Creating World-Best Practice Taxation Treatment of Australian Employee Share Ownership Plans
1
Background
1.1 The current system in relation to taxation of options has a number of difficult areas which are impediments to attracting and retaining high calibre employees essential to the creation of venture capital (“VC”) backed companies, including: (a) Ordinary income: gains arising from the holding period in respect of options are taxed as ordinary income unless circumstances permit the application of the discount capital gains tax (“CGT”) concession; CGT concession: this requires the employee electing to be taxed upfront on the value of the options at the time of issue and then holding underlying shares for at least 12 months after exercise of the relevant options. There are valuation issues (often ignored in practice) surrounding the payment of income tax by the optionholder at the time the options are acquired. For instance, the option valuation rules in the existing rules only take into account the differential between the exercise price and the value of the underlying shares at the time of issue and the exercise period. No account is taken of other hurdles to exercise such as attaining milestone IRR targets. In addition, there are high compliance costs and difficulties in reaching an objective valuation for early-stage, unlisted companies.
(b)
(c)
1.2
Due to the rigid code governing the current taxation treatment of options, adverse tax consequences could arise in various situations where no real gain or benefit has come home to the optionholder, including: (a) (b) Cancellation of “out of the money” options, replaced by a fresh issue of options; and Substitution or exchange of options in a takeover or trade sale context.
2
Rationale for change
2.1 Employee Share Ownership Plans (ESOPs) should not be regarded and therefore taxed as ordinary remuneration. They are an important and integral tool used in the VC context as “equity incentives” to achieve the following:
Employee Share Ownership Plans – Page 1
(a) (b) (c) 2.2
Providing a means to attract and retain key personnel from larger companies, required to grow the business; Encouraging employees to relate to the business as shareholders; and Enabling a young company to leverage its available resources when capital is limited.
To drive the VC Industry, Australia needs a “world's best practice” ESOP scheme which is: competitive with schemes already in place in competitor markets such as the US, UK, Singapore, Canada and India; simple to administer from a corporate perspective; attractive to high calibre employees; and fair in terms of tax administration. It is vital that the tax treatment be aligned with normal attributes of equity ownership, including that tax is on capital account (hence eligible for the CGT concession) and only arises upon realisation.
2.3
3
Proposed model
3.1 3.2 3.3 It is proposed that the taxation treatment of ESOPs (as defined) in the VC context be governed by a totally different set of rules to that existing currently. ESOPs should not be seen as ordinary remuneration and therefore taxation of ESOPs should be wholly on CGT account. There should be no taxation event prior to the disposal of the underlying security (generally the share although the disposal of options for cash consideration should also give rise to a tax event). The grant and exercise of options should not trigger tax events. Therefore, complicated taxation rules and disputes over valuations would be avoided. Calculation of an optionholder’s net capital gain should be based on total net actual (or deemed) proceeds at the time of (actual or deemed) disposal, LESS total costs of exercising the options. Again, this will obviate the need for timeconsuming, costly and uncertain valuations every time options are granted. Similarly, full CGT “rollover” should be provided in circumstances where options are cancelled/exchanged/substituted for other options in all circumstances. The discount CGT concession should be attracted providing the relevant shares (or options) are disposed of more than 12 months after the date the optionholder acquired the original options to which the shares (or options) relate. Quentin Jones Chairman, ESOPs subcommittee, AVCAL Executive Director, Equity Partners Phone: 02 8298 5100 Email: qbjones@equitypartners.com.au
3.4 3.5
3.6 3.7
Ernest Chang Director Greenwoods & Freehills Pty Limited Phone: 02 9225 5965 Email: ernest_chang@gf.com.au
Employee Share Ownership Plans – Page 2