Having loyal, dynamic employees increases the value of your business. They are an asset to your company. How can you keep these star employees happy by rewarding their outstanding efforts? One option is to take advantage of the beneficial tax treatment of an Employee Share Option Plan (or ESOPs or an Employee Share Scheme – ESS).
For a startup company, the office culture and social dynamics can be critical to ensuring its success, as the workforce of a startup is usually much smaller due to restraints on cost and with overheads being so high. Similarly, startups may not be able to offer employees lucrative salaries and so founders may need to provide additional incentives to retain employees.
An Employee Share Option Plan (ESOP) is a scheme that provides a company’s employees with the ability to own shares in the business. Below, we set out the benefits of an ESOP as well as recent changes to their tax treatment in Australia.
What are the Benefits of an Employee Share Option Plan?
These schemes are attractive to startup founders and employees for a number of reasons, including:
- Reducing upfront hire costs as employers usually offer ESOPs as part of an employee salary package;
- Often, people work harder when they own a part of a company, increasing productivity and their quality of work;
- Employees will typically stay with a company longer if they have an ownership stake, allowing the company to retain talent; and
- Sharing ideas and risks with others who have expertise in the market or industry the business operates in.
Terminology Used in an Employee Share Option Plan
An employee receives an “option” under an ESOP – that is a right but not an obligation – to purchase shares in the company at certain scheduled times in the future. The employee will have the right to buy the shares for an agreed price (known as the exercise or strike price).
An employee “exercises their options” when they decide to buy the shares, thereby converting their options into real shares of the company. An employee’s option will normally “vest” (that is, become available to be exercised) gradually when certain vesting criteria are satisfied. The time frame of when options are vested is linked to the performance of the company and the length of service of the employee.
Options usually vest during a period of between three and five years although this will depend on the vesting schedule the employer uses. Before an option vests, an employee would normally have no right to vote or sell their options. If an employee exercises their options and buys shares in the company, they become a shareholder in the company with ownership rights. At that time, they will have the rights, benefits and obligations of being a shareholder and will be subject to the shareholders agreement.
Recent Changes to Tax Treatment of ESOPs in Australia
In July 2015, the Australian government changed the tax treatment of ESOPs for eligible companies making them significantly attractive to employers and employees. These changes increased the number of ESOPs Australian companies were offering key employees.
Under the previous system, an employee who entered into an ESOP had to pay income tax at the time they received those options or shares even though, at that time, they had not received any financial benefit. Every shareholder hopes to sell their shares for more than they bought them for, although the previous tax treatment of ESOPs made it even riskier for employees to opt into ESOP arrangements with their company.
The new system, however, changed the timing of tax payments. Since July 2015, employees will only pay tax on their shares or options when they receive a financial benefit (i.e. when the employee sells the shares). Employees have up to 15 years in which to defer their tax liability.
Are There Restrictions or Criteria to Benefit From the Tax Concessions?
A company must first satisfy the following criteria to receive tax concessions:
- The business must be an Australian resident company;
- The business must be unlisted on the stock exchange;
- The business must be incorporated for no more than ten years;
- The total annual turnover must be less than $50 million;
- The exercise price must not be provided for less than the market value of shares in the company as at the date the options were granted;
- The employee must hold the ESS interest for at least three years; and
- Employees cannot hold more than 10% of a company.
If you are looking into long term ways to reward key employees and continue the growth of your company with them remaining a part of it, get in touch with our startup lawyers to discuss the options avilable to you.
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