The Australian government can be described as very responsive.  It responds to critiques of legislative announcements with new legislative announcements, which in turn, creates new critiques and…well you already have the theme of this article.

Senator Sherry provided a media release and a policy statement on taxation of employee share plans on 1 July 2009 (see HERE).

The new package clarifies many of the issues, which have been swinging since the Budget night (and subsequent) announcements, although leaving some major gaps yet to be filled.  While there is more certainty in regard to general employee share plans, major uncertainty still remains for key management personnel plans.

In its latest amendments, the government responded to many of the issues raised by us in our submission (see HERE).  But major issues of concern to us have not been adequately addressed.  This includes the taxation of options that may be given in lieu of cash, mainly applicable to high growth and start up companies, and the failure to remove cessation of employment as a taxing point, necessary if the timing of performance payments is to be aligned with the legacy left by departing executives.  The government has also ignored calls for taxation to be levied on the realisation of value from employee share and option plans, rather than on vesting or cessation of employment.

In this note we give you our views on what probably will work in light of Senator Sherry’s statement, and how you might stand if you want to proceed quickly with grants of shares or options.

For most companies we suggest you still proceed with caution unless there is a compelling reason to make grants now. 

We have set out what we think you need to plan for over the mid-term. 

First things first: options (in the traditional sense, having an exercise price set at “today’s” market price) are relatively trickier than shares or Zero Price Options (ZEPOs), i.e. performance share rights.  This is because of the valuation approach (there is not one!), and because of the harsh treatment of vested underwater options, where the employee is taxed on vested options that are intrinsically worthless or practically illiquid at the time of taxation.

Companies will probably want to wait for greater clarity before issuing options.  But we suggest you not hold your breath. 

The government  have left open the question of whether to tax options for start up companies.  This will raise more complexities and uncertainties as to how to accommodate exceptions in a legislative framework.  The issue has been referred to the Australian tax board.

If you do feel you need to issue options, you will probably need to:

1. Attach meaningful performance hurdles
2. Add a performance hurdle that the market price must be above the exercise price, before the options become exercisable.  This will properly and appropriately reduce the employee’s risk of paying unrecoverable tax on underwater options. 

What about standard-type performance share plans using ZEPOs?
These are probably OK, with little change.  What changes?
• Well, maximum term of 7 years, whereas many plans had ten years. 
• Employees will not be able to choose to pay tax up front, so if your plan was based on that expectation there may be some related changes you want to put in place, like higher quantum of grant.

Overall, what are the main problems facing companies from the changes, and from the uncertainty?

Most plans for non executive directors (NEDs) to take shares in lieu of fees and build up shareholdings in the company will have to be scrapped.  There is an exception being made for the first $5,000 of salary sacrifice shares, but it is unclear as to whether this is an annual amount or total amount.  In any case, it is too small to be meaningful for NEDs and executives.   And the concept of “salary sacrifice” for shares has not been defined.  So many companies will just give up on these plans for a while.

There is more clarity regarding the $1,000 tax-exempt plans .  So companies are on safer ground to launch these.

The new rules could facilitate significant amounts of employee alignment through share plans, but only if there are further meaningful performance hurdles built in.  This can work alongside new APRA guidelines for banks for deferral of bonuses, but only if the further hurdles are built in.

If the new rules, when we get a chance to look at them in full, seem too onerous or complex for executive LTI plans, there could be a move to use “cash” LTI and phantom equity plans.  These can be just as strongly performance-related and shareholder-aligned as a regular  equity plan.  But they seem the long way around to ensure shareholder alignment compared to the former methods.

Another alternative is to use “loan backed” plans, which are a way of emulating option plans.  They can be quite complex, but can be tax-effective (if they pay off).  They have not been common in Australia for some years, but the whole “change scenario” arising from this review of the tax situation, and the Productivity Commission review of executive remuneration, has meant companies need to explore a wide range of alternatives to ensure an executive remuneration system which is tailored for them. 

So while the way ahead is a bit clearer, we are still peering through a sheet of frosted glass at some of these issues.  But how long can boards hold off making a decision on employee equity plans?  If companies decide to wait for “final” clarification, they could be deferring action for a long time.   Government share scheme clarification could still include clarification number 5 (on the Senate committee’s review), number 6 (the draft regulation), number 7 (the “final” legislation), and possibly numbers 8 to 11 (being the possible number of steps arising from the Productivity Commission executive remuneration review).  Then there is the election…

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