that it is likely that loan plans (where no discount on the value of the shares is provided) will be revived.  Another potential implication of the new legislation is that the ordinary meaning of “market value” will be used and in a plan for unlisted shares, rights or options, it will not be necessary to use an auditor to determine the valuation provided that the company can justify the market value without the use of an auditor.  This may well prove to be a risk management issue on the basis that reliance cannot be placed on the valuation by the auditor.