Are employee share schemes too taxing to attract talent?

Employee Share Schemes (ESS) are a great tool for innovative start ups to attract the best and brightest talent, but recent changes mean they can also be a minefield if SMEs are not aware of them.

Under the new guidelines, start ups will now find it increasingly difficult to remunerate key people using traditional ‘sweat equity’.

The three key areas to be mindful of are tax, valuation and reporting.

How the schemes are treated by the ATO is one of the biggest changes to ESS, a change that makes them less attractive from a tax perspective.

The ESS rules apply when an employee is issued shares or rights at a discount. The employee is taxed on the discount, calculated as the difference between the market value of the share or right and any consideration paid by the employee.

The basic rule is that the discount is taxed when the share or right is granted and must be included in the employee’s assessable income for that income year. Employees may be eligible for a $1,000 tax exemption if they have an adjusted taxable income of $180,000 or less and the ESS meets the strict requirements of a qualifying share scheme.

The taxing point can only be deferred where the shares or rights issued are subject to a real risk of forfeiture and other requirements are met. If the deferral conditions are satisfied the tax will be deferred until the earlier of:

• The ceasing of employment.
• Seven years from the granting of the shares or rights.
• When the forfeiture conditions no longer apply.

Certain salary sacrifice arrangements for shares will also qualify for deferral if the market value of the shares is less than $5,000. These schemes will need to be specifically tailored to meet the new requirements.

To calculate the assessable discount, employers need to determine the market value of the shares.

The valuation of shares and options in a company, especially a start up that has no financial track record, is difficult to say the least.

Apart from unlisted rights where set statutory valuation tables can be used to assess their value, there is presently no defined statutory methodology for determining market value of shares. Instead, unlisted companies may have to embark on a potentially expensive exercise of engaging an external valuer to help determine the value of the shares.

The recent release of the Board of Taxation’s review into the taxation of ESS arrangements agreed with the Government’s methodology to use the ordinary meaning of market value for the valuation of both listed and unlisted shares and options issued under ESS arrangements.

However, the Board also recommended that the Commissioner release public guidance for taxpayers on acceptable valuation methodologies that can be applied when valuing listed and unlisted shares issued under ESS arrangements, so watch this space.

And for SMEs already overloaded with all sorts of compliance burdens, extra reporting to both the tax office and employees with an ESS in place will add an extra level of administration.

Employers need to provide employees with an ESS statement by July 14, and report to the ATO by August 14 each year.

These changes and extra compliance will greatly reduce the ability for start ups to attract management talent.

Marc Peskett is a partner of MPR Group a Melbourne based firm that provides tax advice to innovative businesses, as well as accounting, business advisory and financial services to fast growing small to medium enterprises.