Employee share schemes (ESS) continue to be a popular way for early stage companies to remunerate key employees, contractors and directors. However, the complexity of the legal and taxation framework means these schemes are not for the fainthearted, or (worse) the poorly advised. Happily, there have been two important amendments to these rules recently, which are intended to make these schemes both fairer for employees and simpler for employers to administer.
- with effect from 1 July 2022: cessation of employment is no longer a deferred taxing point. This means an employee is not required to pay income tax on their ESS interests only because he or she ceases employment.
- with effect from 1 October 2022: there will be significant relief from the need for a company to prepare a prospectus (and comply with other financial services laws) for a qualifying ESS. The conditions for relief are significantly less onerous than the existing ASIC class order relief – particularly for unlisted bodies. While there are still disclosure requirements, these are much less onerous than a formal disclosure document (such as a prospectus), particularly for schemes where the participant is not required to pay anything for his or her interests (there are additional conditions and disclosure requirements where the participant is required to pay for those interests).
Background and context
An ESS is an arrangement put in place by a business to reward people who contribute to the business, being directors, employees and service providers, through the issue of shares or other interests in the business in exchange for their labour.
Interests in an ESS are generally subject to tax, with some exceptions. One common exception is the ‘start-up’ tax concession, which is available for newly established companies. Provided certain conditions are met, no income tax is payable by a participant at any time. Some of these conditions are: the participant must not hold more than 10% of the shares in the issuing company; he or she must hold the interests for a minimum period of three years; and any discount to market price must not be more than 15% (as determined under the tax rules).
For other schemes, tax is still payable but this is deferred to the ‘deferred taxing point’. This can be very helpful where the start-up concession is not available for some reason. The deferred taxing point is generally when there is no real risk of forfeiture of the interest (for example, where an option has vested) and there is no genuine restriction on disposal of the right (for example, because the participant is free to sell the share that has been issued to him or her).
First reform | Cessation of employment
Until very recently, cessation of employment triggered the deferred taxing point. So if an employee left the company, then he or she would be required to pay any income tax on any discount in the ESS interest, even though he or she may not have actually acquired an underlying share in the company. This rule has been criticised for some time as being unduly harsh.
However, with effect from 1 July 2022, cessation of employment is no longer a deferred taxing point, so long as the cessation occurs after that date. This means an employee will be able to defer payment of tax until another event occurs which triggers the deferred taxing point. For a common employee share option plan, this will generally be once the options vest and when any disposal restrictions are lifted on the underlying shares.
For example: Mary works for a small FinTech company. She is issued with 100,000 options in return for a reduction in her cash remuneration. Each option gives Mary the right to acquire one share in the company, on payment of $0.10 per share. The ATO considers the market value of the underlying shares to be $1.00 per share.
Under the scheme, the options vest progressively over a five year period, provided Mary meet certain performance criteria each year. For some reason the start up tax concession is not available (if it was, this would mean no income tax would be payable at all). Instead, the scheme meets the rules for deferred taxation.
Unfortunately, part way through her first year, Mary is made redundant and leaves the company. Before 1 July 2022, Mary would have been immediately required to pay income tax on the discount; that is, she would need to pay tax on $90,000. From 1 July, Mary will (most likely) only be required to pay tax once the options vest and once any restrictions on disposal of the shares expire.
Second reform | Securities regulation
Another complex area for ESS is the rules regarding “disclosure” in the Corporations Act. Broadly, any issue of “securities” to a person requires the issuing company to prepare a disclosure document; for example a prospectus or similar. This must be lodged with ASIC. An option or share issued under an ESS is considered to be a “security” for this purpose. This means the company issuing the ESS interest must also prepare and lodge a disclosure document with ASIC.
This rule is very problematic for many reasons. For practical purposes, this means that smaller companies are effectively barred from implementing an ESS unless an exception to the requirement for disclosure could be found. There are various exceptions in the Corporations Act, with some of the more common ones being:
- offers made to a “senior manager” of the company; that is a person who is involved in the overall management of the company. This is on the basis that senior managers can be taken to understand the financial position of the company, and therefore do not need to be provided with a formal disclosure document like a prospectus.
- Offers which are “small scale”. A small scale offer is an issue of securities to no more than twenty persons in any twelve month period, where the total amount raised does not exceed $2 million in total.
- Class order relief. ASIC has published standing relief for certain offers of shares to employees. Unfortunately, this relief is very restrictive – in particular, it is only available where the value of the ESS interests is less than $5000 per participant per year.
In practice, a fast-growing start-up typically finds that it will quickly exhaust the available exceptions for relief – particularly where the small scale offering exception is relied upon. These reforms effectively provide another exception to the disclosure rules from 1 October 2022, if the relief requirements are met.
The base line conditions for relief include: the offer must be for the issue, sale or transfer of a fully paid share; or, a unit or incentive right in a fully paid share, or an option to acquire a fully paid share. Also, the offer must be to a director, employee or service provider of the company. If these conditions are met, then what is required is for the company to provide the participant with an “offer document”, which sets out the following:
- the terms of the offer;
- general information about the risks of acquiring and holding the interests;
- a suggestion that the participant acquire personal advice in relation to the offer; and
- statement that the interest may not have any value, and the value of the interest will depend on future events that may not occur.
This “offer document” is substantially less complex and difficult to prepare, when compared to what would be required under the normal disclosure rules.
For schemes which do not require any payment by the participant, there are no additional requirements to qualify for relief. For schemes which do require the participant to pay for his or her interests, there are some additional requirements:
- the payment must be made by the person who acquires the interest, who can be an employee, director or service provider to the company;
- the participant must not pay more than a monetary cap, which is:
– $30,000 on offers over each twelve month period of the scheme (for example, payment on exercise of an option); plus
– an amount equal to 70% of any ESS distributions, or cash bonuses, received in that twelve month period.
There are some exceptions to the monetary cap for amounts that payable during a liquidity period; for example, a listing on the ASX, or certain offers by unrelated third parties to acquire ESS interests. Also, note that the monetary cap is for the amount paid by the participant, not the actual value of the ESS interests (which is potentially unlimited, although this is subject to the tax rules on discounts mentioned above).
- there is an issue cap for unlisted companies of 20%, unless a different percentage is stated in the company’s constitution (the cap is 5% for listed companies). This means that the company cannot rely upon the relief if it issues more than the cap at any time during the previous three years. Companies seeking to rely upon this relief should consider amending their constitution, if issues may go above 20%.
As well as an offer document (see above), an unlisted company must provide a disclosure document to a paying participant both fourteen days before making an offer and (where the interest is an option or an incentive right) before that interest can be exercised. This is likely to be administratively difficult in practice. The requirements for a disclosure document include:
- the company must provide certain financial information about itself, including a balance sheet and a profit and loss statement prepared in accordance with applicable accounting standards;
- the document must include a valuation of the interests being offered;
- the document must state that the company is solvent.
While these reforms are welcome news for both participants and issuers, taking legal advice is essential in order to correctly structure an ESS in compliance with law. Keypoint Law is currently advising Australian companies in relation to these schemes, including the above issues.
If you are considering implementing an ESS and would like more information then then please get in touch. Also, even if you have already implemented an ESS, it is worth a review of your existing scheme to make sure it is in line with the above requirements.
This alert is not intended to constitute, and should not be treated as, legal advice.
 Existing ASIC relief is contained in ASIC Class Order [CO 14/1000] Employee incentive schemes: Listed bodies and ASIC Class Order [CO 14/1001] Employee incentive schemes: Unlisted bodies.
 Relief is also given for a range of related legal requirements, including: from the need to hold an Australian financial services licence; the provision of general financial advice in relation to the scheme without holding such a licence; the restrictions on advertising and hawking of securities and financial products; and the design and distribution obligations set out in the Corporations Act.
This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please also note that the law may have changed since the date of this article.