In part one he explained how employee share schemes work and how they are used especially by tech companies and startups as an enticement for hiring potential employees. In part 2, he looks at how Australian authorities have tackled the issue and how it could be implemented in the future. Prior to July 1, , the taxation situation in Australia was very similar to the current US situation.

If you chose to make the election, you included the value of any discount you received between the market value of the security and the price you paid in your income tax return in the year the shares or rights were granted. This discount formed part of your cost base of the shares for when you finally got around to selling the shares or rights. The E election allowed you to avoid that nightmare scenario I talked about before where tax had to be paid every time a share or option vests.

If you held for a year, under the Capital Gains Tax rules, on future disposal the top rate was For rights, such as options, it was similar but included the earlier of a the disposal of the right b when employment in respect of the right ceased c if the right was exercised and there were restrictions on either the disposal of the share or the share could still be forfeited — when the restriction was lifted or the share no longer subject to forfeiture d exercise of the right or e 10 years.

In , the Gillard government changed the rules on the taxation of employee share schemes so that:. I think this was probably a misguided attempt to tax senior executives from investment bankers and private equity who had experienced a short-term windfall at the height of the private equity boom.

However, in the process of enacting this legislation, the Gillard government had wiped out the primary means of remuneration for the fledgling Australian technology industry. This was somewhat ironic for Labor, because the whole purpose of an employee share schemes is to distribute wealth from owners to workers, and by passing this legislation all that happened was companies stopped issuing employee share schemes — in other words, the owners just kept the stock to themselves.

The thing that really screwed everything up was that the deferred taxing point in time to when there are no longer any genuine restrictions on the exercise of the right, or the resulting share from the right, and there is no real risk of the employee forfeiting their right or underlying share. So basically, tax is only deferred until vesting — which is the nightmare scenario. Employees have to pay tax well before they can sensibly sell part of the grant to pay for the tax.

Likewise, hiring a heavy hitter at the VP or C-level at almost any stage could easily cost you that much. The problem with the post 1 July regime was that tax was automatically deferred, with no chance for the new hire to make a E election and pay tax up-front at a low current value. There were two fundamental misconceptions in bringing in 83A. The first was that tax revenue was being lost under Division 13A, when it was merely being delayed. The second was that it overlooked that employee share schemes ESS drive productivity, which increases the taxable base.

These changes effectively ended the use of ESS in Australia. This was a huge problem for startups, and resulted in a significant drag on activity in the start-up sector and acceleration of movement of startups and talent going offshore, to the detriment of the Australian economy.

Ironically this not only reduced the amount of tax paid from discounted grants, but also from businesses that could not attract good enough talent to get off the ground, or those that left the country. In , the current Coalition government announced changes to the taxation of ESS. Draft legislation has been released which is intended to be introduced as from July 1, That would have been preferred to what has been proposed.

ESSs will be established as either a deferred or upfront tax scheme through their governing rules. An employee who is granted rights under a deferred tax scheme will be able to defer until the rights are exercised, or employment ceases, up to a maximum of 15 years. On exercise, income tax will be payable on the difference between the market value of the right and amount paid to acquire it.

CGT will be payable when the shares acquired by exercising the right are sold, on the difference between the sale price and the market value of the shares on the exercise date. When there is a real risk of forfeiture, the tax may be deferred until that risk ceases to exist.

At that point in time, income tax is payable on the discount from the market value paid to acquire the shares. In addition, CGT will be payable when the shares are sold, with the taxable amount being the difference between the sale price and the market value of the shares when the risk of forfeiture ceases. Instead this is treated as capital gains at later date. If rights are issued, provided that the exercise price of the right is equal to or greater than market value of the underlying share, then the discount is not subject to upfront taxation and the right, and resulting share once acquired, is then subject to capital gains.

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So basically if options are given for free but with a strike at least equal to the underlying market value of the share on the date of grant , the option premium is taxed later under capital gains and not as income in the year of the grant.

Note however that the goal posts have moved. Under the current regime, you could own 4. Second, in ESS deferred schemes where income tax is deferred, the maximum deferral period has increased from 7 to 15 years, to give people more time. Due to the anaemic funding environment for Australian startups, bootstrapping is the default path for our companies, and as such it takes longer for them to get to the promised land.

More significantly, the changes proposed in the draft legislation alter one of the taxing points from the point at which a right can be exercised vesting to the point in time where the right is actually exercised. For example, on page 10 of the explanatory materials to the bill it states:.

This somewhat defeats the purpose of vesting. I hope that this point is clarified because it appears to be contradictory to the stated intention of the proposed changes. The exclusions for the startup concession seem designed to exclude every meaningful technology company in Australia. First, I disagree with the premise that more advanced companies can pay more and therefore should not be eligible for the concessions.

The technology industry is globalised, and companies like mine Freelancer need to compete for talent with the likes of Google, Uber, Palantir and Facebook.

Tax professionals | Australian Taxation Office

US companies are hoovering up as much talent as they can in Australia to take back to Silicon Valley — talent that can reap the benefit of 83 b elections. Second, to base this on aggregated turnover is just sloppy policy. This is prejudicial to some business models like marketplaces, financial services, payments systems and e-commerce retailers of third party products where the turnover is very large but the margins are wafer thin.

The restrictions imposed to access the startup concession are bad policy. First, all listed companies, such as my company Freelancer. This assumption is patently untrue in the Australian environment.

As I have repeatedly written before, due to the disaster in the venture capital industry in Australia , the ASX is now the primary financing source for Australian technology companies. Just like the resources industry did before them, early stage Australian technology companies are heading to the ASX because a viable venture capital industry does not exist. Not only does the company need to be incorporated less than 10 years ago, but all companies in the corporate group need to be less than 10 years ago.

This rule excludes great Australian companies like Atlassian, Nitro, Campaign Monitor, and so on. Furthermore, if your startup acquires a company that is more than 10 years old you also get caught out by this rule as no companies in the group can be more than 10 years old. Examples are given of performance hurdles or minimum tenure. It was unclear from this consultation whether this automatically requires not just a minimum one year term for vesting agreements but whether a minimum one year cliff was also required.

Similarly, the three year minimum holding period introduces complexities in offering grants to directors of the board, advisory board members and other consultants where typical vesting agreements might be two years with no cliff due to the higher turnover nature of the roles.

In Part I of this article I explained how not all shares in startups are the same, and that in particular financial investors are almost always issued preferred stock, which subordinates both the rights and financial returns of the ordinary stock.

As a result, the value of ordinary stock is often vastly less than preferred. The major issue here is how startups value the market value of ordinary stock in those circumstances when it is highly likely the only points in time where a price has been determined is based off the share price of the Series A or B of the preferred stock.

The schedule also introduces a new power for the Taxation Commissioner to approve market methodologies for valuation of rights and shares that worries me. This is quite nasty. If you do not meet the startup rules you continue to face the nightmare vesting scenario that Gillard introduced in if you are given a share grant.

So any discount is treated as income tax at each vesting point. This is a nightmare. I am not sure if the Explanatory Materials to the proposed legislation are in error over this point as it seems contradictory to what I believed the intention of the changes is supposed to be which is to provide for exercise as a relevant taxing point but as currently drafted it looks like this is the case.

Additionally, if those rights are provided at a discount for example, given options for free without paying the premium then you will be assessed for income tax at the time of the grant on the discount. Even worse, rights acquired under deferred tax schemes by companies that do not meet the startup concession will be subject to income tax, and not to capital gains tax, on exercise.

Now the full amount of the increase in the capital value of the right since acquisition will be subject to income tax. This goes to show just how horribly complex the Australian government has made taxation law around this issue. Different departments even within the ATO differ in their view of such basic issues. So complicated is the issue that the drafting of the explanatory memorandum for the proposed new changes has mistakes such as the clarification on taxation on the vesting of rights I explained above.

All of this needs to be a lot simpler, in one section. Employee share schemes are vital to Australian technology companies being able to attract and retain talent in a highly competitive environment. Done well they create alignment between employers and employees and greatly increase productivity which delivers two great benefits to the country; it grows taxable wealth and distributes that wealth from employers to employees.

The tax it did collect is also directly a false saving — changing the rules so workers would pay tax on the value of the shares they were issued, even though this would be years before shares were sold and gains realised in most cases.

Employee share schemes should just be a simple, easily understood and applied tool that is off the shelf and cheap to implement.

With thanks to David Kenney, Partner at Hall Chadwick, for his assistance as a sounding board and in reviewing this article. Improvements to the taxation of employee share schemes. Submissions closed on Friday, February 6. SmartCompany is the leading online publication in Australia for free news, information and resources catering to Australia's entrepreneurs, small and medium business owners and business managers. Monday to Friday, SmartCompany.

Andrew Sadauskas Andrew Sadauskas is a former journalist at SmartCompany and a former editor of TechCompany.

Employee share schemes | Australian Taxation Office

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