What is the Difference Between an ESS and Option Scheme?

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Table of Contents

• Incentivising Key Employees
• How Many Shareholders Can My Startup Have?
• The Tax Considerations

The tax information contained in this article is not tax advice and should not be relied on as such. 

The Corporations Act 2001 (Cth) (the Act) governs who can issue shares. For small proprietary companies offering shares or options to their employees, there are relatively few restrictions, many of which are procedural. Issues that will affect your scheme include: 

• Whether to issue shares or options or both; 
• What incentives you want to give employees; 
• The company and employees’ cash-flow situation; 
• The amount of control in the company you want to give away; and 
• Taxation treatment of your scheme.  

Taxation is an important consideration when it comes to employee share and option schemes – in fact, for many, it’s the deciding factor. Tax laws changed in this area on 1 July 2015. Below, we consider the difference between an employee share scheme and an option scheme. For ease of reference, we use the acronym ESS (Employee Share Scheme) regardless of whether it is a scheme for granting shares or options. The share or option granted to the employee is an ESS Interest.

Incentivising Key Employees

Startups typically use an ESS to incentivise key employees to stay with the company and help it grow. Founders may, however, worry about losing control by issuing new shares – particularly regarding voting rights at shareholder meetings. If you grant shares, they must be ordinary shares to qualify for tax concessions and would, therefore, carry voting rights from the day of issuance and dilute your control over the company. On the other hand, if you issue options granting the right to buy ordinary shares, these would not carry a right to vote until the employee exercises his or her ‘option’. Your scheme can contain rules specifying that an employee cannot exercise such options for a period.

How Many Shareholders Can My Startup Have?

If you are a larger startup, then you may face another issue in that additional regulations apply to a proprietary company which has 50 or more shareholders under the Act. Startup founders should keep this in mind when choosing between shares and options.

The Tax Considerations

The following is a high-level summary of the tax considerations that may affect whether an employer decides between a share or option scheme. Employees and employers should both seek tax advice whether they are setting up an ESS or joining one. 

The basic income tax rule for an ESS is that any discount the employee receives on a share or option should be declared as income on their tax return, and taxed at their marginal rate of tax. For example, if a company grants an employee options at no cost which are worth $5,000, the employee must declare the additional income of $5,000 (the “discount” to market value) and pay income tax. The rules in the Income Tax Assessment Act 1997 (Cth) (ITAA) are designed to reduce or defer this initial taxation burden from employees if the ESS meets certain criteria.

There are three types of concession available under the ITAA:

1. For a startup ESS (sections 83A.33 and 83A.45 of the ITAA), the discount does not need to be reported as income at all. Instead, it is taxed under capital gains tax (CGT) rules when realised, which may potentially make use of the 50% CGT reduction.
2. For an ESS that doesn’t meet the requirements above (but do meet those set out in sections 83A.35 and 83A.45 of the ITAA), the amount of discount to be reported as income can be reduced by up to $1,000. This is a materially less generous exception than the one above.
3. For an ESS that doesn’t fall in either of the categories above, there are possibilities to defer the taxation of the discount, but it would still be taxed as income if certain criteria in sections 83A-C of the ITAA are met.

It is typically more favourable for employees if their ESS falls into category one. To do so, at least 75% of permanent employees who have worked at the startup for at least three years can acquire an ESS interest under the scheme. That is, a share based ESS must have been broadly available among staff for a period to qualify for the startup ESS tax concession. If you are a startup founder and only want to offer the ESS to a small proportion of staff, then an option scheme may better suit your business’ needs.

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Ultimately, non-tax and tax reasons will influence your decision to choose a share or option scheme. If you have any further questions or need assistance drafting a scheme or letters of offer, get in touch with our startup lawyers on 1300 544 755 or fill out the form on this page.