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In March 2022, the government announced reforms to make it easier for businesses to utilise employee share schemes (‘ESS’) and reduce the red tape so that employees at all levels can directly share in the business growth they help to generate. These changes include:

  • amending the disclosure rules, allowing unlisted companies to offer an unlimited number of shares, of an unlimited value, as long as the employee is not charged more than $30,000 a year for them (up from a $5,000 a year cap). Employees will also be able to accrue up to $150,000 over a five year period; and

  • for employee share schemes where there is no payment to participate, independent contractors will receive the same treatment and receive the same regulatory relief as employees and directors who are participants in the scheme.

In July 2015, the Australian government introduced tax concessions for the participants of Employee Share Schemes (ESS) and Employee Option Schemes (EOS) in eligible startups. The tax incentives aimed to help startups attract top talent by enabling them to offer employees, contractors and directors a tax efficient ownership interest in the startup in addition to what is typically a below market base salary. Below, we revisit what the startup tax concessions mean for participants as well as weigh up the advantages and disadvantages of an ESS and EOS.

What are the Startup Tax Concessions?

The startup tax concessions mean that a participant must only pay tax in respect of a share or option when it receives a financial benefit (usually when the participant sells their shares). Consequently, the participant does not need to pay tax when they receive the shares or options, when the shares or options vest, or when they exercise the options. Also, for the purposes of the capital gains tax discount on disposing a share, the participant is seen as having received the share at the time the startup granted the share or option. To qualify for the startup tax concessions, the following must satisfy certain eligibility criteria:

  • the company;
  • the employee/contractor/director; and
  • the ESS or EOS (as applicable). 

If a startup founder offers their team-member shares in a way that does not meet the eligibility criteria, then the team-member will not be eligible to receive tax concessions.

What’s the Difference Between an ESS and EOS?

Under an ESS, the startup issues the participants with shares. The shares usually vest over time so that if the employee leaves the business before all of their shares have vested, the company can buy back any unvested shares. This motivates the participant to remain with the startup and help it grow. For the tax concessions to apply, the startup must, among other things:

  • issue the participants with ordinary shares;
  • issue shares for at least 85% of fair market value (although it’s often possible to use a negligible value through the ATO’s net tangible asset valuation methodology); and
  • offer shares to at least 75% of its Australian permanent employees who have worked at the business for at least years.

Under an EOS, the startup issues the participants with options to purchase shares. The options usually vest over time. Only once an option has vested can the option-holder exercise the option (i.e. purchase a share). A participant will not exercise an option until a liquidity event occurs so that it can use the sales proceeds from the liquidity event to pay the exercise price (known as a ‘cashless exercise’ as the participant is never actually out of pocket). Again, for the tax concessions to apply, the startups and participant must meet the eligibility criteria, which means:

  • the company must issue the participants with options to purchase ordinary shares; and
  • the exercise price of an option (i.e. the price which the participant must pay to purchase a share) must be at least fair market value on the date the option is granted.

The participant must hold the options/shares for the minimum withholding period of 3 years or the startup stops employing the employee (if earlier).

ESS v EOS: Key Advantages and Disadvantages

ESS EOS
Participation Company must offer shares to at least 75% of its Australian permanent employees who have worked in the startup for at least three years. The startup can extend the EOS to as many or few participants as it chooses.
Employee Engagement Participants have shares in the startup from day one. Participants are not shareholders from day one. Also, people are less familiar with options and so may perceive options as inferior to actual equity.
Dividends If a startup is in a position to declare dividends, a participant may find holding shares preferable to options. As participants are not shareholders, they are not entitled to dividends.
Voting Rights Participant has ordinary shares in the company from day one, meaning he or she has the right to attend and vote at general meetings. This can be a disadvantage for the startup as it increases the number of shareholders to obtain approvals from. As participants are not shareholders, they will not have voting rights.
Shareholder Rights Company is likely to exceed the 50 shareholder limit. Consequently, increasing the cost of any investment in or acquisition of the business due to Chapter 6, Corporations Act 2001 (Cth) compliance issues. Company is likely to exceed the 50 shareholder limit. It’s possible for a startup to structure its EOS so when a liquidity event occurs, it can arrange to sell all options to the acquirer of the company and avoid Chapter 6 compliance issues.
Participant Costs The participant must pay at least 85% of a share’s fair market value upfront (it’s often possible to use a negligible value via the ATO’s net tangible asset valuation methodology). The participant must only pay the exercise price for the option. However, most participants will wait until a liquidation event to exercise their options enabling them to effect a cashless exercise.

It’s important startup founders and employees understand the advantages and disadvantages of an ESS and EOS to determine which best suits the business’ circumstances. If you have any questions or need assistance drafting an ESS or EOS, get in touch with our startup lawyers on 1300 544 755. 

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