Employers often wish to incentivise their key employees by issuing them with shares, usually at a discount. However, shareholders must pay market value for shares if they want to avoid significant and upfront tax expenses on the discount received.
In this article, we look at limited and full recourse loans as tax-efficient ways to provide share incentives to employees.
What is are Recourse Loans?
There are two types of recourse loans that your company can use to issue shares to employees: a limited recourse loan (LRL) and a full recourse loan (FRL).
In both cases, a company (lender) makes a loan to an employee (borrower) to buy a particular asset (e.g. shares). But if the employee defaults on the loan, different consequences result depending on if the loan was a LRL or FRL.
Limited Recourse Loan
If a borrower defaults on a LRL, the lender can only recover the assets which were purchased using the loan.
In the context of employee equity incentives, a company can make an LRL to an employee so that the employee can buy company shares. This is particularly useful if the employee has insufficient funds to pay market value for their shares upfront. If the employees defaults, the company can recover the shares.
Full Recourse Loan
If a borrower defaults on a FRL, the lender may recover any of the borrower’s assets to satisfy the debt.
In the context of an employee equity incentive, a company can issue shares to an employee and make a FRL to the employee to pay for the shares. If the employee defaults under the loan, the company can recover any of the employee’s assets, not just the purchased shares.
Terms of the Loan
The terms of a LRL and FRL can vary but generally, employees:
- can only use the loan to buy company shares;
- pay no, or minimal, interest on the loan;
- may use share dividends to repay the principal loan; and
- can repay the loan early and without a penalty fee.
Issuing Shares with a Recourse Loan
To issue shares with a recourse loan, a company prepares a subscription offer letter with a FRL or LRL agreement. It is best practice to include an explanatory memorandum which explains the offer in easy-to-understand terms.
Once the documents are signed, the company or board must agree to:
- issue the shares;
- give the employee a share certificate; and
- update both the share register and notify ASIC.
A company may issue shares using a recourse loan to:
- a new shareholder; or
- an existing shareholder.
Below, we discuss the specific tax implications for the employees or company in each scenario.
Issuing Shares to a New Shareholder: Tax Implications
Where a company issues shares with a recourse to an employee that is not a current shareholder, the recourse loan is treated as a loan fringe benefit. A loan fringe benefit is a loan to an employee where the interest rate is anything less than the statutory interest rate.
Consequently, companies that provide loan fringe benefits to employees must pay fringe benefit tax. You can calculate the taxable value of the loan fringe benefit by using the following equation:
(Statutory interest rate – Interest rate paid by employee) x Loan Amount = Taxable Value of the Loan Fringe Benefit
Companies may reduce the fringe benefit tax owing if the loan is made directly to the individual employees, rather than a trust or other related entity under the ‘otherwise deductible rule’. Under the ‘otherwise deductible rule’, the taxable value is reduced by the amount the employee could have hypothetically claimed as an income tax deduction.
Issuing Shares to an Existing Shareholder: Tax Implications
As a general rule, a private company cannot lend money to its employees, shareholders or their associates. So if a company issues shares to an existing shareholder using a FRL or LRL, the loan is treated as a dividend for tax purposes. This means it forms part of the employee’s assessable income for tax purposes, and could create a significant tax cost for the employee.
To avoid the tax expense, companies and employees may consider the following two exceptions.
- A recourse loan to an employee is not treated as a dividend if the loan meets the following conditions:
- Written Form: The loan must be recorded in a written agreement. Although there is no prescribed form, the agreement must set out the loan’s essential terms (principal amount, term, requirement to repay and the interest rate payable). It must be signed and dated by both parties.
- Interest Rate: The interest rate must be equal to or greater than the benchmark interest rate for the year.
- Maximum Term: The maximum term of the loan is 25 years if:
- the loan is secured over real property; and
- the market value of the property is at least 100% of the amount of the loan.
The maximum term of the loan is 7 years for any other type of loan.
- A recourse loan made to an employee is not taxed as a dividend if the company does not have any distributable profits. This is because there would be no dividends to distribute and therefore be taxed on.
To benefit its employees, a company may choose to issue shares upfront with a full or limited recourse loan. This gives the employees an opportunity to repay the market value of the shares in the future. The company and employees must be wary of the tax implications of this arrangement. These will vary based on whether employees are existing or new shareholders.
If you would like specific tax advice on recourse loans or how best to incentivise employees, contact LegalVision’s taxation lawyers today on 1300 544 755 or fill out the form on this page
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