Management Incentive Plans
As a general guide, the key tax rules which need to be considered when issuing shares to employees or management are as follows:
- The Employee Share Scheme (ESS) rules: under the ESS rules, where rights or shares are issued to employees at a discount to market value, the discount is included in the employee's assessable income (and therefore taxed at their marginal rate of tax) in the year of income in which the rights or shares are issued, unless the issuance is structured to comply with the tax deferral rules or another concession applies;
- Capital gains tax (CGT) rules: gains on disposal of shares or options may be subject to the CGT rules to the extent they do not fall within the ESS rules. The potential for discount capital gains exists if the gain is made by an individual (50% reduction) and the gain is made on an asset held for at least 12 months;
- Deemed dividend rules (commonly referred to as Division 7A): Division 7A applies in certain circumstances where a private company makes a loan or a payment to a shareholder or an associate of a shareholder, and can deem such loans (or forgiveness of a loan) or payments to be a taxable dividend. Division 7A will broadly be relevant if the shares being issued are loan-funded, for example a company loans money to an executive who uses funds to subscribe for shares at market value; and
- Fringe benefits tax (FBT): FBT is levied on the value of any non-cash benefits (ie. fringe benefits) that are provided to employees or their associates in the context of the employee's employment. FBT is payable by the employer, not the employee. FBT does not generally apply to shares and options issued where the ESS rules apply but it can be relevant to certain loans made to employees to acquire shares.
However, the above is not an exhaustive list, and depending on the specific management incentive plan, other tax rules such as in respect of payroll tax (which is assessed by State and Territories) would need to be considered. Also, there are other Australian legal issues (including corporate law and employment law) which need to be considered.
The management incentive plan can be subject to vesting conditions related to performance or time. For example, performance shares can be issued which convert to ordinary shares when the performance conditions are satisfied (such as a private equity sponsor achieving a target return).
Transfer pricing
Key features
An employer lends money (interest-free) to an employee for an amount equal to the fair market value of the shares in the company that will be acquired.
General tax treatment
In circumstances where the employee receives the loan before they become a shareholder in the company, Division 7A should not apply. Although the loan is interest-free, the FBT provisions do not apply because of the "otherwise-deductible" rule (broadly, if there was interest, it would be tax deductible to the employee) which has the effect of reducing the taxable value of the FBT to nil.
In such circumstances, provided the shares are held on capital account, any gain sale of the share should be eligible for the CGT discount (provided the relevant criteria are satisfied – mainly, that the shares are held for at least 12 months by an individual).
Examples where this type of plan is typically encountered
Private Equity Investee Company, amongst others.
Key features
Employees receive a right to acquire shares in the future. A premium priced option is an option issued with an exercise price sufficiently more than the current value of the underlying share.
General tax treatment
If the option and resultant share are held on capital account, the CGT rules should apply as for loan funded share plans. However, note that the 12 month holding rule is reset if the option is exercised.
However, FBT issues are more complex than in the case of loan funded share plans.
Examples where this type of plan is typically encountered
Not commonly used, but was typically seen in start-up contexts, before the introduction of the ESS start up concessions and in some private equity investee arrangements.
Key features
An employee will receive shares, or options to purchase shares at a discount to market value.
General tax treatment
Where rights or shares are issued to employees at a discount to market value, the “discount” is included in the employee's assessable income (and therefore taxed at their marginal rate of tax) in the year of income in which the rights or shares are issued.
The “discount” is generally the market value of the ESS interest less any consideration paid by the employee.
These plans are typically structured so that the taxing point is deferred until there is an ability to liquidate the relevant shares. However, it is generally the case that all, or a significant proportion of any gain is taxed at marginal tax rates (without the benefit of the CGT discount).
For certain start-up companies, employees may be eligible for a concession under section 83A-33. Where a taxpayer qualifies for this concession, employees can access tax deferral and also CGT discount concessions.
Examples where this type of plan is typically encountered
Listed Companies. Early stage companies, including those which qualify for the start-up concession.
Key features
Performance rights entitle their holder to a particular number of shares in the company in the future if certain conditions are satisfied.
General tax treatment
Properly structured, performance rights can be structured in a tax deferred manner until such time as the holder of the resultant shares can achieve liquidity in those shares.
However, it is generally the case that all, or a significant proportion of any gain is taxed at marginal tax rates (without the benefit of the CGT discount).
Examples where this type of plan is typically encountered
Listed Companies.
Key features
An employee can receive shares without dividend rights or voting rights. Where an employee meets performance conditions, the share rights increase over time and can eventually provide rights equivalent to an ordinary share.
General tax treatment
A flowering share is often intended to have a value equal to the issue price at the time of issue.
Due to the limited rights at the time of issue, it is typically contended that the market value of the share is simply the nominal issue price.
The expectation is that these shares fall within the CGT rules, thereby raising the prospect of deferred and discounted tax treatment.
These types of arrangements often raise complex valuation and technical issues and so are not as commonly used.
Examples where this type of plan is typically encountered
Various including private equity investee arrangements.
Key features
A cash bonus at a future point in time that is generally calculated with reference to the value of the underlying equity.
The bonus would be paid on the basis that the employee had notional equity, but no real shares would be allotted.
General tax treatment
Generally, the bonus is paid as a cash payment net of tax so that there is no taxing point until the cash is received – at which time the bonus would be taxable as ordinary income at the employee's marginal tax rate.
Properly structured, the payment should also be deductible to the employer and generally not subject to FBT.
Examples where this type of plan is typically encountered
Closely-held private companies where controllers do not want to bring in outside minority shareholders and global employee equity plans where there are a small number of Australian participants (it may be more convenient to proceed down this route than trying to provide direct access to equity in the parent entity).