On 23 April 2010, the Assistant Treasurer released the Board of Taxation’s review into technical aspects of the taxation of employee share scheme (ESS) arrangements, together with the government’s response.
Following the release in July 2009 of the government’s policy statement setting out changes to the taxation of employee share schemes, the government was inundated with comments and analyses that questioned the viability of the proposed approach. Among these were concerns that high potential, high growth, and/or start-up companies that were cash poor would become severely disadvantaged. These companies, like their counterparts in other developed countries, use share options and rights to attract and retain key employees from established companies. With this avenue denied them by the new share scheme taxation, Australian investors could have more limited potential sources of wealth creation.
The other issue was how to determine the value of options and rights, which now are taxable on vesting rather than when they are exercised.
The fundamental principle of the employee share scheme rules, now contained in Division 83A of the Income Tax Assessment Act (ITAA) 1997, is that any discount given in relation to a share or right acquired by a taxpayer under an ESS arrangement is included in the taxpayer’s income in the income year in which the share or right is acquired. The intention is to ensure taxpayers are taxed consistently regardless of the forms of remuneration received. Concessions allowing either partial exemption or deferral of tax are available in some circumstances, as explained in previous GuerdonNews® articles, for example (see HERE and HERE)
The discount on which tax is calculated in relation to a share or right is generally taken to be the difference between the market value of the share or right and any consideration paid by the employee to acquire it.
In most cases, the new share scheme tax provisions (Division 83A of the Income Tax Assessment Act) stipulate that the market value is to be calculated in accordance with the “ordinary meaning of market value”.
With these issues in mind, and possibly because the government did not want any more criticism of its share plan taxes from independent regulators and commissions (see APRA views within the article HERE, and the Productivity Commission’s HERE), the Board terms of reference were quite narrow. The Board had been asked to review:
- How best to determine the market value; and
- Whether shares and rights under an employee share scheme that are provided by start-up, research and development and speculative-type companies should be subject to separate tax deferral arrangements.
The Board’s key findings, and the Government’s response to each, were as follows:
Recommendation 1: Valuation of listed securities: The Board recommended that the methodology for valuing listed securities issued under ESS arrangements be in accordance with the “ordinary meaning of market value”. That means a security, such as a share that is listed on a stock exchange, has a transparent and public market value that allows it to be bought or sold.
The Government supports the recommendation.
Recommendation 2: Valuation of unlisted shares: The Board recommended that the methodology for the valuation of unlisted shares issued under ESS arrangements be in accordance with the “ordinary meaning of market value”. One definition given in the Australian Tax Office guidance on this matter is
“… the estimated amount for which an asset should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing, wherein the parties had each acted knowledgeably, prudently and without compulsion.”
See HERE for further guidance.
However, the Board recognised that ATO guidance may be insufficient so have recommended that the Commissioner of Taxation release a public document which offers taxpayers further guidance on acceptable valuation methodologies that can be applied when valuing unlisted shares issued under ESS arrangements.
The Government supports the recommendation.
Recommendation 3: Valuation of unlisted rights: The Board recommended that the methodology for the valuation of unlisted rights issued under qualifying ESS arrangements be in accordance with the “ordinary meaning of market value” (see the prior ATO link). In effect, this means that share options or rights can be taxed on the intrinsic value, which is the market value of the underlying share that may be acquired by exercising the right, and the amount the individual must pay to exercise the right.
But the Board also acknowledged that, in certain situations, the valuation of a right in accordance with its intrinsic value may produce the most accurate reflection of market value attributable to the right. However, as explained below, it also perceived deficiencies in that methodology and ultimately opted to preserve the existing “safe harbour” approach that determines the value for tax purposes to be the greater of their intrinsic value or the value attributed to them under the statutory valuation tables.
The Government supports the recommendation.
A consequence if these three recommendations is that the Board has endorsed not using statutory valuation tables for listed securities and unlisted shares, but retaining them for unlisted rights.
Although not a surprising outcome, this result means that recipients of option grants under employee share schemes will still incur tax on options that are “underwater” at the taxing point.
The Board had received a number of submissions suggesting that an unlisted right (which includes an option) be valued purely in accordance with its intrinsic value, but rejected this approach because it ignores the ‘time value’ of the right.
In its report, the Board commented at sections 5.25 and 5.26:
“… the Board rejects using a purely intrinsic value valuation approach. The Board believes that the intrinsic value approach gives a clearly inappropriate outcome in certain situations, for example, where the right is ‘out of the money’ at the taxing point but has a relatively lengthy time period remaining till its expiry.
In the above situation, the use of intrinsic value is not considered to be an acceptable proxy for market value as it disregards any potential upside associated with holding the right for an extended period of time. In this circumstance, the Board considers that the value determined under the statutory valuation tables, which attempt to place a value on this ‘potential upside’ in calculating a market value for the right, to be more appropriate.”
Recommendation 4: Statutory valuation tables: The Board recommended the continued use of the statutory valuation tables as a “safe harbour” for valuing unlisted rights, however the Board recommended that the factors underlying the statutory valuation tables be reviewed and updated to more accurately reflect current market conditions. The Board further recommended that the tables be reviewed from time to time to ensure the tables remain broadly reflective of market conditions, and the basis and assumptions behind the statutory valuation tables be made available to the public. The Board also recommended that the Commissioner of Taxation develop an online calculator tool to assist taxpayers to apply the statutory valuation tables to value their unlisted rights.
The Government supports the recommendations, including the need for greater transparency of the factors underlying the statutory valuation tables, but will defer any decisions on updating the statutory tables for at least 12 months, purportedly because of the likelihood that adjustments would increase the level of tax on these instruments.
While nice of the government to acknowledge this, they forgot to mention that the tax take in the year will be significantly and temporarily boosted anyway because they are taxing options and rights at vesting and not at realisation, as under the prior rules (as the rest of the world does).
Recommendation 5: Separate tax deferral regime for start-up, R&D and speculative-type companies: The Board did not recommend the introduction of separate tax deferral arrangements for start-up, R&D and speculative-type companies, suggesting that should the Government wish to provide additional support to these companies it should consider more targeted approaches outside the ESS tax regime.
In effect, the Board said that under the government’s new rules, this was just too difficult.
The Board held concerns as to the ability of the legislature to clearly define eligibility requirements and isolate a specific group of companies to which any additional tax concessions could be directed, given the disparate nature of these companies. It perceived a risk that easing the existing eligibility restrictions would compromise the integrity of the ESS taxation regime under the new rules, create situations of inequity and increase the possibility of tax avoidance, contradicting the policy intent behind the 2009 ESS taxation changes.
They did not note that this was not an issue under the old rules.
The Government supports the view of the Board on this issue.
The release of the report and Government’s response removes the remaining outstanding matters arising from the ESS taxation changes announced in the 2009 Budget almost a year ago.
So, a year from the government’s announcement of the new share scheme tax rules, we are stuck with a system not applied by other OECD countries that makes it more difficult to continue to attract the 20% of migrant executives required to run our listed companies (unless, of course, we just pay more). In addition, there is no resolution to the fact that cash poor high potential companies no longer can attract and retain capable professional management via stock options in lieu of cash. Hence it is more likely that Australia’s full economic potential will be unfulfilled, and those with more transportable assets (such as high value intellectual capital and the brain that produced it) may seek to put it to work in markets where there is more capital and a better means for paying people in stock rather than cash.
The Australian Tax Board’s report can be found HERE© Guerdon Associates 2023 Back to all articles