Four years after it issued its first draft ruling on employee remuneration trusts (ERT), the Australian Taxation Office (ATO) has finalized its thinking and, on 31 October 2018, released TR 2018/7 explaining its view on the range of tax implications for the employer, the trustee and the employee.
Companies with employee share schemes that rely on the taxation rules in Division 83A of the Income Tax Assessment Act 1997 (ITAA) need read no further. The ATO’s latest ruling on employee share schemes, TR 2018/7, does not apply to you or the employee share scheme you operate.
ERT arrangements have been promoted in recent years as providing the deferral benefits of traditional employee share schemes with better capital gains tax (CGT) outcomes in certain circumstances.
This ruling is particularly relevant for large and small private companies, unlisted public companies and ASX-listed companies that have used or are contemplating to use ERTs.
Here is a brief checklist of things to watch out for.
1 . Is the contribution to the ERT deductible?
The employer’s contribution to the ERT should be deductible if it is expected to be fully distributed by the trustee within five years as a payment of taxable salary or fringe benefits.
The contribution must also be an irrevocable payment of cash by the employer to be deductible. If the trust deed enables the trustee to distribute the contribution amount back to the employer, it is unlikely to be deductible in the first place.
Further, the contribution will not be deductible if it is capital in nature. This could include, among others, the contribution being used by the trustee to:
- Acquire shares in the employer company in circumstances where it is not intended to divest legal and beneficial ownership of the shares within 5 years
- Acquire arm’s length investments with the intention of deriving a yield to be distributed to employees
- Provide loans, on a continuous basis, to employees
The ruling provides other examples of circumstances when the contribution will not be deductible. If you are contemplating an ERT arrangement, it requires careful reading.
2 . Will the prepayment provisions apply to a deductible contribution so that the deduction is spread over the vesting years?
Where a contribution is otherwise deductible, the prepayment provisions of the tax legislation may apply to spread the deduction over the ‘eligible service period’.
These rules are quite technical and complex so the warning for employers is not to go into an ERT arrangement thinking that the contribution is immediately deductible on payment – that may not be the case.
3 . Will the contribution be a fringe benefit and taxable to the employer?
If a contribution is made to the ERT is identifiable in respect of a particular employee it can potentially be a taxable fringe benefit.
The contribution should not be a fringe benefit if it ultimately leads to the payment of salary or wages, or is a deemed dividend (see below).
4 . Do you know when the employee will be taxed – when the contribution is made or when the distribution is received?
The ruling indicates the employee should be taxable when the payment from the ERT is ultimately received after service and/or performance conditions have been met.
However, it does indicate that the employee can be taxable at the time the contribution is made if the circumstances are such that it has the character of ordinary income, is applied or dealt with on the employee’s behalf or as the employee directs. In this case, the Commissioner argues the contribution to be a payment of salary or wages by direction.
The example provided in the ruling appears to be specific to a particular structure.
5 . Will the contribution be a deemed dividend in the hands of the trustee?
A contribution made by a private company may be deemed to be a dividend received by the trustee if, at the time the contribution is made, the trustee is a shareholder of the company, or associate of a shareholder.
Accordingly, if the trustee, who is the recipient of the contribution, is a shareholder of an employer that is a private company at the time when the employer makes a contribution to the ERT, the contribution is deemed to be a dividend, and included in the assessable income of the ERT, unless a relevant exception or exclusion applies.
The interaction of the deemed dividend provisions and potential exceptions or exclusions is technical and complex and requires careful consideration.
6 . Will loans and other benefits provided by the trustee be fringe benefits?
If the ERT arrangements include the trustee making a loan to the employee, the ruling indicates a range of circumstances where the employer may be liable for FBT on the loan fringe benefit.
An interest-free loan will give rise to a taxable fringe benefit for the employer where the trustee makes it under an arrangement with the employer and the otherwise deductible rule does not apply to reduce the taxable value.
As above, a careful review of the ruling will be necessary to ensure the ERT arrangements do what is intended.
7 . Will a loan from the trustee be deemed to be a dividend for the employee?
A private company is taken to pay a dividend directly to an employee under Division 7A of the ITAA where a reasonable person would conclude that a contribution to the trustee is made mainly as part of an arrangement that involves a loan by the trustee to the employee who is a shareholder (or an associate of a shareholder) or former shareholder of the private company.
The example provided in the ruling again indicates the Commissioner may be targeting ERT arrangements structured in a particular way.
8 . Do you know how the employees will be taxed?
An employee who is a beneficiary of an ERT may receive an amount that is taxable under more than one provision in the ITAA, so the tax laws operate to ensure an amount is taxed only once to that employee.
The Commissioner’s ruling provides a range of examples that include the trustee being taxed during the vesting period on dividends received and then the employee being taxed on the after-tax dividend equivalent payment.
We know this sounds apocryphal, but, yes, it is true. The Commissioner seeks to collect tax twice on effectively the same amount.
There are other examples that indicate an employee may not get the benefit of franking credits on the distribution by the trustee of franked dividends it receives.
9 . Will the employee get a CGT benefit rather than ordinary taxable income?
Some ERT arrangements have been structured on the basis that the employee should be subject to CGT when they redeem their units in the ERT for a gain. The example in the ruling indicates that gain would be assessed as ordinary income at marginal rates rather than concessionally taxed as a capital gain.
10 . Will a gain derived by the trustee be taxed as ordinary income rather than a capital gain?
The ruling provides an example of the trustee of the ERT acquiring assets to effectively hedge its obligations to employees. The trustee sells the assets for a gain, which the Commissioner says is taxable as ordinary income on the basis they were acquired in the course of a commercial transaction with the intention of making a profit from their disposal.
11 . What should you do?
TR 2018/7 is 37 pages long and is the third and final version of the Commissioner’s attempts to provide a view on Employee Remuneration Trust arrangements. This indicates the complexity of the issues and the concerns the ATO has with such structures.
If you are considering adopting an ERT arrangement you will need comprehensive advice and should probably consider obtaining a private binding ruling from the ATO on all aspects of the arrangements.
The ruling can be read HERE© Guerdon Associates 2023 Back to all articles