As noted last month, the Australian government is committed to amending share scheme taxation to encourage start-ups, and has commissioned a sympathetic Treasury enquiry as to how best achieve this. Not surprisingly, there are a several common themes to submissions made to Treasury in response to its 21 January invitation to comment on improving the rules for employee share schemes (ESS) in start-up companies. The two key ones (that would fix a number of specific problems) are that:

1. Income tax should only apply when an employee can realise a reward from their ESS benefit – when options are exercised and/or shares sold, rather than when shares vest or options become exercisable
2. The rules need to be simple and encourage the low cost establishment of ESSs

Considerable attention has been focussed on attempts to come up with a more workable definition of ‘start-up’ than the government has managed. Suggestions include Australian-based companies with revenue up to $15m and where the company has been in operation for no more than 10 years (Deloitte), and $20m aggregated turnover (the same turnover threshold that currently exists for access to the R&D refundable tax offset) with concessions available for a maximum of 10 years (William Buck) and some suggestions for maximum employee numbers of up to 100.

In one respect we most likely share a concern with Treasury – that attempts to precisely define a ‘start-up’ are likely to be difficult and costly to administer, and inefficient economically. Associated with this will also be uncertainty about access to the concessions, as companies may move in and out of eligibility, and there are bound to be anomalies because the rules do not cover all deserving cases.

This is why Guerdon Associates suggest that eligible companies be defined to cover all companies with negative cash flow from operations in the year in which an offer is made under an ESS, or in the prior year. This will, of course, cover more than just what are traditionally considered start up companies. It will include companies in economic trouble. In the current Australian context, this will include companies exposed to an ongoing, and intractable, feature of the Australian economy, i.e., the exchange rate.

In our view, such a definition will not only encourage start-ups, but also allow exchange rate exposed companies to survive and thrive. Employees share the risk, in terms of up-front cash pay, in exchange for potentially significant upside, as well as a job. In the case of both true start-ups and trade exposed companies, better a job for employees who are shareholder aligned, focussed and energised than no job at all.

Another common theme in the submissions was that improvements to the ESS regime are required for all companies and for all employees, not just for start-ups. The government and Treasury have indicated that the current considerations will not be extended beyond start-ups, apparently because of concerns about lost revenue.  The Guerdon Associates’ approach is a half way house that we trust will be acceptable because it extends relief to companies in addition to start-ups where their viability as a going concern is in question, and tax revenue is under threat from the prospect of higher unemployment.

This simple definition of eligable companies also sidesteps questions of start-up size, which would be an administrative headache, and irrelevant. As we have witnessed with the likes of Yahoo, Amazon, Genentech, Facebook and many others, companies can be large in terms of employee numbers and revenues before turning a profit.

The Guerdon Associates’ submission was also careful not to suggest constraints on who is eligible for tax deferral until the benefit is realised. For example, one submission suggested the tax deferral be limited to those employees earning $180,000 or less. This would encompass the vast majority of start-up employees, so why impose an administrative burden requiring this? In any case, the rare instances of start-up employees earning more than this would be the truly valuable employees the country is trying to attract and retain. It is no accident, for example, that 50% of Silicon Valley CEO’s are migrants. They typically move to the US once their idea has been through the first three funding stages in their home country, and has proven to be highly viable.

These are the men and women a country needs to nurture new growth. By the time they get to the fourth stage of funding their equity may have been diluted to about 10%. Stock options are as meaningful to them as a regular employee. But as their value has been proven they also typically receive more cash. So why take the chance of losing out to the US by limiting tax deferral eligibility based on cash salary?

The changes made to the ESS regime in 2009 to introduce tax at grant or vesting of options, rather than on exercise, seem to have been intended to meet the government’s objective of improving “…horizontal equity in the tax system by treating all forms of remuneration more consistently…” [Explanatory Memorandum to the 2009 tax changes, para 1.15]. This implies the government was of the view that granting an ESS option conferred some special financial advantage prior to exercise. This is difficult to fathom when a vested option cannot be exercised because it is underwater or the underlying stock is illiquid. 

Incidentally, getting the principles right would address that other constant source of irritation with the ESS rules – the taxation of unvested ESS interests on cessation of employment. The Productivity Commission’s recommendation on this point was the only one not accepted by the then government, which is inconsistent with the underlying principle within all submissions we have seen so far that tax should only apply on realisable benefits.

The Guerdon Associates submission to the Treasury consultation can be seen HERE.

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