To incentivise your employees, you may be thinking of giving them discounted shares in your startup. However if they pay less than market value for the shares, they will be taxed upfront on the discount. This is because the discount will form part of their taxable income. Instead, you could take advantage of the tax concessions under an Employee Share Scheme (ESS) if eligible, and provide an outcome more beneficial to employees.

In this article, we look at the eligibility requirements and tax concessions available under an ESS.

Tax Concessions

If eligible for the ESS startup concession (discussed further below), your employees can benefit from two tax consequences.

1. No Upfront Taxation

The value of the discount will not be taxed upfront when the employee receives the shares, or exercises an option to receive shares. Instead, it is taxed when those shares are sold. This allows employees to plan for the tax expense, and possibly to use the proceeds of the sale to pay it.

For example, a startup offers 100 shares at $5 per share to their employee Sam in April 2015. The market value of a share is $10. Accordingly the taxable discount income is:

($10 – $5) x 100 =  $500

(Market value – discounted share price)  x  number of shares bought

Sam later sells these shares in April 2019. He will only be taxed on the discount value ($500) at this time (i.e. as part of his 2018-19 income).

The share sale also generally creates a Capital Gains Tax (CGT) event. This means a 50% CGT discount may apply if the shares are sold at least 12 months after the share issue or the grant of the options. 

Sam sells his shares in April 2019 for $1500. As he is selling these shares more than 12 months after the share issue (which was in April 2015), he will only have to pay CGT on:

($1500 – $500) x 50% = $500.

(Share sale value – discounted share price) x CGT discount

As Sam is an individual, the CGT tax rate that will apply to the $500 is the same as his income tax rate.

2. Safe Harbour Valuation

You may also reduce employees’ taxable discount income by issuing shares or options using the safe harbour valuation method.

Generally, market value of shares is calculated as the amount for which the shares can be sold on the date of valuation. However using the net tangible assets test, a 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;
  • 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 in the company.

For many startups, their tangible assets are minimal or nil. Often this is because their value relies on their intangible assets. So the safe harbour valuation is usually beneficial for employees as:

  • employees are more likely to afford to pay market value for the share; or
  • there is no or little taxable discount income.

ESS Eligibility

To be eligible for the startup tax concessions under the ESS, you must meet the following criteria. 

 

Criteria Description
Shares Cannot be Listed The company’s shares (and the shares of any holding company, subsidiary or sister company of the company) are not listed on a stock exchange.
Company Incorporation Company incorporation (along with any holding company, subsidiary or sister company of the company) occurred in the last 10 years.
Aggregated Turnover The aggregated turnover of the company (and any holding company, subsidiary or sister company of the company) in the previous income year was less than $50 million.
Payment Amount If the proposed ESS scheme is an options scheme, employees must pay at least fair market value to exercise the right (unless eligible for the Safe Harbour Valuation).
If the proposed ESS scheme is a share scheme, the share price offered to employees must be at least 85% of fair market value (unless eligible for the Safe Harbour Valuation). 
Australian Residency The company must be incorporated in Australia.
Employee Status The company can only grant ESS interests to employees (i.e. not contractors) of the company or its subsidiaries.
Ordinary Shares Only All the options or shares under the ESS relate to ordinary (not preference) shares.
Company’s Predominant Business The company’s main business is not investing in other shares or investments (e.g. an investment bank).
ESS Operation An employee must hold the ESS interest for:

  • three years; or
  • until they stop working for the company.
Maximum Share Limit The company cannot grant an ESS interest to an employee who:

  • holds more than 10% of the shares in the company; or
  • controls more than 10% of the vote at a general meeting.  
Share Offer If the proposed scheme is a share scheme, the company must offer shares to at least 75% of its Australian resident permanent employees who have completed at least 3 years’ service.

 

Valuation Test Eligibility

If your startup wants to use the net tangible assets test under the safe harbour valuation, you must also meet the criteria below. 

 

Criteria Description
No Change of Control The company reasonably anticipates that it will not be subject to a change of control within the 6 months after share valuation takes place.
Capital Raising The company has not raised more than $10 million in capital during the 12 months prior to the valuation.
Incorporation At the time of valuation, either:

  • the company has been incorporated for a maximum of 7 years; or
  • the company is a small business entity under the Income Tax Assessment Act 1997 (Cth).
Financial Reporting The company must prepare a financial report for the income year in which the valuation occurs, that complies with the accounting standards under the Corporations Act 2001 (Cth).

 

ESS Ineligibility and Further Options

Even if your employees are ineligible for the ESS, you may still choose to issue employees with shares upfront. This may be the case if you issue shares early enough for their value to be low or nil, so that the discount itself is low or nil. 

Alternatively, you could consider using a deferral tax regime, recourse loan or premium priced option plan if:

  • the taxable discount income could create a significant tax expense; or
  • where the parties prefer to avoid paying market value for the share upfront.

Key Takeaways

Employee Share Schemes can be an affordable, tax-effective way of rewarding employees and granting them a real ownership stake in the business. If your startup meets the eligibility criteria, your employees will be taxed only when they make a financial gain in respect of their ESS interest.

If you want help determining whether an ESS is appropriate for your business, contact LegalVision’s startup lawyers on 1300 544 755.

 

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