Most ASX 100 company boards have or are introducing a minimum shareholding policy under which senior executives and non-executive directors (NEDs) are required to accumulate a minimum shareholding in the company, generally over a period of three to five years.

We first advised company boards in November 2015 how it is easier and more tax-effective to pay board fees in equity on a pre-tax basis after the release of amendments to the tax law a few weeks earlier (see HERE).

The Commissioner of Taxation has confirmed the effectiveness of these arrangements in a class ruling released in August (see Class Ruling CR2018/35 HERE).

While some elements of the director equity plan subject to the ATO class ruling could be enhanced for optimum effectiveness, it is otherwise a useful guide.

Before FY 2011, it was easy and tax-effective to grant equity to NEDs. In fact, it was a regular practice for NEDs to elect to take some of their board fees in the form of shares. In the 2011 budget, however, the government changed the rules so that it was simply not smart for NEDs to take their board fees in the form of fee-sacrifice equity – they would be taxed at grant unless they had a forfeiture condition. Forfeiture conditions, such as service or performance, raise several governance issues. These include, but are not limited to, NEDs being their own judge and jury when determining if conditions had been met, and undesirable behaviours impinging on their duty as directors (such as electing to remain on the board to receive a service contingent equity grant when board renewal is required).

Fortunately, the income tax legislation was amended with effect from 1 July 2015. It now provides tax deferral for share rights granted to employees and directors (who are defined to be employees for this purpose) without requiring a forfeiture condition. After exercise (usually on an automatic basis when the next round of audited results is announced), the NEDs can receive shares that are subject to holding requirements. Tax on the shares is deferred until the end of the holding period (which could extend to the end of their service on the board). This was a significant change to the tax rules because directors’ fees delivered in the form of equity (rather than cash) should not be subject to forfeiture as they have been earned.

NEDs can, therefore, accumulate shareholdings in their company on a pre-tax basis. The pre-tax compounding of share growth and dividend reinvestment can provide a significant tax-deferred benefit to NEDs as well as enabling them to accumulate minimum equity interests as a multiple of fixed fees more quickly than on an after-tax basis.

While the arrangements need to be carefully structured to ensure they are effective, this is what is involved:

• The board determines the level of director fees for the year to be taken in equity

• Rights to acquire shares for that value are granted that will vest on expiry of a specified period, typically each six months

• The director will also specify the period for which the shares (acquired on exercise of the rights) will be restricted from sale or transfer. This period of restriction on sale should be well chosen as it will be a genuine restriction and enforced for that period. Guerdon Associates suggests that boards either allow the director to nominate the period or it be set for the duration of the director’s tenure.

• While the restriction on sale may be lifted in extenuating circumstances, it will, for all practical purposes be a genuine restriction that will prohibit any sale or transfer.

• The director will be taxed on the market value of the shares on the day on which the restriction on sale is lifted. Tax is not paid on that date but paid on assessment of the director’s income tax return for the year in which the sale restriction lifts.

The amended tax legislation provides that income tax on the acquisition of share interests can be deferred for up to 15 years.

The share rights can be structured in a number of ways so that they do not need to be exercised early to get the benefit of dividends. This is particularly useful if the board has US domiciled or American nationals as directors. In this case, the board should acknowledge that share rights are the equivalent of shares for the purpose of the minimum shareholding policy.

Boards that are seeking to increase their directors’ shareholdings can consider these measures to ensure newly appointed directors reach the minimum levels required quickly.

However, as always, take care with the design to ensure it is able to cope with various applications and contingencies, including overseas appointments.

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