Employee Share Scheme (ESS) offering an option

What is an ESS?

An Employee Share Scheme (ESS), also known as an Employee Share Option Plan (ESOP), is a contribution plan that remunerates employees by providing them with securities or an option to acquire securities and create a beneficial interest in the company.

An ESS can generally be used to entice, retain and reward employees where offering large salaries is not a viable option for a company.  It can also provide as an incentive for employees to improve their performance as the prospect of having a beneficial interest may encourage them to commit to the growth of the company in order to increase their own wealth down the track.

What are the types of ESS?

As of 1 July 2009, there are different types of ESS that can be offered to employees:

• Taxed-Upfront Scheme: Default Position;
• Taxed-Upfront Scheme: $1,000 Reduction;
• Tax-Deferred Scheme: Salary Sacrifice; and
• Tax-Deferred Scheme: Real Risk of Forfeiture.

What are the taxation implications?

Depending on the type of ESS, there are different taxation implications.

Pursuant to section 104.40 of the Income Tax Assessment Act 1997 (Cth) (Act), granting an option is a Capital Gains Tax (CGT) event that occurs when the option is granted.  However, in an ESS, the share options will generally be provided to an employee at a discount or no cost.

Taxed-Upfront Scheme: Default Position

An employee will be taxed on the discount in the year that the option was provided if the ESS is a Taxed-Upfront Scheme which does not qualify for a concessional tax treatment.

Concessional tax treatment may be available if:

• the option is for securities in the employer’s company or the employer’s holding company;
• the option relates to ordinary shares; and
• the employee will not result in having ownership of more than five per cent (5%) of the shareholding or control more than five per cent (5%) of the maximum voting rights.

These are known as the General Conditions.

Taxed-Upfront Scheme: $1,000 Reduction

Where the ESS is a Taxed-Upfront Scheme and the General Conditions are satisfied, the employee will be eligible to a $1,000 reduction if:

• their income for the year is $180,000 or less;
• the employee has no real risk of forfeiting the option under the ESS;
• the ESS operates in a way that requires all employees to hold the option for three (3) years or until employment ceases; and
• the ESS must be offered on a non-discriminatory basis to seventy-five per cent (75%) of the permanent employees with three (3) years’ service and are Australian residents.

Tax-Deferred Scheme: Salary Sacrifice

In order to have this type of ESS, the following conditions must be satisfied in addition to the General Conditions:

• the interest provided are shares or stapled securities that are acquired under a salary sacrifice arrangement from the employer;
• the discount must equal the market value of the shares or stapled securities;
• the ESS Rules must state that the deferred tax arrangement applies;
• at least seventy-five per cent (75%) of the employees with three (3) years’ service who are Australian residents are entitled to interests under an ESS;
• the rights acquired under the ESS must be subject to a real risk of forfeiture; and
• the employee must not receive more than $5,000 worth of shares or stapled securities during the year.

Pursuant to section 83A.105 of the Act, a salary sacrifice agreement is in place where:

• an employee agrees to acquire the option in return for a reduction in their salary that would not have happened apart from the agreement; or
• an option is provided as part of the employee’s remuneration package, in circumstances where it is reasonable to conclude that their salary would be greater if the option was not part of that package.

Tax-Deferred Scheme: Real Risk of Forfeiture

In order to have this type of ESS, the following conditions must be satisfied in addition to the General Conditions:

• there must be a real risk of forfeiting the interest under the conditions of the ESS;
• if the interest are shares, at least seventy-five per cent (75%) of the Australian resident employees with at least three (3) years’ service have been entitled to acquire an interest under an ESS.

Is there a real risk of forfeiture?

The answer to this question will depend on the circumstances of each ESS and the employee.

ATO Decision ATO ID 2010/61 provides that there is a real risk of forfeiture if a reasonable person would consider that there is a real risk that the employee will forfeit or lose the interest, other than by intentionally taking no action to realise the benefit.

Examples include where the ESS imposes conditions such as:

• a minimum term of employment before allowing the employee to exercise their option; or
• certain performance hurdles.

Taxing under a deferred tax scheme

Employees provided with an option to acquire an interest in the company under a deferral scheme will be assessed for tax purposes in the year that the deferred taxing point occurs in.

Pursuant to section 83A.120 of the Act, the deferred taxing point for a right (such as an option) is the earliest of the following:

• seven (7) years after the employee acquires the right;
• when the employee ceases employment;
• when there is no real risk of forfeiting the right and the ESS no longer restricts the exercise of the right; or
• when there is no real risk of forfeiting the right or underlying share, and the ESS no longer restricts exercise of the right or disposal of the resulting share.

What documents should be prepared?

ESS Rules

The ESS Rules govern the ESS and set out the terms and conditions.  These rules should state that the employee must sign a deed of accession, or similar document, under which the employee agrees to be bound by the company’s shareholders’ agreement, if any, before exercising any options.  This will ensure that the employee is aware of their obligations should they choose to obtain a beneficial interest in the Company.

Letter of offer

The managing director of the company should send a letter of offer to the employee.  This letter should provide:

• the cost, if any, of the option;
• the number and class of shares being offered pursuant to the ESS;
• the conditions imposed on exercising the option;
• the price (per share) to exercise the option; and
• the date the option lapses.

Other documents

How a company chooses to set up its ESS may vary, but the following should also be prepared:

• Summary of the ESS – to provide to potential participants;
• Summary of taxation implications – to provide to potential participants;
• ESS Application Form – to set out the agreed terms between employer and employee;
• Salary Sacrifice Agreement – if the ESS is a Tax-Deferred Scheme: Salary Sacrifice; and
• Notice of Entitlement – to advise the employee of the number of securities acquired on their behalf once they have exercised their option.

Other considerations

Employers should be aware of their reporting and withholding obligations if they have provided an option to acquire securities to their employees under an ESS after 1 July 2009.

Employers are required to report to:

• the Australian Tax Office in the form of an ESS annual report by 14 August after the end of the financial year; and
• the employee by providing them with an ESS statement.

Links and further references

The Taxpayer and Commissioner of Taxation [2011] AATA 508 (25 July 2011) 

Further information

If you need assistance in assessing the merits of your ESS, or would like to create an ESS for your company, contact us for a confidential and obligation-free discussion:

Disclaimer

This article contains general commentary only.  You should not rely on the commentary as legal advice.  Specific legal advice should be obtained to ascertain how the law applies to your particular circumstances.

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