Are the revised valuation tables included in the exposure draft of Employee Share Scheme tax amendments better?
30/01/2015
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They are if you want to pay tax on options upfront.

The government has released an exposure draft of the revised valuation tables for employee share scheme (ESS) share rights that it is proposing to include in the Regulations to Division 83A.

The exposure draft refers to ESS rights (which includes options), however, because an exercise price is required to use the tables, most people will think of the instruments discussed here as options. For this reason we will refer to them simply as options. Discounted, market priced and premium options refer to options with an exercise price that is less than, equal to or greater than the share price on the grant date, respectively.

The new tables are based on revised assumptions (specified in the exposure draft) that reflect current market conditions. In most instances, the new assumptions produce lower taxable values for options than the tables currently in use.

The tables can be used to determine the taxable value of a grant of options when income tax is paid upfront in the year of grant. Use of the tables is voluntary and an individual may choose to use general principles (presumably Black Scholes and lattice methodologies) to calculate the market value instead. However, in most instances it will be advantageous to use the tables, assuming they remain in their current form when the Regulations to Division 83A are finalised.

Who can use the tables?

The tables are only relevant for options grants where tax deferral does not apply, so their application is limited. In general, the tables may be used for grants of options that vest immediately, have no restrictions on exercise or sale, have no risk of forfeiture and have an exercise price greater than zero. Hence, they may be applicable to board director grants where governance considerations preclude the application of conditions related to forfeiture.

Some additional concessions are proposed for “start-up” companies, as defined by the government, see our related article HERE.

The tables provide values for options with a life (exercise period) of up to ten years and with an exercise price up to twice the market price on the grant date.

What are the revised assumptions used to generate the tables?

The three primary inputs into the table values are the risk-free interest rate, company yield and the share price volatility. Table 1 summarises the values used in the exposure draft and provides an indication of current benchmark values.

Table 1: Assumptions behind the valuation tables

Input

Assumption

Benchmark

Guerdon Associates Commentary

Risk-free interest rate

4%

2.1%-2.7%

The benchmark relates to RBA zero coupon interest rates for periods from 1 to 10 years. They suggest that the 4% assumption is high.

Dividend Yield

4%

3.7%-4.8%

The benchmark relates to the median of S&P/ASX 300 companies over the previous five years and is consistent with the 4% assumption.

Volatility

12%

31%-35%

The benchmark relates to median S&P/ASX 300 volatilities over the short and long term.

We suspect that the 12% volatility assumption is based on an index. The S&P/ASX 300 index currently has a volatility of 11%. Index volatilities are generally significantly lower than the volatilities of the constituent companies. Since ESS options relate to shares in a company and not an index, median company volatility would seem more appropriate when estimating option values.

What is the impact of the revised tables on taxable value?

Provided the life of the option is at least one year, the taxable value will be lower using the revised tables than it would be using the current tables. The following graph shows the taxable value using the current tables (blue), the revised tables (green) and the equivalent Black Scholes value using the assumptions shown in Table 1 above. The calculations are based on a market priced $1 option with a life of one to ten years.

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Figure 1: Impact of revised tables on taxable value

The values from the revised table are close to, but below the Black Scholes value of the option.

The largest reduction in taxable value using the revised tables is for options with a life of ten years. At ten years, the revised table produces a taxable value that is half of the value derived from the current tables. The table values differ for options with a discounted or premium exercise price. However, the overall trends in Figure 1 are consistent regardless of the exercise price.

Why use the tables rather than other methodologies?

If an individual elected to use the Black Scholes valuation methodology, rather than the tables, then the yield and volatility assumptions are required to relate to the shares over which the option was granted. That is, it is not appropriate to use the assumptions used to generate the values in the revised tables.

We calculated the Black Scholes values of a $1 market priced option based on a mature company and a young company and compared them with values from the revised tables.

Mature companies are assumed to be in a low growth, low volatility and reliable yield phase. They would include major banks, insurers, property companies and healthcare providers.

Young companies are assumed to be in a low cash-flow, zero yield and high growth phase. They are not “start-up” companies as defined by the disclosure draft, because we are assuming they are listed in order to calculate the inputs required for the Black Scholes calculation. They would include young biotech, IT and mining companies. Table 2 summarises the outcomes for options with a life varying from one to ten years.

Table 2: $1 option value using the valuation table and Black Scholes formula

Life

(in years)

Revised Valuation Tables

Black Scholes – Mature

Yield=5%

Volatility=20%

Black Scholes – Young

Yield=0%

Volatility=40%

1

$0.029

$0.071

$0.176

2

$0.044

$0.094

$0.255

3

$0.051

$0.107

$0.316

4

$0.062

$0.116

$0.367

5

$0.070

$0.122

$0.412

6

$0.077

$0.126

$0.452

7

$0.082

$0.128

$0.487

8

$0.085

$0.129

$0.520

9

$0.088

$0.129

$0.549

10

$0.091

$0.128

$0.577

These values are also shown on the graph below.

Because option values increase as volatility increases and as yield decreases, the tables significantly underestimate the value of an option relating to a young company. The tables also underestimate the value of options relating to mature companies, but to a lesser extent. To produce a value that is lower than the table value, a company would need to have volatility lower than 12% and yield higher than 8%. No company in the S&P/ASX 300 currently has both these characteristics.

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Figure 2: Potential impact of using the revised tables instead of Black Scholes

To illustrate, for a grant of 10,000 $1 market priced options, the tables produce a taxable value of $910. Using Black Scholes the taxable value would be $1,280 for a mature company and $5,770 for a young company. Our calculations suggest it is unlikely that traditional Black Scholes and lattice valuation methodologies would produce a taxable value that is lower than the revised tables, which means most individuals will find it advantageous to use the revised tables if they are implemented in their current form.

Can options have no taxable value?

A premium priced option may have no taxable value, depending on the level of the premium and the life of the option. Table 3 summarises the premium required to produce a zero taxable value, including an example based on an option to acquire a $1 share.

Table 3: Premium exercise price required for a zero taxable value

Life

(in years)

Premium Required

Exercise price of a $1 option

1

25%

$1.25

2

33%

$1.33

3-4

43%

$1.43

5-6

67%

$1.67

7-10

100%

$2.00

Granting options with a zero taxable value is going to be most relevant for young companies with high growth prospects.

Want to read more or make a submission?

If you make a submission, you may want to ask Treasury how an unlisted ESS right with a life off more than 10 years is to be valued for tax purposes, given that the table in the draft only goes out to 10 years.

The government’s latest documents are available at:

http://www.treasury.gov.au/ConsultationsandReviews/Consultations/2015/Improvements-to-the-taxation-of-employee-share-schemes

Written submissions can be lodged with Treasury until Friday 6 February 2015.

See HERE for details of the government’s original 14 October 2014 announcement on the taxation of employee share schemes.

© Guerdon Associates 2021
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