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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 participants of Employee Share Schemes (ESS) implemented by eligible startups.

The startup tax concessions mean that a participant in an ESS must only pay tax on a share or option that it acquires when it receives a financial benefit. As such, the participant does not need to pay tax when it receives the shares or options, when they vest or when they exercise the option. The financial benefit occurs when the participant actually sells its shares.

Further, for the Capital Gains Tax (CGT) discount, the participants are seen as having received the share at the time the company grants the share or option. The CGT discount is available when the shareholder disposes of a share (provided he or she has owned the share for over 12 months).

The startup tax incentives aimed to help startups attract talent by offering employees a tax efficient ownership interest in the business in addition to a salary that may be less than the market rate. We set out the eligibility criteria below that the company, employee and the ESS must meet as well as the valuation methodology.

Startup Tax Concessions: Eligibility Criteria

A startup must satisfy certain criteria to be eligible for the tax concessions (set out below).

Criteria Description
Shares Cannot be Listed Company’s shares (and the shares of any holding, subsidiary or sister company) are not listed on an approved stock exchange.
Company Incorporation The company (and any holding, subsidiary or sister company) was incorporated less than ten years before the end of the company’s most recent income year before the employee acquired shares or options.
Aggregated Turnover The company (together with any connected or affiliated entities has an aggregated turnover of no more than $50m in the most recent income year before the employee acquired shares or options.
Residency The employer company is an Australian resident.
Company’s Predominant Business The predominant business of the company is not the acquisition, sale or holding of shares, securities or other investments.
Employee’s Status When the employee acquired shares or options, they were employed by the company or a subsidiary of the company.
Operation of the ESS ESS participants cannot dispose of their options or shares earlier than (a) three years from the grant date or (b) when the employee ceases employment (whichever is earlier).
Type of Shares The shares or options granted to an employee under an ESS must be ordinary shares.
Percentage of Shares Held An employee cannot hold a beneficial interest in more than 10% of the shares in the company and cannot control the casting of more than 10% of the maximum number of votes at a general meeting.
Discounted Shares When issuing shares, the share price must be at least 85% of fair market value.
Exercise Price When issuing options, the exercise price must be at least fair market value of a share at the date of grant of the options.

ATO’s Safe Harbour Valuation Methodologies

The ATO has issued two safe harbour valuation methodologies which startups can use to value their shares for an ESS. One is essentially a formal valuation and the other is a net tangible assets test. A startup must satisfy certain eligibility criteria to use the net tangible assets test. If it meets the criteria, then the startup’s valuation can be calculated using the following formula:

(A-B)/C=Valuation 

Where:

  • A means the company’s net tangible assets at that time (disregard any preference shares on issue);
  • B means the return on any preference shares on issue at that time if the shares were redeemed, cancelled or brought back; and
  • C means the total number of outstanding shares (e.g. ordinary shares) in the company.

Startups tend to have few, if any, tangible assets. So, the net tangible assets test enables startups to issue shares or grant options with a share or exercise price that is lower than the share’s market value.

Net Tangible Assets Valuation Methodology: Eligibility Criteria

Again, a company must meet certain criteria to be eligible to use the net tangible assets test, namely: 

  • the company must be an eligible startup;
  • the company must reasonably anticipate that it will not be subject to a change of control within the period ending 6 months after the valuation time;
  • the company must not have raised more than AUS $10 million during the 12 months immediately before the valuation;
  • at the valuation time, either the company:
    (a) has been incorporated for no more than 7 years; or
    (b) is a small business entity within the meaning of section 328-110 of the Income Tax Assessment Act 1997 (Cth) (i.e. has a turnover of less than AUS $2 million);
  • the company prepares a financial report for the income year in which the valuation occurs, and that complies with the accounting standards under the Corporations Act 2001 (Cth).

Key Takeaways

If you’re a startup looking to attract and motivate key talent, you should consider implementing an ESS. If you’re eligible for the startup tax concessions and can use the net tangible asset test to keep the share price/exercise price down, offering potential employees options or shares in your startup can be an attractive option for both parties. If you have any questions about whether your startup meets the relevant eligibility criteria, or you need assistance drafting an ESS, get in touch with LegalVision’s taxation lawyers on 1300 544 755 or fill out the form on this page. 

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