Government Review of Employee Share Schemes

As part of the Government’s update to the National Digital Economy Strategy, on 12 June 2013 they have announced a review of the regulatory arrangements for employee share schemes which will see consultation by December 2013.

Due to concerns raised by several industry sectors about the current tax arrangements that apply to share and option schemes offered by start-up firms, the government will review the situation and address the barriers faced by start-ups including:

  • developing guidance to reduce the administrative burden of establishing an ESS (meaning the cost of valuing shares and options)
  • adjusting the valuation methodology of options
  • examining the point at which share options are taxed for start-up companies
While the document that contains this announcement is focused on the digital industries, with a particular focus on high-tech start-ups, it is equally applicable to other industries that contain start-up ventures.
As those who have implemented employee share or option schemes would know, there is a balance that is required between providing the employee meaningful value and reward through equity incentives in the company they work for, and ensuring that the tax outcomes for the employee do not leave them worse off than if they had not received any equity incentive.
One aspect of the review that will be followed very closely will be any changes to the valuation methodology of options, particularly when it comes to the taxation outcomes.
Currently the Income Tax Assessment Act 1997 and Regulations provide the ability to value options using a Black-Scholes method that has very concessional factors, such as volatility of 10%. Should the variables in the valuation method be changed, this may result in higher taxation values than currently exist.
A government review 2 years ago raised a possible increase in the assumed volatility to 20%. An increase of this nature could result in much higher taxation values for options, depending on the ratio of share price to exercise price at the time of issue, and the length of time to expiry for the options.
Given the importance of any potential changes to the ESS rules, Value Logic will be involved in the discussion and consultation with the government.
If you have any concerns or views on the potential changes to the ESS rules, please contact Value Logic or Treasury to make your concerns known.

Need help reporting your ESS to the ATO?

ESS ATO reporting
ESS ATO reporting

With companies due to provide ESS Statements to their employees and the Australian Taxation Office (ATO), it is now time to start preparing the information required to meet the reporting requirements.

Listed below are 5 tips on issues, and items to consider when preparing that information.

1. Recognising that an ESS interest has been provided to employees

This might sound like a simple task, but with the level of complexity in some share based payments, it is important to recognise whether employees have received an ESS interest.

More importantly, it is necessary to determine what the interest is – whether it is a share, option, performance right, or some other form of equity can make a big difference in the way it is reported, when it is reported, and how it is valued.

It is also vital that an employer recognises when an ESS interest has been provided to employees to identify what type of scheme applies to the interest, and when that interest must be reported to the ATO.

In some cases, that interest might not be reported in the year in which it is issued, and therefore adequate records must be kept in order to identify when the taxing point might occur.

2. Working out if a taxing event has occurred

As important, or even more important, than recognising whether an ESS interest has been provided, is determining whether a taxing event has occurred within the financial year.

There are 4 types of taxing events:

 (a)     Taxed up-front scheme – eligible for reduction

Generally, all ESS interests are taxed up-front except in limited circumstances.

To be eligible for a reduction, the following conditions must be met for the ESS interests:

  1. The employee is employed by the company or a subsidiary when the ESS interest is acquired;
  2. The ESS interests relate to ordinary shares;
  3. The predominant business of the company is not acquisition, sale or holding of shares;
  4. The ESS is operated on a non-discriminatory basis in relation to at least 75% of the permanent employees who have completed 3 years of service;
  5. There is no real risk of forfeiture of the ESS interest;
  6. You are not permitted to dispose of your ESS interest before the earlier of 3 years, or when you cease employment; and
  7. No employee holds more than 5% beneficial interest in the shares of the company immediately after the acquisition of the ESS interest.

(b)     Taxed up-front scheme– not eligible for reduction

Unless any of the special conditions above are met, then most ESS interests will fall into this category.

This will be especially so where the ESS is operated for only a select group of employees such as senior management and executives, and directors.

(c)     Deferral schemes

An ESS will have a deferred taxing point where the following conditions are met:

If the interest is a share:

  • points 1, 2, 3 and 7 from the conditions above apply; and
  • at least 75% of the permanent employees with at least 3 years of service are, or have been, entitled to acquire ESS interests under the scheme; and either
  • there is a real risk of forfeiture; or
  • the market value of the ESS interests acquired are less than $5,000 and the amount was salary sacrificed.

If the interest is a right to acquire an interest in a share:

  • points 1, 2, 3 and 7 from the conditions above apply; and
  • there is a real risk of forfeiture.

(d)     Discount on ESS interests acquired pre 1 July 2009

Where ESS interests were acquired before 1 July 2009 under the previous ESS rules, and the cessation time under those rules occurs during the financial year, the market value of those interests at the cessation time must be reported.

3. Getting the acquisition date correct

Where ESS interests are taxed upfront, the relevant date for determining which income year they fall into, as well as the value of the ESS interest, is the acquisition date.

The acquisition date is different under tax law to the date used for accounting purposes when reporting the expense in the financial statements.

The important aspect of acquisition date for tax purposes is when the share or right actually came into existence and hence was “acquired”, as this is the date on which the interest will be valued.

Commonly, shareholder approval is given at an Annual General Meeting, but there is a delay in the share registry issuing the interests to the employees.

This delay can see a significant change in the market value of the underlying share price, and this in turn can see a dramatic change in the amount that needs to be included in the assessable income of the employee.

A more thorough discussion of when is the correct “acquisition date” can be found on the Value Logic website.

4. Calculating the correct value of the discount to report

For taxed upfront schemes, the value that must be reported is the discount provided to the employee.

The discount = (market value – amount paid by employee) x number of interests received

The key information that must be determined includes:

  • Number of interests with taxing event in current year
  • Correct acquisition date on which to value the share or right
  • Correct price of share /option/right at the taxing point/acquisition date
  • The market value of options/rights, either market value or as determined by the formula in the Regulations.

Determining the value of a right (including options and performance rights) is especially vital, as most often these interests are not quoted on a stock exchange and therefore a market price cannot be readily found.

 5. Reporting to employees and the ATO by the relevant dates

Employees

An ESS statement must be prepared and provided to employees if:

  • The employee acquired ESS interests under a taxed upfront ESS at a discount during the financial year
  • A deferred taxing point for ESS interests acquired under a tax-deferred ESS has arisen or could have arisen in the financial year.

The ESS statement must be provided to employees by 14 July after the end of the financial year.

Australian Taxation Office

Where an ESS statement has been provided to an employee/s, an Employee Share Scheme (ESS) Annual Report must be provided to the ATO by 14 August after the end of the financial year.

Where an employee has not quoted a Tax File Number and receives a discount on ESS interests acquired, the employer is required to withhold tax at the top marginal rate.

Reporting the amount withheld to employees is important to allow the employee to lodge their tax return with the correct information, and give the employee a chance to obtain a refund if the amount withheld is more than their tax liability.

CONCLUSION

Given the impact that receiving an ESS interest can have on an employee’s taxable income, it is vital that the correct details are reported to employee and to the ATO.

Amendments can be made to reports that have been lodged, so if any errors are detected there is an opportunity to correct them.

However, in the interest of keeping good relations with employees, clear and timely communication and advice is the key.

Tips for employee option and performance right valuation

With 30 June signalling the end of financial year and the beginning of the reporting season, thoughts now turn to working out the value for share based payments made during the year to meet the requirements in AASB 2 Share Based Payment.

Through Value Logic’s experience, the valuation of most options and performance rights encounter common issues which can be resolved with some careful advice and analysis of the situation.

At Value Logic we provide efficient turnaround for option valuation and performance right valuation to help companies with preparation of their accounts and ensuring that the auditors have adequate time to sign off before reporting deadlines. We also consult with companies prior to establishing plans and issuing equity interests to ensure that there are no unforeseen valuation issues which may produce unexpected results at reporting time.

What type of interest has been issued?

To report the correct value for share based payments requires the correct valuation technique. Of course, which valuation technique is appropriate is dependent on what type of equity interest has been issued, and the terms and conditions attaching to that equity interest.

An option with no vesting or exercise conditions, and an underlying share that does not pay dividends might be valued using the Black-Scholes model. A similar option whose underlying share does pay dividends might be valued using a modified version of the Black-Scholes model, or a Binomial model.

Options or performance rights with vesting or exercise conditions that are linked to market conditions, e.g. Total Shareholder Return relative to the ASX 200, could be valued using a Monte-Carlo Simulation model.

Vesting or exercise conditions

Vesting or exercise conditions can only be taken into account to value options or performance rights if they are a market condition. Examples of market conditions include measuring a share’s Total Shareholder Return against the ASX 200, or requiring a specific share price in order for the equity interest to be exercised.

Vesting conditions such as a condition of continuing employment, or a requirement to achieve a certain net profit, are taken into account when working out the number of options which are estimated to vest, rather than the value of the option.

When is the grant date?

The date on which the equity interest is to be valued is defined in AASB 2 Share Based Payment as the grant date. This date is the date on which the terms and conditions of the equity interest are agreed upon between the employer and the employee. This date can be a later date where shareholder approval is required for the issue of the equity interest.

Getting the correct date is important as it determines the share price used in the valuation. Where there are significant fluctuations in the underlying share price, this can significantly influence the valuation that results.

The grant date also affects the period over which the option or performance rights vest, and hence the allocation of the expense to each financial period. This may have a significant impact on the expense that is required to be recognised in each given financial period.

Share price volatility

Along with the time to expiry, the volatility is the other biggest influence on the value of an option. As the volatility has such a big influence on the valuation, it is important that the correct volatility is used.

AASB 2 requires the use of the expected future volatility of the share price over the life of the option or performance right. As it is the volatility expected in the future, an expectation of future volatility must be derived. Where a share price’s volatility is not expected to vary from its historical average, the historical volatility may be used as a guide.

Some cases when past volatility is not sufficient as a measure include:

  • low trading volumes
  • changes in business structure for the entity
  • changes in economic conditions and stock-market performance
  • the company is unlisted.

The key factor is to understand all the circumstances and use best judgement as to when another company’s share price volatility or an index’s volatility might be a better proxy.

Don’t confuse accounting valuation requirements with tax valuation requirements

Commonly it is assumed that the valuation techniques and requirements of AASB 2 are the same requirements found in the Income Tax Assessment Act 1997.

One of the key differences is that the tax legislation requires the valuation to ignore any vesting or exercise conditions when valuing the equity interest.

As the regulations provide a valuation methodology that uses a highly concessional version of the Black-Scholes model, the tax valuations quite commonly turn out lower than the corresponding accounting valuation.

This highlights the importance of getting both valuations performed so that employees are adequately advised of their tax obligations.

Conclusion

While the use of a valuation model may seem relatively simple, the selection of the correct inputs is vital to obtaining a valuation that correctly measures the fair value of equity interests issued as Share Based Payments.

If you have any questions or require any valuations, contact Ian Wood at Value Logic for further assistance.

5 Tips for ESS reporting to the ATO

With employers due to provide ESS Statements to their employees and the Australian Taxation Office (ATO), it is now time to start preparing the information required to meet the reporting requirements.

Click below to read the 5 tips on reporting to the ATO on Employee Share Scheme (ESS) interests, and make sure you are fully prepared.

 

If you have any concerns with reporting to your employees, or any issues determining what to report and how much to report, contact Value Logic for assistance.

 

When are employee incentives acquired for tax purposes?

A common situation that arises when companies issue options and performance rights to employees is a delay between agreeing on the terms of the options and the company issuing the rights to the employee.

This delay can also see a significant difference in the company’s share price between when the terms are agree and the options are actually issued.

Where there is an increase in the share price, this can affect the option valuation with the employee going from a position where there is little or no taxable value when the terms are agreed, to a position where there is a significant taxable value when issued – which can result in a significant tax liability.

The key issue is to accurately determine the day on which the options or performance rights are considered to be acquired, so that the proper option valuation can be calculated.

Tax vs accounting

The Income Tax Assessment Act 1997 provides that an employee includes in their assessable income any discount given in relation to rights received in the income year in which they acquire the ESS interest (s. 83A-25(1)).

The ATO provides further guidance on their website that a share or right is acquired when:

  • the share or right is transferred to you, other than by a share issue;
  • in the case of a share, the share is allotted to you;
  • in the case of a right, your employer or another person creates a right (to acquire a share) in you;
  • you otherwise acquire a legal interest in the share or right;
  • you acquire a beneficial interest in the share or right.

This contrasts with the grant date defined in AASB 2, which is the date at which the employer and employee agree to the share based payment arrangement. If the agreement is subject to an approval process (such as shareholder approval), the grant date is the date when that approval is obtained.

Getting the date right

This difference has been highlighted in two recent case before the Administrative Appeals Tribunal.

As can be seen with two cases, it is vitally important to ensure that the relevant date of acquisition is determined properly so that the correct amount of assessable income is reported.

In the case of Re: Willis and Commissioner of Taxation (2010) 79 ATR 287, the company passed a resolution at the AGM on 3 May 2004 approving the issue of options to Willis, who was a director and chairman of the company. However the options were not issued and allotted by the company until 8 April 2005, as evidenced by the holding statement which was issued at that time.

In Case 2/2012, [2012] ATA 142 a partner in a prominent law firm was offered a position with a public company, which included being granted options in the company as one of the components of his remuneration package. Discussions took place during May 2003 and agreement was reached via email and phone, however the draft contract of employment was never executed by either party. The taxpayer commenced employment with the business on 1 July 2003, and was appointed a director of the company on 11 September 2003. The issue of the options was approved at the Annual General Meeting on 28 November 2003, with the actual issue occurring on 22 December 2003.

The judge in Willis concluded that there was no evidence that the options were created prior to 8 April 2005, and “while the act does not define a time of acquisition, it is difficult to see it being prior to a time when the right is created”.

In Case 2/2012 it was considered that the employee had a right to receive options when he commenced his employment on 1 July 2003, as the terms of the unsigned employment agreement were agreed upon in emails, phone calls and by the virtue of the commencement of employment on 1 July 2003. It was also considered that shareholder approval was not a necessary condition to be satisfied before the right to receive options was created. As such, the acquisition date was 1 July 2003, not the later date of approval or actual issue.

The judge in Case 2/2012 concluded that the decision in Willis was distinguishable on the following bases:

  • there was no contract with Willis which gave him an immediate contractual right to the options as there was in the more recent case;
  • shareholder approval was not required in this recent case as at the time of the contract (1 July) the taxpayer was not a director and approval was not necessary for the grant of the right to the options under the contract.

How to determine the right date?

In most circumstances where options are to be issued to directors and key management personnel, shareholder approval will be required prior to the issue of the options.

In those cases, the views in Willis would seem to be the more correct interpretation of when options are acquired. The acquisition date will be when the options are actually issued by the company, as the right cannot be acquired before it is created. Even where shareholder approval is given prior to the issue of the option, that does not give the employees a contractual right to receive options, but merely authorises the company to take the necessary steps to issue those options to the relevant employees and executives.

In circumstances where options are to be issued under the terms of an employment contract agreed upon (particularly where signed) prior to the commencement of employment, and shareholder approval is not required, then this latest case provides precedent that the date of acquisition of a right to acquire shares can occur upon signing the contract.

Should shareholder approval be a condition of the issue of the options in the employment contract, then that right would not be satisfied until the shareholder approval is obtained, and the acquisition date would be at that later point in time.

How do I determine the acquisition date?

Each situation will be different, so it is extremely important to review the circumstances of each case on its own facts.

The key things to review are:

  • terms of the employment contract – is the right created in the contract, or is further action required?
  • details of shareholder approval and general meeting notices – does the resolution merely give approval, or does it confirm an earlier issue of options?
  • The date recorded on the holding statement – when were the options actually issued by the company?

If in doubt, contact Value Logic to have your situation reviewed and be certain of your tax obligations.