Taxation of Employee Share Schemes for Startups

In simple terms, a tax issue arises due to employee share schemes when there is a “discount” at the time ESS interest is granted to employees. When interest is granted under an employee share scheme, two notable tax issues arise:
• The employee will be taxed on any discount received at the time they acquired ESS interest. A discount occurs when the amount paid by the employee is less than the market value of the ESS interest when granted. This discount is taxed unless the employee qualifies for a deferral of the taxing point to a future date
• If an employee qualifies for a deferral the difference between the market value at ESS interest granting and the amount paid for the ESS interest will be taxable as ordinary income when the deferral period ends — the employee will pay full marginal rates at this time.

The ESS start-up concession can provide favourable tax outcomes in these scenarios.

The taxation of employee share schemes delivers benefits because of the ESS start-up concession. This  concession provides a number of benefits:

• The startup concession allows employees to hold ESS interest on capital account, opening the door to favourable tax outcomes — the employee may, for example, qualify for the 50 percent capital gains tax discount on later disposal.
• Any discount obtained by the employee when acquiring ESS interest is not taxable at the time of grant.
• A share acquired via exercising an option may qualify for a 50 percent capital gains tax discount as the date of acquisition is defined as the date the right was first acquired.
• The cost base of ESS interest as an option is defined as any amount paid to acquire and subsequently dispose of the option. The amount paid to exercise the option is added to the cost base if the option is exercised and subsequently sold.
• The start-up concession can also affect cost base when calculating capital gains tax. If the ESS interest is a share, the capital gains tax cost base is calculated as the market value of the share when it is acquired. This scenario can provide significant tax benefits, as the employee can potentially obtain market value with minimal tax.

In order to qualify for the start-up concession, the following criteria must be met:
• The ESS interest must be either an option over an ordinary class share or an ordinary class share.
• The company that issues the ESS interest must not be an investment company or a share trader company.
• The ESS interest must not be able to be disposed of for a minimum of 3 years from the time it is acquired, or until the employee ceases employment with the issuing company. The exception to this criteria is the scenario in which 100 percent of the company is sold to a third party before the 3-year period elapses,
• Neither the employee nor the employee’s associates may hold or have the right to acquire more than 10 percent of the shares of the issuing company. This criteria includes any shares the employee acquires or has the right to acquire under the employee share scheme.

There are a number of unique criteria that apply only to the taxation of employee share schemes concessions that must also be met in order to qualify:

• Both the company in which an employee acquires an ESS interest and each company within its company group can not be listed on a stock exchange.
• Each individual company within the company group must have been incorporated within 10 years of the beginning of the income year in which the employee acquires the ESS interest.
• The aggregated turnover of the company group must not exceed $50 million.
• In the case that the ESS interest is a share, the discount must amount to no more than 15 percent of the interest’s market value at the time it is acquired.
• In the case that the ESS interest is an option, the exercise price must exceed or be equal to the market value of the ordinary share.
• The entity for which the employee works for must be an Australian resident.

It’s important to note that there is no need for the share or option to be subject to any genuine risk of forfeiture in order to qualify for the ESS start-up concession. Similarly, there is no need for the ESS to be made available to at least 75 percent of permanent employees.

The ATO has not, to date, published any guidance on whether a company must state that the ESS is intended to qualify for the start-up concession. It is, however, a good idea to do so in order to ensure employees are aware of the concession, should criteria be met.

The Australian Taxation Office has outlined two methods through which shares and options can be valued when applying the ESS start-up concession in a binding legislative instrument (ESS 2015/1). Using either of these methods will greatly increase the likelihood that the tax office will accept the valuation. These valuation methods are referred to as “safe-harbor” valuation methods.

These ATO-approved market valuation methods are used to value options and shares in order to ensure the criteria outlined above are met satisfactorily.

The first safe-harbor valuation method is based on an altered version of the net tangible assets of a company. A company must meet specific criteria in order to apply this method — the most important of which is that the account of a company must be prepared in a professional manner.

The second safe-harbor valuation method is based on a valuation performed by the CFO of a company or a similar individual with relevant knowledge, training, and experience. This method is referred to as a “director’s valuation.”  The Australian Taxation Office provides specific guidance on the relevant factors that the individual performing the valuation must take into account via the ATO website.

The ESS startup discount can help employees access special tax treatment when working with entities that meet specific criteria. The ESS concessions for start-up companies can help Australian startups motivate, reward, and retain key employees while assisting in the minimization of tax.