Minimum Shareholding Requirements (MSR) policies for both non-executive directors (NEDs) and KMP executives are a significant ASX-listed company trend. They can, however, create problems if poorly crafted. After reviewing a wide range of such policies it can be said that for most companies they are a policy schemozzle. Most companies fail on virtually every important assessment dimension including:

• ease of understanding
• employee equity
• attraction and retention
• tax effectiveness
• consistency with shareholder expectations and/or requirements, and
• ease and cost of administration.

Let’s take income tax, as an example. It is desirable to have a policy that limits the probability an executive has to search his or her pockets for the after-tax income to acquire shares on market. Better that they meet the policy with before-tax income, either through incentive plans or fee sacrifice. In this way, they only need half the gross income to meet the MSR, and they will meet requirements for shareholder alignment sooner. Should be simple. And it is. Yet many listed companies mess this up with negative tax consequences for the executives. Why is this?

Deferred taxing point and genuine disposal restrictions

Earlier this year the Commissioner of Taxation released Taxation Determinations TD2022/4 and TD2022/8, on:

• the principles for a genuine disposal restriction that determines the deferred taxing point of an Employee Share Schemes (ESS) interest, and
• the tax deductibility for employers of expenditure incurred on establishing an ESS.

A key benefit to employees of a complying ESS is the ability to invest gross (pre-tax) remuneration and defer the taxation on the equity to a later date. Taxation can be deferred when the ESS ‘genuinely’ restricts the employee from immediately disposing of their interest under the scheme. If there is a ‘genuine’ restriction on disposal, the deferred taxing point is the time when all ‘genuine’ restrictions are lifted and the employee can dispose of their equity interest.

TD2022/4 was released as a draft determination in November 2021 (see our previous article HERE ). The final Determination seeks to clarify that a ‘genuine’ restriction must be “sufficiently identifiable, certain, and legally enforceable”. Furthermore, there must be “serious and enforced consequences” where the schemes disposal restriction is breached.  If the company routinely approves requests to waive certain disposal restrictions, the Commissioner says it will NOT be considered a genuine restriction.

The Determination provides examples of the treatment of contractual vesting periods, holding locks and inside trading blackouts.

Challenges remain though.  The Determination recognises restrictions imposed by trading blackouts, but their existence does not, of itself, qualify as a genuine disposal restriction.  Rather, the employee must be able to show they actually possessed such inside information by providing contemporaneous records or other evidence as to why it was price sensitive, the date from which it was held, and the period it was price-sensitive.  The ATO Public Advice and Guidance Compendium states that the intent is not to have employees disclose price-sensitive information to the ATO in breach of company policy.  It instead throws the evidence challenge back to the company in determining when the taxing point occurs.

An MSR policy is a blind spot and has not been specifically addressed in the examples. However, the Guidance Compendium refers to contractual conditions and the principle of a time-based vesting example.  MSRs are more nuanced than a defined restriction period applying to a parcel of ESS interests.

Companies often express MSRs as a $ value being a multiple of an employee’s fixed pay and not a set number of shares or equity instruments.  It is unclear how the challenges of a fluctuating value of an executive’s ESS holding to meet the MSR would be treated by the ATO.  If on any given day the holding exceeds the MSR, would that surplus and the associated number of shares be deemed taxable as no longer subject to restriction?

Many MSR policies will not have factored the potential tax liability for employees into their policy design or administration.  This aspect of an MSR policy is straightforward to change, yet companies stick with policies that could lead to breaches.

The Commissioner makes several important distinctions including that “a disposal restriction is not genuine if it is open to manipulation such that it does not in a real, practical sense limit the disposal.” An example provided is where the employee is the director of a closely held company and can control the decision of the ESS administrator.

Another distinction is that a disposal condition IS considered ‘genuine’ notwithstanding that it may be lifted in exceptional and extraordinary circumstances, the example cited of severe financial hardship.

Again, these issues can be readily fixed to avoid the potential for adverse outcome for NEDs and executive KMP.

Costs of establishing an ESS not immediately deductible

TD2022/8 was released earlier this year in draft as draft TD2022/D2 and addresses the tax deductibility for the employer of the costs of establishing an employee share scheme. The ESS plan expenses treatment was discussed in our March newsletter: see HERE.

For further examples, detail and clarification you can find TD2022/4 HERE and TD2022/8 HERE.

The ATO Public Advice and Guidance Compendium on the determinations can also be found HERE.

You can also find the full income tax assessment act 1997 HERE.

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