Employee share plan tax is still very odd, while executive termination pay is subject to termination

If you feel punch drunk with the Australian federal government’s announcements of variations to employee share scheme taxation, then hold on.  There is more.  On top of that the political process that should have seen passage of the government’s executive termination pay law did not count on one Senator’s frame of mind.

The legislation to give effect to the government’s changes to the taxation of employee share schemes was introduced into the House of Representatives on 21 October 2009. Pending any amendments in the Senate, far from simplifying the taxation of employee share scheme benefits, these provisions introduce new uncertainties.  These include retrospective application of taxation to rights which were not classed as ‘share scheme interests’ at the time the rights were granted.

Major disappointments with the draft bill are that:

  • The bill retains cessation of employment as an automatic trigger for income tax on employee share plan grants that had been subject to tax deferral, despite the Productivity Commission’s recommendation that deferral be allowed to continue past termination of employment and APRA’s support for using deferred equity to manage risk
  • Tax paid on options that are underwater when they vest can still not be recovered where the options lapse because the employee chooses not to exercise them because the options remain underwater.  Disconcertingly, if not at least a bit unfairly, the bill confirms that an employee who ceases employment before the underwater options lapse could get a refund of the tax paid but an employee who elects to remain employed until after the underwater options lapse could not (refer s 83A-310).

Changes from the exposure draft of the bill and the accompanying explanatory material released on 14 August 2009 (see summary HERE) that warrant special comment include:

1. “Indeterminate rights”

A new provision has been included which will impact restricted stock units payable in cash or shares, or bonuses that may be paid in shares.  The acquisition of a right that will not necessarily provide shares or that will provide an unknown number of shares will be treated as though it had always been an employee share scheme interest if and when it becomes clear that the right will result in the receipt of a definite number of shares (see new section 83A-340).

This provision will apply to an employment benefit that is a right to an indeterminate number of shares, or to a benefit that may be received in shares, in cash, or in some other form.  For example, it will apply to a ‘share appreciation right’ under which the number of shares is calculated by reference to the increase in a company’s share price over the relevant performance period, with the result that once the number of shares the right will provide has been determined, the right will be treated as though it had always been an employee share scheme interest.  Where the rights are subject to a real risk of forfeiture (e.g. because they would be forfeited on resignation prior to the right vesting) and tax deferral applies, tax will be deferred to the time the shares are acquired.  This produces a sensible outcome in such situations.

A more difficult situation arises where, to use example 1.53 from the explanatory materials, an employee, Miranda, is granted rights under which the number of shares she will receive is calculated by reference to the increase in the company share price over the next 5 years, but is not eligible for deferral because she already owns more than 5% of the shares in the company. When the 5 years is up and the number of shares the rights provide is known, those rights will be taken to always have been interests to which the employee share scheme tax rules apply. 

As Miranda is not eligible for deferral, she would have been taxed on the rights at the date they were granted.  According to the government’s explanatory materials, “Miranda will seek an amendment of her income tax assessment for the income year five years earlier to include an amount in relation to these ESS interests in her assessable income.”  Miranda’s employer will also be obliged to submit a new or revised report on the employee share scheme interests it granted five years ago.  The government does not indicate whether the value to be included is the current value when the shares are actually acquired, the market value of that number of shares at the grant date, or some other value. 

It is difficult to understand how income tax can be paid in Miranda’s 2009 tax return on the 2014 value of shares.  Equally, however, using the 2009 value would mean Miranda could pay capital gains tax on the increase in the value of the shares between 2009 and 2014. Is this really the government’s intention?  The most logical approach would seem to be that income tax should be paid on the 2014 value, which is the value received by Miranda, in the year in which she actually receives the benefit i.e. 2014. 

How much simpler and more reasonable would share plan tax be if tax simply applied at the time employees actually realise the benefit – i.e. when shares vest or options are exercised?

Example 1.56 in the explanatory materials unintentionally provides a powerful argument for removing cessation of employment as an automatic taxing point.  In this example, as part of his employment package, an employee named Odon receives a right to 50,000 shares in his employer company if the company’s share price increases 30% or more over the next 7 years, but the employer reserves the right to grant the cash value of the shares rather than actual shares.  Because it is uncertain whether Odon will receive shares or cash, the right is not an employee share scheme interest at the time it is granted.  Odon ceases employment with the company 4 years after acquiring the right.  The company share price increases by 50% over the 7 years, and Odon becomes eligible to receive the 50,000 shares.  Odon is now considered to have acquired an employee share scheme interest when the right was granted 7 years previously.

When will Odon pay tax on the right?  The requirement that the share price increase by at least 30% means the right was subject to a real risk of forfeiture, so that tax deferral applies.  Although Odon could not sell his right during the 7 years, he will be liable for tax on the right (as an employee share scheme interest) on cessation of employment 4 years after he acquired it.  Again, according to the explanatory materials,  “Odon will seek an amendment to his income tax assessment for the income tax year in which he ceased employment, to include an amount in relation to his ESS interests in his assessable income.”  Once again, the employer will need to submit a revised employee share scheme report.  But again, we do not know what value the government expects will be included in the amended tax return (the value at the end of the 7 years, the value of the shares at Odon’s cessation of employment, or some other amount?). 

Again, it would be much simpler if the income was simply taxed in the year in which it is realised by the employee. 

The above examples emphasise the importance of structuring employee arrangements to avoid the risk of retrospective application of the share plan tax rules.

2. Increased flexibility for salary sacrifice schemes

Only shares (to a maximum value of $5,000) can be acquired via salary sacrifice on a tax-deferred basis.  However, the government has clarified that employers have the flexibility to offer schemes under which employees can acquire shares on a tax-deferred salary sacrifice basis and, for example, the employer provides a number of matching shares or rights that qualify for tax deferral because they are subject to forfeiture conditions.

In last Friday’s Australian Financial Review the head of the Australian Treasury, Dr. Ken Henry, pleaded mea culpa to the 70% increase in tax regulation during his tenure.  Yet a primary objective of his tax review report due in December is tax simplification.  We have an idea where he can look for it.

The draft bills are available HERE and HERE.

Meanwhile the Senate (at the instigation of Senator Xenophon) amended the government’s proposed changes to the Corporations Act termination payments provisions.  The Xenophon amendment would impose a 3-year sunset clause on the exemption (under section 200F(2)(ii)) that allows a termination payment of up to one year’s base salary to be made without shareholder approval where the payment is made pursuant to an agreement made before the recipient’s appointment as the consideration or part of the consideration for agreeing to the appointment. 

Removal of this exemption would require shareholder approval for all termination payments, of any amount, made in such circumstances. 

The amended bill was returned to the House of Representatives on Friday 30 October, and rejected.  It now goes back to the Senate.

© Guerdon Associates 2024
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