Tax Implications of Employee Share Scheme (ESS) Arrangements

If you’re the business owner of a start-up or high-growth company with tight cash flow, you’ll likely find employee share schemes a particularly useful growth tool. But there are tax obligations to be considered, of course, and the tax implications of employee share schemes are not always simple.

The main considerations include the type of interests being offered (shares or options), the agreed market value and discount to be provided, the vesting period (if applicable), any conditions that are imposed on those interests and whether the ESS interests are offered to most employees or just a very select few. We do a deep dive into employee share schemes in our downloadable e-book, a BlueRock Guide to Employee Share Schemes . But in this article, we wanted to focus on providing a clear summary of the tax implications of employee share schemes.

We’ll start by outlining the tax implications under the general ESS rules and then compare these with the extra tax concessions available where the ESS qualifies as for the ESS start-up concessions.

General Employee Share Scheme Rules

Taxed upfront schemes

The default position under the general ESS rules is that the discount to market value on the acquisition of ESS interests is taxed upfront to the employee in the year in which the ESS interests are acquired.

Taxed upfront schemes - $1,000 reduction

In some circumstances, the amount taxed to the employee under a ‘taxed upfront scheme’ may be reduced by $1,000. Specifically, the following conditions must be met:

• The sum of the employee’s taxable income, reportable fringe benefits total, reportable superannuation contributions and total net investment losses for the income year does not exceed $180,000
• The recipient is employed by the company (or a subsidiary) offering the share or right
• The scheme is offered to at least 75% of permanent employees with at least three years of service
• The ESS interest relates to ordinary shares that cannot be sold within three years of the date of acquisition (unless the employee ceases to be employed by the company) and cannot be at risk of being forfeited, and
• The employee does not, after acquisition of the shares own or control more than 10% of the company.

Tax-deferred schemes

There are some circumstances in which the discount to the market value of an ESS interest is taxed at future point in time (i.e. the taxing point is deferred rather than taxed up-front). Such schemes are referred to as tax-deferred scheme.

To qualify for deferral of taxing, the following general conditions must be satisfied:

• The ESS interests must be in your company or your holding company
• When your employee acquires the interest, all ESS interests available for acquisition under the scheme must relate to ordinary shares
• Immediately after acquiring the ESS interests, your employee (and their associates) must meet the:
  • 5% ownership and voting rights test (ESS interests acquired before 1 July 2015)
  • 10% ownership and voting rights test (ESS interests acquired after 30 June 2015).

In addition to the general rules, there must also be a real risk that ESS interests will be lost or forfeited or a genuine restriction on the disposal of those interests. Examples of real risk of forfeiture may include conditions where retention of the ESS interests is subject to performance hurdles, minimum terms of employment and good leaver conditions.

The deferred taxing point for a shares is the earliest of the following:

• The recipient must be “employed” by the company that issued the ESS interest or its subsidiary.
• ESS interests that employees may acquire under the employee share scheme must only relate to “ordinary” shares.
• After acquiring their ESS interest in the company, the employee must not beneficially own shares in the company, or control its voting power, beyond a 10% limit.
• Where the ESS interests are shares, the ESS must be broadly available to at least 75% of the Australian resident, permanent employees who have completed at least three years of service.
• ESS interests acquired under the employee share scheme must satisfy the minimum holding period, which is generally three years (subject to some exceptions), before they may be disposed.

Tax deferred Salary Sacrifice Arrangements

Deferral of the taxation of the discount is also available where an employee acquires a beneficial interest in an ordinary share under a salary sacrifice arrangement. The discount must equal the market value of the beneficial interest at the time of acquisition. The share plan rules must specifically state that Subdiv 83A-C ITAA 97 applies, and the salary sacrificed amount cannot exceed $5,000.

Employee Share Scheme Start-up Concessions 

Under the ESS start-up concessions, employees can reduce to nil the tax that would otherwise payable on the discount to market value on shares or options provided to them by their employer. This means that eligible employees do not pay tax on their shares or options until they are sold.

The concession is intended to enable eligible start-ups to set aside more cash for developing the business, which may have been previously used to remunerate key employees, ultimately with the intention of making Australia’s tax arrangement more attractive to innovative start-ups. Read our case study on start-up concessions to see how this might look in real life.

Note that companies that are eligible for the start-up concession can’t access the $1,000 up-front concession.

Benefits of Employee Share Scheme Start-up Concessions

The benefits of the ESS startup concessions can be summarised as follows:

• Employees are not taxed upfront on the discount obtained when acquiring the ESS interests

• In relation to shares, the discount is not subject to income tax. Rather, the cost base of the shares for CGT purposes is reset at market value.
• In relation to options, CGT on the exercise of options is deferred until the resulting shares are sold. The exercise price is added to the cost base of the resulting shares.
• Shares acquired via exercising an option may qualify for the 50 percent CGT discount as the date of acquisition is defined as the date the right was first acquired (rather than the date the resulting share ware acquired).
• Approved concessional valuation methods available (subject to further conditions being met).

Qualifying for Startup Concessions

To qualify for the startup concessions, in addition to the conditions that must be satisfied under the general ESS rules, the following additional conditions must also be satisfied:

• The company issuing the ESS interest must not have its “equity interests” listed on certain stock exchanges. 
• The issuing company (and certain related entities must have been incorporated for less than 10 years.
• The aggregated turnover of the issuing company (including connected entities and affiliates) must not exceed $50m. 

• If the ESS interest relates to an issue of shares, the discount must not be more than 15% of the market value of the share at the time of issue. 
• If the ESS interest relates to an issue of rights to shares (options), the exercise price must not be less than the market value of the share at the time the right was granted. 
• The employer must be an Australian resident.

Have Questions About Employee Share Scheme Tax Implications?

If you’re keen to explore employee share schemes as a model for your business, or if you have questions about ESS tax implications, feel free to reach out to our Melbourne-based accountants from our experienced business advisory team.