nsw 9th annual tax forum - · pdf filesme startups written by: cameron blackwood director...

© Cameron Blackwood, Greenwoods & Herbert Smith Freehills 2016

Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests. 510724231

NSW 9th Annual Tax Forum

New employee

share scheme rules:

SME Startups

Written by:

Cameron Blackwood

Director

Greenwoods & Herbert Smith Freehills

Presented by:

Cameron Blackwood

Director

Greenwoods & Herbert Smith Freehills

NSW Division

2-3 June 2016

Sofitel Wentworth, Sydney

Cameron Blackwood New employee share scheme rules: SME Startup

© Cameron Blackwood, Greenwoods & Herbert Smith Freehills 2016 2

CONTENTS

1 Introduction .................................................................................................................................... 3

2 ESS startup provisions .................................................................................................................. 5

2.1 Background to the amendments ............................................................................................... 5

2.2 Timeline..................................................................................................................................... 6

2.3 Which companies are eligible for the new ESS startup provisions? ........................................ 7

2.4 What other conditions must be satisfied? ............................................................................... 11

2.5 How the new ESS startup provisions apply ESS interests? ................................................... 15

2.5.1 Shares v options .............................................................................................................. 15

2.5.2 How ESS interests are taxed under the ESS startup provisions? ................................... 16

2.5.3 Key commercial considerations ....................................................................................... 18

2.5.4 Determining market value ................................................................................................ 20

2.6 Other considerations ............................................................................................................... 22

3 Other ESS arrangements............................................................................................................. 25

3.1 Premium priced options .......................................................................................................... 25

3.2 Purchased options .................................................................................................................. 27

3.3 Loan plan ................................................................................................................................ 29

3.4 Converting shares ................................................................................................................... 35

3.5 Phantom plan .......................................................................................................................... 38

Cameron Blackwood New employee share scheme rules: SME Startups


1 Introduction

The focus of this paper is on the new employee share scheme (ESS) startup provisions that apply

from 1 July 2015.1 These new provisions, primarily through the use of options, should provide a useful

means for companies to attract, retain and motivate key employees.

As outlined in further detail in the paper, the key features of the ESS startup provisions (from a tax

perspective) are:

no tax paid until the options / shares are sold – regardless of vesting, lifting of disposal

restrictions or cessation of employment;

any gain derived in respect of the options / shares should be subject to the capital gains tax

(CGT) provisions only. Further, provided the option were granted at least 12 months prior to sale

of the options / shares, the CGT discount should be available; and

if certain conditions are met, a concessional valuation safe-harbour has been introduced which

allows a valuation of a company to be based on net tangible assets only, thereby avoiding the

need for an external valuation to be undertaken. Market value remains relevant, as to be eligible

for the new ESS startup provisions, options must have an exercise price at, or in excess of, the

market value of the shares, and shares can only be issued with a discount of 15%.

But challenges still remain.

In particular, when considering implementing an ESS startup plan, it is important to consider:

whether an exit event is likely within 3 years (in which case the concession may be lost); and

ensuring that the Corporations Act disclosure requirements / disclosure exemptions have been

satisfied.

This paper will also consider alternative structures where the ESS start-up regime is either not

available or is not appropriate, including:

premium priced options;

purchased options;

loan plans;

converting shares; and

phantom plans (which will always be the simplest to implement, albeit it does not achieve CGT

treatment and has a cash cost for the company).

1 All legislative references are to the provisions of the Income Tax Assessment Act 1936 and the Income Tax Assessment Act

1997.



For completeness, a number of other amendments were made to the ESS provisions from 1 July

2015 which apply to all companies (not just the next Atlassian) which are beyond the scope of this

paper, as are the ATO’s current review of employment benefit vehicles.



2 ESS startup provisions

2.1 Background to the amendments

The introduction of the new ESS startup provisions was first announced by the Abbott Government on

14 October 2014 as part of its “Industry Innovation and Competitiveness Agenda”.2

The announcement in relation to the ESS provisions was in response to a concern that the manner in

which Australia taxed ESS interests, and options in particular, was acting as a deterrent to startups

incentivising their employees.

In particular:

an “ESS deferred taxing point” would generally arise at vesting, prior to the employee being able

to realise any value and to fund their tax liability3; and

if an ESS deferred taxing point occurred at vesting and the options were not exercised because

they were “under water”;4 then (i) the employee may still be taxed at vesting if the options had a

market value; and (ii) the employee could not obtain a refund of any tax paid if the options

ultimately lapsed.5 Rather, a capital loss would generally arise equal to the market value at

vesting.6

Both of these concerns have been addressed by the 2015 amendments for all companies.

In addition, the startup ESS regime was announced, which would allow ESS interests to be issued by

qualifying startup companies with no tax paid up-front; no tax paid until the options/shares were sold

(i.e., no taxing point when exercised) and the gain to the employee is taxed as a capital gain that is

eligible for the capital gain tax (CGT) discount.

Finally, it was also announced that:

the maximum period of tax deferral would be increased from 7 years to 15 years; and

the safe-harbour valuation tables for unlisted rights would be amended (despite initial concerns

that the ‘update’ would be unfavourable for taxpayers, these concerns did not evaluate).

2 Refer http://www.industry.gov.au/industry/Pages/Industry-Innovation-and-Competitiveness-Agenda.aspx#header. 3 Refer s.83A-120(4) prior to the amendments. 4 That is, the market value of the shares acquired on exercise of the option remained less than the exercise price of the

option. 5 Refer s.83A-310 prior to the amendments. 6 This is because the employee should receive a cost base equal to the market value of the options at vesting, and no

proceeds are received under CGT event C2 on lapsing.

http://www.industry.gov.au/industry/Pages/Industry-Innovation-and-Competitiveness-Agenda.aspx#header



2.2 Timeline

Date Details

14 October 2014 The Industry Innovation and Competitiveness Agenda released.

16 January 2015 Exposure draft legislation released (ESS ED). A number of technical

corrections were made to the final legislation as a result of consultation on

the ESS ED, including:

ensuring appropriate exclusions were made for VCLPs and ESVCLP

from the grouping provisions that apply to the 10 year

incorporation/not listed requirements;

ensuring the 75% widely offered test did not apply to ESS start-up

options;

ensuring that ESS interests that qualified for the ESS start-up regime

and had a real risk of forfeiture were not subject to deferred taxation;

and

allowing the CGT discount to be available where shares were sold

within 12 months of exercise of the options (normally shares must be

held for 12 months from exercise of the options).

However, the 3 year disposal restriction period was retained.

25 March 2015 The Tax and Superannuation Laws Amendment (Employee Share

Scheme) Bill 2015 (ESS Bill) introduced into Parliament.

It is worth noting that the Senate Economics Legislation Committee,

despite recognising 50 submissions on the ESS ED and 7 submissions on

the ESS Bill, made no recommendation for amendment to the ESS Bill,

but did note:

“there are further matters, in respect of employee share ownership,

worthy of consideration. For example, the present system of taxation

on cessation of employment seems to be an anomaly internationally,

and might provide an opportunity for further reform”7 (but that is for

another day…).

23 June 2015 Legislative instrument made by the ATO for the ESS valuation safe-

harbour to come into effect from 1 July 2015.

30 June 2015 ESS Bill receives Royal Assent.

ATO releases standard documents for options issued under the new ESS

startup provisions. These are discussed further below in section 2, but

include standard plan rules, a standard offer letter and an instruction

7 Paragraph 2.16 of the Committee’s report.



Date Details

guide, and are found at: https://www.ato.gov.au/General/Employee-share-

schemes/In-detail/Standard-documents-for-the-start-up-concession/

2.3 Which companies are eligible for the new ESS startup

provisions?

In order for a company to be able to issue ESS interests that are eligible for the new ESS startup

provisions, it must satisfy a number of ‘bright line’ tests in s.83A-33.8

Despite the focus of the new provisions being on startup companies9, the bright line tests do not focus

on what the company is doing, but rather focus on the age and size of the company.

This approach is welcomed, particularly if it is contrasted with the proposed approach in the Tax Laws

Amendment (Tax Incentives for Innovation) Bill 2016 for determining whether a company is an “early

stage innovation company” for the purposes of the new 20% tax offset; which requires the company to

satisfy a bright line “100 point innovation test”, or certify that it is essentially the next Google, Uber or

Facebook.

The requirements that the company (the test company) must satisfy in order to be eligible for the

ESS startup provisions are outlined below:

Requirement Observation

Not listed on a stock exchange

Subsection 83A-33(2) provides that the test

company (and its related bodies corporate –

discussed below) must not be listed on a stock

exchange at the end of the most recent income

year before the ESS interest is acquired.

The EM to the ESS Bill justifies this requirement

as follows: The concession is intended to be

limited to small start-up companies without easy

access to capital and which are difficult to value.

A listing of equity interests on an approved stock

or securities exchange generally allows easier

As discussed below, when evaluating whether

the test company satisfies this requirement, it is

crucial to examine the test company’s

shareholders (and their investments) to

determine whether a related body corporate of

the test company satisfies this requirement.

Given the requirement is that the company not

be listed at the end of the most recent income

year, if the other ESS startup requirements are

satisfied, it would be possible for the test

company (or a related body corporate) to be

listed in the year of grant. For example, for ESS

interests granted in the 2017 income year, this

8 Refer s.83A-33(1)(a). 9 For example, the Explanatory Memorandum (EM) to the ESS Bill states: On 14 October 2014, the Government

released the Industry Innovation and Competitiveness Agenda. As part of this, the Government announced that it will

reform the tax treatment of ESS interests to bolster entrepreneurship in Australia and support innovative start-up

companies. The changes are designed to make Australia's taxation of ESS interests more competitive by

international standards and to facilitate the commercialisation of innovative ideas in Australia. The changes will assist

innovative Australian firms to attract and retain high quality employees in the international labour market.

https://www.ato.gov.au/General/Employee-share-schemes/In-detail/Standard-documents-for-the-start-up-concession/

https://www.ato.gov.au/General/Employee-share-schemes/In-detail/Standard-documents-for-the-start-up-concession/




access to capital and generally allows a value

for a company to be more easily ascertained. A

listing also demonstrates that a company is in a

more advanced period in its development where

concerns around ESS compliance costs and

liquidity are likely to be less prohibitive.

requirement is satisfied if the test company is

not listed as at 30 June 2016.

Incorporated for less than 10 years

Subsection 83A-33(3) requires that the test

company (and its related bodies corporate) was

incorporated by or under an Australian law or

foreign law less than 10 years before the end of

the test company’s most recent income year

before the ESS interest is acquired.

As for the listing requirement, given this test

also looks at related bodies corporate of the test

company, an examination of the test company’s

shareholders (and their investments) is crucial.

Again, given the time at which the 10 year

incorporation requirement is tested, it is possible

for a company to have been incorporated for

more than 10 years at the time the ESS interest

is granted.

Grouping requirements for listing/10 year

incorporation requirement

As outlined above, these two requirements also

apply to the related bodies corporate of the test

company.

The key concepts are that of “holding company”

and “subsidiary”, which are defined in the

Corporations Act 2001:

A holding company in relation to a body

corporate, means a body corporate of which

the first body corporate is a subsidiary.10

A subsidiary is defined to mean a body

corporate (the first body) where another

body corporate:11

• controls the composition of the

board, including by having the

power to appoint a majority of

directors to the board;

• is in a position to cast more than

50% of the votes at a general

meeting; or

To illustrate this requirement, consider the

following example:

Even if test company is not listed/incorporated

for less than 10 years, these requirements will

be failed if either HoldCo or Sister Co are listed

or have been incorporated for more than 10

years (as both are related bodies corporations).

It is worth noting that the primary reason for the

exclusion of VCLPs and ESVCLPs is to ensure

that the policy intent of these entities to

encourage foreign and domestic investment in

early stage Australian entities is maintained.

This is because the Venture Capital Act was

introduced to encourage foreign and domestic

investment in early stage Australian companies

10 Refer s.9 of the Corporations Act 2001. 11 Refer s.46 of the Corporations Act 2001.

>50% >50%

Hold Co

Sister Co Test Co




• holds more than 50% of the

issued share capital of the first

body.

Importantly, eligible investments by a VCLP, an

ESVCLP, and AFOF or an exempt entity that is

a deductible gift recipient is disregarded when

identifying any holding company.

that meet strict criteria, such as industry, size

and location. While a VCLP or an ESVCLP may

take a significant stake in the test company, the

test company is generally not related in any

other way to the other investee entities of those

funds. Thus, to ensure that investment by

VCLPs/ESVCLPs (which are encourage to

invest in startup companies) are eligible for the

ESS startup provisions, it is appropriate that

VCLPs and ESVCLPs are excluded from these

grouping provisions.

Aggregated turnover does not exceed $50m

Subsection 83A-33(4) provides that the test

company not have an aggregated turnover

exceeding $50m in the most recent income year

before the ESS interest is acquired.

Unlike the listing and 10 year incorporation

requirements, the $50m turnover requirement

does not look at the related bodies corporate of

the test company.

Rather, the aggregated turnover is determined

under s.328-115 and s.328-120 – but in

practice, the groups that must be considered will

generally be the same.

Eligible investments by a VCLP, an ESVCLP,

and AFOF or an exempt entity that is a

deductible gift recipient are also disregarded

when determining aggregated turnover.

The aggregated turnover will include the

turnover of the test company, its “connected

entities” and its “affiliates”.

As the concept of affiliates should be limited to

any investments by the test company,12 the key

issue will be determining the test company’s

connected entities.

Section 328-125 provides that an entity is

connected with another entity if:

either entity controls the other entity in a

way described in s.328-125; or

both entities are controlled in a way

described in s.328-125 by the same

third entity

Section 328-125(2) goes on to provide that an

entity controls a company if it owns, or has the

right to acquire either (i) interests that carry the

right to 40% of the distribution of income or

capital; or (ii) equity interests that have 40% or

more of the voting power in the company.

Again, as for the other requirements, given the

time at which the $50m turnover is tested, it is

possible for a company to have an aggregated

turnover of more than $50m at the time the ESS

interest is granted.

12 Refer s.328-130.




Employer must be an Australian resident

Subsection 83A-33(6) requires that the

employer of the employee must be an Australian

resident.

This requirement does not require that the entity

issuing the ESS interests be an Australian

resident; rather that the employer be an

Australian resident. That is, it is enough if a

subsidiary of the test company is both (i) the

employer; and (ii) an Australian resident.

This is for three reasons:

1. the definition of “employee share

scheme” includes ESS interests

provided to employees of subsidiaries

of the company issuing the ESS

interest;13

2. the 10 year incorporation requirement

specifically refers to a company being

incorporated under a foreign law;14 and

3. the ESS Bill EM states: To access the

concession, the employing company

(which may or may not be the company

issuing the ESS interest) must be an

Australian resident taxpayer. If the ESS

interests are not in the employing

company, only the employing company

needs be an Australia resident

taxpayer”.

Presumably, the requirement that the employer

is an Australian resident is to ensure that the

test company has at least some link to Australia.

The key takeaways from the above are:

due diligence must be undertaken on the test company’s shareholders and their investments to

determine whether the listing, 10 year incorporation and $50m aggregated turnover requirements

are satisfied; but

provided each of the requirements are satisfied as at the end of an income year, it is possible to

still be eligible in the next income year where any of those requirements are failed.

13 Refer s.83A-10(2). 14 Refer s.83A-33(3), noting that foreign incorporation is not determinative of Australian resident, but does imply that the

test company need not be Australian resident.



2.4 What other conditions must be satisfied?

Assuming that the startup company is eligible for the new ESS startup provisions, there are a number

of other conditions that must also be satisfied for both shares and options. These are generally not

new, and many of the issues apply generally to ESS plans. In summary:


Employment condition

Section 83A-45(1) requires that when you

acquire the ESS interest, you are employed by

the test company or a subsidiary of the test

company.

This requires that at the time the ESS interest is

acquired, you are employed by the relevant

entity – this can be contrasted to the definition of

“employee share scheme” which can apply to

past or prospective employees.

Thus, if the participant is not actually employed

at the time the ESS interest is granted (for

example, it is part of new sign-on arrangement),

then technically the ESS startup provisions will

not apply.

This is not a new issue, and applies to Division

83A generally. Care will be required where ESS

interests are being granted to a person who will

become an employee to make sure that the

ESS interest is only granted when they become

an employee. This is because under the

indeterminate rights rule in s.83A-340, and as

demonstrated in the Federal Court decision of

Davies v Deputy Commissioner of Taxation

[2015] FCA 773, a contingent contractual right

to an ESS interest is capable of, itself, being an

ESS interest.

Ordinary shares

Subsection 83A-45(2) provides that the ESS

interests must relate to ordinary shares only.

There is no definition of “ordinary share”, but the

following provides some insight into the

requirement:

the explanatory memorandum to the Act

that introduced Division 83A in 2009 states

(83A EM):

Shares that are not ordinary shares, such as

preference shares, may have less 'risk'

associated with them. For example, they

may pay a more stable income stream or

have priority over ordinary shares in the

event of bankruptcy. They are therefore less




likely to align the employee's interest with

that of the company;

ATOID 2010/62 (in the context of an interest

in a limited partnership) states: Whether a

share is an ordinary share in a company for

the purposes of the condition in subsection

83A-35(4) of the ITAA 1997 is to be

determined by considering the rights

attached to the share in relation to

distributions of profits and capital and on

winding up of the company, as compared to

other shares in the company. Shares that

have a priority as to dividends or

distributions in the event of winding up are

preference shares. If shares are not

preference shares, they are ordinary shares.

The ATOID suggests that the focus on whether

a share is an ordinary shares is on whether that

share has priority rights to dividends or

distributions in the event of a winding up. That

is, whether or not the voting rights are available

to be freely exercised by the participant does

not (arguably) seem to matter.

Share trading and investment companies

Subsection 83A-45(3) provides that (i) the test

company cannot be in the predominant

business of acquiring, selling or holding shares,

securities or other investments; and (ii) the

employee cannot be employed by both the test

company and a related body corporate of that

entity.

This provision is unclear in its scope, particularly

when dealing with a holding company with

multiple subsidiaries – but this is not a new

issue to the startup provisions.

It is worth noting that, the 83A EM did state:

1.322 This rule prevents schemes which are

contrived to provide employees with an interest

in unrelated companies, through the

establishment of share trading companies within

the company group.

1.323 A holding company that holds shares in

operating subsidiaries that are not investment

companies will not itself be an investment

company.

1.324 This integrity measure has been

replicated from Division 13A of the ITAA 1936,




where it was introduced to prevent a particular

tax avoidance arrangement

(As an aside, it would have been useful if the

scope of this provision was limited to schemes

with the purposes referred to in para 1.322, as

the carve out referred to therein does not

actually appear in s.83A-45(3).)

3 year minimum holding requirement

Subsections 83A-45(4)-(5) requires that the

employee not be permitted to dispose of the

ESS interest (or share acquired on exercise of

an ESS interest) for a 3 year period starting

from when the ESS interest was acquired.

There are three exceptions to this:

the participant ceases employment15;

all membership interests (not some) in the

company are sold under the same scheme

and the Commissioner of Taxation

exercises a discretion to allow the 3 year

holding requirement to be waived16; or

under a scrip for scrip transaction,

participants receive ESS interests in the

“new company”.17

If this requirement is not satisfied, then the new

ESS startup provisions will not apply, with the

implication being that Division 83A will then

operate to tax the employee either upfront or on

a deferred basis.

Despite submissions in response to the ESS ED

noting that this requirement would operate as a

potential impediment to startups using the new

provisions, the requirement was retained.

The main objections were as follows:

Startup companies will often have, or will

seek, to have investment from professional

venture capital providers. Those investors

will want to ensure that a sale cannot be

frustrated by minority shareholders refusing

to sell. This is particularly important as

bidders may make their offer conditional on

100% acceptance or alternatively, so that

the company can be listed under an IPO.

Accordingly, all holders of shares and

options in such companies will generally be

required to be a party to a shareholders’

agreement where, among other things, all

parties are required to sell their shares or

options to a purchaser if a specified

percentage of investors (usually 75%) wish

to accept the offer. These ‘drag along’

clauses are standard for these types of

investments.

15 Refer s.83A-45(5)(b). 16 Refer s.83A-45(5)(a). 17 Refer s.83A-130(3).




If an investor cannot secure a clear path to

an exit because the employee equity is not

able to be ‘dragged’ to comply with the

restriction in proposed s.83A-45, those

investors may not allow companies to issue

employees with equity which accesses

these concessions.

In a similar fashion, many shareholders

agreements will include a right entitling

minority shareholders to participate in a sale

by majority shareholders at the same time

and at the same price for each share. The

minority shareholder then "tags along" with

the majority shareholder's sale. This

protects the minority shareholder from not

being able to sell when the majority investor

exits, or at the same price as that investor.

In short, unless an exit event within 3 years of

grant is a sale of all membership interests in the

test company, it is not possible to get the

Commissioner to waive this requirement.

10% holding limit

Subsections 83A-45(6) – (7) provide that the

participant cannot hold more than 10% of the

total shares in the test company or be in a

position to cast or control the casting of more

than 10% of the votes at a general meeting of

the company.

The key changes since 1 July 2015 is that the

limited has increased from 5%, you are now

required to take into account any options to

acquire shares (whether vested or unvested).

This limit will generally mean that the founders

of the test company are not eligible to access

the new regime.

Further, in determining the employee’s stake, it

should be the case that all options on foot

should be taken into account. That is, the stake

should be determined on a fully diluted basis.



2.5 How the new ESS startup provisions apply ESS interests?

2.5.1 Shares v options

In the author’s experience, putting tax aside, an option is generally the favoured ESS interest that is

granted to employees of startups - this was the case even prior to the new ESS startup provisions

being introduced. Options being favoured over shares is supported by the fact that the first tranche of

standard ATO documentation relates to options rather than shares.

Before we consider why, it is worth observing what an option is: an option is a right (but not an

obligation) to purchase shares in a company at a specified time in the future - being either when the

employee has satisfied specified performance conditions or been employed for a minimum time

period (the vesting conditions) for a specified price (the exercise price).

The reason options are generally favoured is because:

1. it avoids having to issue shares in the company on Day 1 prior to the vesting conditions being

satisfied;

2. if the vesting conditions are not satisfied, it is easier to take an option off an employee (as the

option is a contractual right that simply lapses) compared to taking a share off an employee;

and

3. if an employee has a share from Day 1, then they will also have the rights attached with being

a shareholder (rights to vote, rights to dividends etc) and the company will need to consider

how it deals with minority shareholders.

From a tax perspective, there are three additional reasons why options are generally favoured over

shares:

1. It is possible to grant an option without the employee having to pay anything for that option on

Day 1. This is because if the ESS startup provisions are available, the option needs to have

an exercise price at least equal to the market value of the shares at the time of grant – the

exercise price gets paid later, but nothing has to be paid for the option at grant.18 In contrast,

a share can only be granted with a discount of no more than 15% on Day 119 – which means

that if the share has a market value of $1.00 at grant, the maximum discount is $0.15 which

means the employee must fund the balance of $0.85 per share (this could be funded by a

bonus or loan from the employer);

2. Unlike shares, options do not need to satisfy the 75% widely offered test.20

3. Deemed market value disposal proceeds can arise for shares under the buy-back provisions.

18 Refer s.83A-33(5)(b). 19 Refer s.83A-33(5)(a). 20 Refer s.83A-33(1)(c).



2.5.2 How ESS interests are taxed under the ESS startup provisions?

A summary of how the ESS interests are taxed under the ESS startup provisions is outlined below:

Tax features Shares Options

No upfront taxing point21 √ √

The ESS deferred taxing

points do not apply 22

√ √

This means that no taxing point on cessation of employment, exercise

of the option or lifting of any sale restrictions on the shares.

Note: a sale of the option/share within 3 years may cause the ESS

startup provisions to cease applying, which would mean either upfront

taxation or deferred taxation would then apply

No CGT event on

exercise of options23

N/A √

CGT cost base Cost base will equal market value at

grant.24 That is, if the shares have a

market value of $1.00 and are

acquired for $0.85, the cost base is

$1.00.

Cost base of the shares

acquired on exercise of the

options will equal the exercise

price.25

CGT event Generally when shares sold Generally when shares/options

sold

CGT discount Available if shares sold more than 12

months from date of grant.

Provided that the option or

share is sold more than 12

months from when the option

was granted, the participant

should be eligible for the CGT

discount.

This is a change from the

general position that shares

acquired on exercise of an

option must be held for at least

12 months from when the

option is exercised.26

21 Refer s.83A-33. 22 Refer s.83A-105(1)(b). 23 Refer s.134-1(4). 24 Refer s.83A-30 and example 1.1 of the EM. 25 Refer s.83A-30(2) and Item 1 of the table to s.134-1(1); and example 1.2 of the EM. 26 Refer Item 9A of the table to s.115-30(1).



Bringing this all together, and using (and modifying) examples for the EM:

Shares (EM example 1.1)

Tracy is issued with 10,000 shares in a small Australian start-up entity under an ESS.

The shares at issue have a market value of $1 per share.

Tracy contributes 85¢ per share under the scheme.

Tracy and the ESS meet all the rules for her 10,000 shares to be covered by the small start-up

ESS tax concession.

After 5 years, the Australian start-up entity is sold under a trade sale where Tracy receives $1.50

per share for each of shares.

On acquisition, Tracy receives a discount of $1,500 which is not included in her assessable

income (i.e., not subject to income tax).

Her shares will then have a cost base for capital gains tax purposes of $10,000.

When Tracy sells her shares she has a discount capital gain of $2,500 this is included in her net

capital gain or loss for the income year. If she has no other capital gains or losses for that year,

and no capital losses carried forward from a previous year, the $2,500 is then included in her

assessable income.

So in summary:

No tax paid upfront

No tax paid on vesting

Tax paid when shares sold, $0.15 “discount” is tax-free

Eligible for the CGT discount

Options (Modified EM example 1.2)

Tim is issued with 10,000 at the money' options under an ESS operated by his small Australian

start-up employer for no consideration.

The options allow Tim to acquire 10,000 ordinary shares in his employer after paying an exercise

price of $1.00 per right (which is equal to the current market value of each share - $1 per share).

Tim and the ESS meet all the rules for his 10,000 rights to be covered by the small start-up ESS

tax concession.

After 5 years, Tim exercises each right by paying $15,000.

Tim then immediately sells each share for $2.00 with his total proceeds being $20,000.

On acquisition, Tim does not include any amount in his assessable income in relation to the

discount received on his options. His options will have a nil cost base for capital gains tax

purposes.

There will be no capital gains tax on exercise of his rights and receipt of his shares (due to the

availability of a capital gains tax rollover). However, on exercise, the cost base of his shares will

be $1.50 per share.

On sale of his shares Tim will have a discount capital gain of $2,500 that is included in his net

capital gain or loss for the income year. If he has no other capital gains or losses for that year,

and no capital losses carried forward from a previous year, the $2,500 is then included in his

assessable income.



So in summary:

No tax paid upfront

No tax paid on vesting or exercise

Tax paid when shares sold, any “discount” is tax-free

Eligible for the CGT discount as long as shares sold >12 months from when options acquired

(clock not restarted on exercise)

2.5.3 Key commercial considerations

As noted above, the ATO has released standard documentation for option plans.

The key commercial considerations when designing and implementing an ESS plan are outlined

below:

Consideration Detail

Vesting conditions (i.e., conditions that

must be satisfied before the employee

can exercise their options)

The standard documentation has a default position that

25% of the options will vest 12 months after issue, and

the remaining 75% will vest on a quarterly basis over 3

years.

This is the standard vesting for Silicon Valley companies.

Some companies use an annual vesting of 10%, 20%,

30% and 40%.

There are no set requirements on how the time based

conditions operate (as noted above, the only tax

requirement is that the employee is not generally

permitted to sell their ESS interest within 3 years of grant,

which is different to the vesting requirement).

An employer may also wish to include performance

based conditions, whereby the options vest if specified

targets are met.

Exercise price (Options only) The option must have an exercise price at least equal to

the market value of the shares at the time the options are

granted.

As discussed below, the market value safe harbour may

assist in the test company determining the market value

of the shares.

Cessation of employment The standard rules do not distinguish between good

leavers and bad leavers – whether the plan should is

ultimately a commercial decision.

The default position is that if an employee has unvested

options when employment ceases, the company may




determine whether those options will lapse or stay on

foot.

For vested options, the company can require the options

to be transferred for market value.

The standard documentation also includes a discretion

for the board to accelerate vesting. This will usually be

exercised where:

the company is acquired; and

the employee is not continuing employment.

Corporate law disclosure requirements Unfortunately, when the Government was introducing the

ESS startup provisions, it appears that corporate law

disclosure/ASIC class order requirements were not

appropriately considered.

Under the Corporations Act 2001, unless an exemption

or ASIC relief applies, the issue of shares (or the grant of

options or performance rights over unissued shares) by a

company to its employees would require the company to

issue a prospectus (or some other formal disclosure

document). In addition, in some instances, the employer

company can be required to hold an Australian financial

services licence to offer and issue the equity securities.

Given the administrative cost and burden of preparing a

formal disclosure document, unlisted companies wanting

to implement an employee scheme are often forced to

structure it in such a way so it can only be offered to

participants who fall within the statutory exemptions in

s.708 of the Corporation Act 2001 (e.g. small scale

offerings, sophisticated investors or senior managers).

The consequence of relying on the statutory exemptions

can be that not all of the employees that an employer

would like to include in the employee scheme are able to

participate.

ASIC has recognised that the statutory requirements

applicable to employee schemes are, in some cases,

disproportionately burdensome for an employer company

and that compliance with such requirements can deter

employers from establishing an employee scheme. The

recognition of this issue by ASIC is manifested by the

relief it has granted to unlisted companies though CO

14/1001 (though such relief is more limited than the relief

provided to listed companies).

However, CO 14/001 is only available where the value of

the offer of options does not exceed $5,000 per




employee in any 12 month period. Valuation of the offer

is calculated by reference to a directors’ valuation

resolution, which must be disclosed in the offer document

along with the methodology used to determine the value.

This $5,000 limit is a real limitation on the ability of

companies to utilise the Class Order relief.

Appendix 1 contains a road-map of the Corporations Act

disclosure obligations and exemptions that is include in

the ATO standard documentation.

2.5.4 Determining market value

As outlined above, a critical element in determining eligibility for the ESS startup provisions is

ascertaining the market value of the test company.

This is because:

if options are issued: the options must have an exercise price at least equal to the market value

of the shares on the day of grant; and

if shares are issued: the shares must have a maximum discount of 15% to the market value on

the date of grant.

Historically, for unlisted companies, this has required an external valuation of the company:

Division 13A (which applied until 1 July 2009) required that the market value of shares in an

unlisted company be specified in a written report by a qualified person;27 and

the consequences of getting the valuation wrong would result in the employee being taxed at their

marginal tax rate on a deferred basis under the ESS provision, as the shares would be taken to

have been acquired at a discount to market value.

This would often be the most expensive piece of advice required to implement an ESS plan, and

would be required each time that a new grant of ESS interests was made.

In recognition of this, two new market valuation safe harbours has been introduced.28

Method Detail

Method 1: net tangible assets This method can be used by a company that satisfies the

following requirements:

has not raised capital of more than $10 million during the

period of 12 months immediately before the valuation time;

at the valuation time, either:

27 Refer s.139FB. 28 Refer http://law.ato.gov.au/atolaw/view.htm?DocID=ITD/ESS20151/00001

http://law.ato.gov.au/atolaw/view.htm?DocID=ITD/ESS20151/00001



Method Detail

o has been incorporated for not more than 7 years; or

o is a small business entity within the meaning of

s.328-110; and

prepares, or will prepare, a financial report (within the

meaning of the Corporations Act 2001), for the year in which

the valuation time occurs, that complies with the accounting

standards under the Corporations Act 2001.

The net tangible asset method is as follows:

1. Work out the amount of net tangible assets of the

company (disregarding any preference shares on issue)

at that time.

2. Work out the amount of the return that would be required

to be provided under the terms of any preference shares

on issue at the valuation time if those shares were to be

redeemed, cancelled, bought back or otherwise satisfied

at that time (disregarding any contingencies as to the

provision of that return and any return that would not rank

before ordinary shareholders upon a winding up). This is

known as ‘liquidation preference’.

3. Reduce the Step 1 amount by the Step 2 amount.

4. Divide the Step 3 amount by the total number of:

(i) ordinary shares; and

(ii) any preference shares that may participate

together with any ordinary shares in the residual

assets of the company upon a winding up;

on issue in the company at that time.

Under this method, the market value of the company (for ESS

startup purposes) may be significantly less than the actual market

value, as only tangible assets are taken into account, which will

often by the cash at bank and any PP&E.

If the entity qualifies as a startup, but does not meet the Method 1

requirements, method 2 can be used.

Method 2: market valuation This requires a written valuation performed by either the CFO or

a person having the requisite knowledge, experience and training

to perform such a valuation.

The report must be endorsed by the directors, and taken into

account on a reasonable basis:

the value of tangible and intangible assets of the company;

the present value of anticipated future cash flows;

the market value of similar businesses, including the use of

earnings multiples;

uplifts and discounts for control premiums, lack of

marketability and key person risk.



Method Detail

So realistically, an external valuation is often required. As

discussed in section 3, disposal restrictions on the shares should

be disregarded in valuing the shares.

Further, unlike Method 1, intangible assets are included.

2.6 Other considerations

Other considerations that should be considered are outlined below:

Issue Detail

Value shifting An area of technical uncertainty for ESS plans implemented by unlisted

companies has long been the application of the value shifting provisions in

Division 725.

This is because:

the ESS provisions (including the ESS startup provisions) require that the

ESS interest be acquired by the employee at a discount, which can

include having ESS interests issued by the company;29 and

the value shifting provisions in Division 725 can apply where, amongst

other things, shares or options in the company are issued at a discount.30

The value shifting provisions can result in a deemed capital gain arising if

there is a shift in value from existing equity interests, such as from

issuing new shares at a discount. Division 725 generally only applies to a

company where there is a controller and less than 300 shareholders –

this means that a startup company with a controller is likely to be subject

to Division 725.

There are a couple of possible outs from the value shifting provisions:

The value shifting provisions will not apply unless the decrease in market

value of existing equity interests exceeds $150,000.

At least for shares issued under an ESS startup plan, s.83A-30 (which

deems the share to have been acquired for its market value for the

purposes of the Act) should ensure that the value shifting provisions do

not apply. But s.83A-30(2) provides that s.83A-30 does not apply to

options issued under an ESS startup plan.

Given the purpose of an ESS plan is to incentive key staff without an

outlay of cash, it could be argued that there is in fact no decrease in the

market value of existing equity interests.

In any event, given the policy intention of the ESS startup provisions to

encourage startup companies to issue equity at a discount, it is disappointing

29 Refer s.83A-20. 30 Refer s.725-50 and s.725-145.



Issue Detail

that a specific provision to switch off the value shifting provisions where

equity interests that are subject to Division 83A are issued.

Fringe benefits tax

(FBT)

No FBT should arise.31 This is because Subdivision 83A-B still applies to an

ESS interest issued under an ESS startup plan, with s.83A-33 then excluding

the discount from assessable income.

Deductions

For an ESS plan, a deduction will typically only arise for a company where

the shares are bought on-market (which will not be relevant for an unlisted

company) or a contributions is made to an ESS trust.32

It would appear that, technically, a deduction should arise if a contribution is

made to an ESS trust:

it should not matter that the discount is exempt in the hands of the

employee;

the specific rule in s.83A-205 dealing with $1,000 exempt plans is to

allow a deduction for the issue of shares rather than overcoming any

issue with deductibility for an exempt plan generally; and

for similar reasons as discussed above for FBT, the ESS trust should still

be capable of satisfying the sole activities test in s.130-85(4).

However, the commercial rationale for establishing an ESS trust would be

critical when considering the general anti-avoidance provisions in Part IVA.

ESS reporting

requirements

ESS interests subject to the ESS startup provisions are still subject to the

ESS reporting provisions, to both the employee and the ATO.

The likely format is included as Appendix 2.

Relevantly, it is understood that the ATO will not require companies to

determine the market value of options issued on Day 1, but to simply note the

market value of the ordinary shares on the date of issue of the options and

the exercise price.

Most companies that meet the concessional criteria will have issued options

with an exercise price based on the market value determined under the

Commissioner’s safe harbour valuation methodologies. It is therefore

welcome news that companies will not need to also disclose “the market

value of the ESS interests acquired” (i.e. the market value of the options).

The one caveat would be where TFN withholding tax (ESS) applies because

an employee has not provided their TFN to the employer – in which case the

31 Refer paragraph (h) of the definition of “fringe benefit” in the Fringe Benefits Tax Assessment Act 1986. 32 A full discussion of trusts that are considered in TR 2014/D1 is beyond the scope of this paper. A deduction will not

arise if shares are simply issued, as there is not outgoing by the company (TR 2008/5).



Issue Detail

withholding tax is assessed on the discount to the employee (i.e., the market

value of the option at grant).33

Associates If the ESS interest is acquired by an associate of the employee, the ESS

startup provisions should still apply.34

Note that care should be taken if SMSF of the employee acquires the ESS

interest. These issues are beyond the scope of this paper, but the following

ATO publication provides a useful overview:

https://www.ato.gov.au/Super/Self-managed-super-funds/In-detail/SMSF-

resources/SMSF-technical/Employee-share-scheme-options-and-acquisition-

of-shares-by-self-managed-super-funds/

Forfeiture/lapsing

ESS interests

The forfeiture/lapsing of ESS interests should be manageable from a tax

perspective on the basis that s.130-80(4), which ensure that the market value

substitution rule does not apply, should be available on the basis that

Subdivision 83A-B applies to the interests.

However, care should be taken if a share is forfeited by way of a share buy-

back, and in particular whether a deemed dividend arises for the participant

under Division 16K.

33 As for a $1,000 exempt plan, the ESS startup provisions are disregarded when determining whether TFN withholding

tax (ESS) applies – refer s.14-155(2) of Schedule 1 to the Taxation Administration Act 1953. 34 Refer s.83A-305.

https://www.ato.gov.au/Super/Self-managed-super-funds/In-detail/SMSF-resources/SMSF-technical/Employee-share-scheme-options-and-acquisition-of-shares-by-self-managed-super-funds/





3 Other ESS arrangements

This section contains an overview of alternative arrangements that may be considered if the ESS

startup provisions are not available or appropriate to apply to a startup company.

This could be the case if the test company does not satisfy the 10 year incorporation or $50m

turnover test, or the employee will breach the 10% ownership threshold.

Other than the phantom plan, a common feature of these plans is that the employee is generally

subject to the CGT provisions, and may be eligible for the CGT discount. Hence determining market

value is key – because if the options/shares are acquired at a discount to market value, then the ESS

provisions will apply.

Given the importance of determining market value for these arrangements (other than phantom

plans), it is worth making the following point: where the market value of the shares or options is

determined under ordinary principles (as the startup market valuation safe-harbours will not be

relevant), s.960-140 provides:

In working out the market value of a *non-cash benefit, disregard anything that would prevent

or restrict conversion of the benefit to money.

A number of private rulings indicate that the ATO have interpreted this provision such that vesting

conditions and performance hurdles are not taken into account in determining market value (see for

example edited PBR 1011690719326).

In the author’s view, this interpretation is technically wrong – vesting conditions and performance

hurdles go to the amount of money that a taxpayer could convert an ESS interest into. Yet s.960-410

only requires anything that could would prevent or restrict conversion of a benefit to money to be

disregarded – that is, conditions which go to the amount of money that could be realised is not a

relevant factor.

Further, from a policy perspective, it is inappropriate for employees to be taxed on an amount which

bears no resemblance to the market value of the benefit actually received. Clearly performance

hurdles, for example, are fundamental to determining market value of an ESS interest and should be

taken into account.

3.1 Premium priced options

A premium priced option is an option with an exercise priced that is sufficiently out of the money that it

has no market value for the purposes of the ESS provisions, and is therefore generally subject to the

CGT provisions.



Whether or not such an arrangement is commercially attractive for employees will have to be

determined on a case by case basis.

Key features Observations

Determining the

market value

The amount by which the exercise price must be greater than the market

value of the shares is determined using the valuation tables in the Income

Tax Assessment Regulations 1997.

Where the exercise price is more than double the market value of the

shares at the date of grant and the exercise period does not exceed 15

years, the market value of the option for tax purposes will always be nil.35

Otherwise, assuming the market value of the shares is $1.00, the following

exercise period/exercise price is required:

Exercise period (months) ~Min exercise price

0-3 $1.06

3-6 $1.11

6-9 $1.18

9-12 $1.25

18-24 $1.34

24-48 $1.43

48-72 $1.67

72-180 $2.01

As the ESS startup provisions do not apply, the net tangible

asset safe- harbour is not available. Thus, the company will

need to obtain an appropriate valuation of the company to

determine the market value of the shares, which can be

expensive.

Options not subject to

the ESS provisions

As the premium-priced options is not issued at a discount, it is not subject

to the ESS provisions (which means that upfront/deferred taxation is not

relevant).

35 Refer regulations 83A-315.01(1) and 83A-315.07.




Options subject to the

CGT provisions

The premium-priced options are generally considered subject to the CGT

provisions (and are not taxed as ordinary income).

This means that the exercise of the option is not a CGT event; but rather a

CGT event will generally only arise when either the option is cancelled or

the shares acquired on exercise of the options are sold.

Importantly, unlike options subject to the ESS startup provisions, the

12 month period for the CGT discount is restarted when the options are

exercised, which means that the shares must be held from the date of

exercise in order for the CGT discount to be available.

FBT Prior to the 2015 amendments, there was technical uncertainty as to

whether options which did not have a value for the purposes of Division

83A would still have a value, and therefore give rise to an FBT liability for

the company.36

This issue was rectified in the ESS Bill for the 2011-12 income year and

later income years.37Thus, no FBT should arise.

Option lapses If the option lapses for no consideration in accordance with its terms, then

the correct outcome should be that no capital gain arises on the basis that

the option, at that time, has no market value.38

3.2 Purchased options

Alternatively, the options can be purchased by the employee on Day 1 for their market value – again,

this should mean that the options are not acquired at a “discount” such that the options are not taxed

under the ESS provisions in Division 83A.

Consideration will be required as to how the employee will fund the acquisition of the options – the

two obvious ways being (i) from a bonus payment; or (ii) a loan from the employer; each of which will

have a cost to the employer in the form of PAYG withholding and FBT (on the basis that the otherwise

deductible rule won’t be satisfied) respectively.

36 This was because the option had a nil value for Division 83A purposes, the exclusion from FBT for Division 83A ESS

interests did not apply. But because the nil value did not, technically, apply for FBT purposes, the option may still

have a value for FBT purposes. 37 This is achieved by having such interests technically subject to Division 83A, but continuing to not be assessed under

Division 83A – which in turn ensures that the FBT exemption for Division 83A interests applies. 38 Consideration will need to be given to s.116-30(3A), but one would think that a lapsing of an option in accordance

with its terms should be an event that is properly taken into account in considering market value.




Determining market

value

By way of example, under the valuation tables in the Income Tax

Assessment Regulations 1997, if the market value of a share was $1.00

and the exercise price was also $1.00, the minimum option purchase price

would be as follows:

Exercise period ~Minimum purchase price per

option

1 year $0.029

2 years $0.044

3 years $0.051

4 years $0.062

5 years $0.07

6 years $0.077

7 years $0.082

Note: as the ESS startup provisions do not apply, the net tangible asset

safe- harbour is not available. Thus, the company will need to obtain an

appropriate valuation of the company’s shares.

Options not subject to

the ESS provisions

As the purchased options are not issued at a discount, no amount is

included in the employee’s assessable income (either upfront or on a

deferred basis).

Options subject to the

CGT provisions

As above for premium priced options (save that the CGT cost base will

include the purchase price of the options).

FBT As above for premium priced options, the 2015 amendments should

ensure that no FBT arises for the employer.

This is because if the actual market value of the options exceeded the

purchase price, the options would be acquired at a discount so

Subdivision 83A technically applies – this then allow the FBT exemption to

apply. However, it would still be the case that no amount is included in the

employee’s assessable income under Subdivision 83A using the market

value determined under the regulations.



3.3 Loan plan

Under a loan plan, the employee is provided with a limited recourse loan to acquire shares at market

value; and is required to repay that loan on vesting; or alternatively surrender the shares in

satisfaction of the loan. Again, as the shares are acquired for market value, the CGT provisions

should generally apply.

The steps to establish a loan plan are typically:

Step Detail

1 A limited recourse loan is provided to participating employees prior to the participating

employee becoming a shareholder.

2 The employee would subscribe for shares at market value using the loan.

Dividends paid on the shares can be applied against the outstanding loan balance (net

of the tax liability on the dividends).

3 On the date of the relevant “Liquidity Event” or cessation of employment, the

participating employee can either forfeit the shares in full repayment of the loan or

repay the loan and retain the shares as follows:

a Liquidity Event (such as an IPO or takeover)

cessation of employment as a “Good Leaver” – disposal for market value

consideration; or

cessation of employment as a “Bad Leaver” – disposal at lesser of outstanding

balance of the loan and cost.

The key tax issues include:


Determining the

market value

The key issue is to determine the market value of the shares – this is

because if the shares are acquired at a discount, then the ESS provisions

will apply, and either upfront or deferred taxation will arise with no CGT

discount.

Rather, the expectation is that any gain made on disposal of the shares

would be eligible for the CGT discount provided the shares have been

held for more than 12 months. In contrast to non startup options, which will

require participating employees to have held the shares for 12 months

from the date of exercise of the options, the participating employee will

have to hold the shares for 12 months from the date of acquisition of the

shares only.




Thus, it will be necessary for the company to have a defendable market

valuation to support the plan.

Making the loan

(Division 7A)

Division 7A provides that in certain circumstances, loans by private

companies to their shareholders can be treated as a dividend for income

tax purposes.

Generally, a company will be treated as private company if:

the shares are not listed for quotation on the Australian stock

exchange; and

more than 50% of the shares in the company are not owned by a

listed company.

Division 7A will apply if:

the loan is not fully repaid before the lodgement day of the company’s

tax return for that income year - i.e., if the loan is made during the

2016 income year, it must be repaid prior to the due date for

lodgement for the 2016 income year;

the employee is a shareholder or is an associate of a shareholder or a

reasonable person would conclude that the loan is being made

because the entity has been such a shareholder or associate at some

time; and

the loan does not meet certain requirements (which will be the case

as the loan is interest-free).39

Importantly, a loan is taken to have been made to an entity when any of

the following occur:

an advance of money;

a provision of credit or any other form of financial accommodation;

a payment of an amount for, on account of, on behalf of or at the

request of, an entity, if there is an express or implied obligation to

repay the amount; and

a transaction which in substance effects a loan of money.

Effectively, this means that care is required to ensure that the loan

(including the payment of money or the advance of credit under the loan)

to the employee is made prior to the employee becoming a shareholder in

the company, otherwise the loan may be a deemed dividend under

Division 7A.

39 Refer s.109D(1)




The amount of any deemed Division 7A dividend would be up to the

amount of the unpaid loan, and is generally not frankable.

As a result of Division 7A, it generally means that a loan plan can only be

used once for each employee prior to them becoming a shareholder.

Where another member of the corporate group makes the loan instead,

careful consideration of the interposed entity rules in Subdivision E of

Division 7A is required.

Interest-free loan

(FBT)

Where an employer provides an interest free loan to an employee, FBT

may be payable by the employer.

However, if an employee utilises the loan for income producing purposes

and would have obtained an income tax deduction had they incurred the

interest, the FBT taxable value on the loan benefit should be reduced to nil

(referred to as the otherwise deductible rule) (s.19 of the FBTAA ).

This in turn will require consideration of whether dividends are likely to be

paid on the shares.

Generally, an employee is required to provide a declaration to the

employer but no declaration is required to be provided by the employee

where the loan is an “employee share loan benefit” (s.19(c)(ii) of the

FBTAA), which is defined in s.136(1) of the FBTAA as follows:

“employee share loan benefit", in relation to a year of tax, means a

loan fringe benefit in relation to an employee in relation to an

employer in relation to the year of tax where:

(a) the sole purpose of the making of the loan is to enable the

employee to acquire shares, or rights to acquire shares, in a

company, being:

(i) the employer; or

(ii) an associate of the employer; and

(b) the shares or rights were beneficially owned by the employee

at all times during the period during the year of tax when the

employee was under an obligation to repay the whole or any part

of the loan.”

There is no requirement in the definition that the shares be acquired under

an employee share scheme (cf paragraph (ha) of the definition of fringe

benefit in s.136(1) of the FBTAA). Accordingly, employees should not be

required to provide a declaration.




Critically, as the otherwise deductible rule does not apply to associates of

an employee, shares should only be provided directly to employees, and

not to associates (such as family trusts) of employees.

Franking credits It is generally expected that the employee will be entitled to the franking

credits, but regard should be had to the “45 day rule”, which is beyond the

scope of this paper (but it is worth noting that a “position” in relation to

shares can include a non-recourse loan made to acquire the shares).

Debt forgiveness Division 7A

A deemed dividend may also arise under Division 7A where a private

company forgives a loan given to an entity where either:

(1) the amount is forgiven when the entity is a shareholder; or

(2) a reasonable person would conclude (having regard to all the

circumstances) that the amount is forgiven because the entity has

been such a shareholder or associate at some time (s.109F(1)).

In relation to (1), if amount of the loan is forgiven after the shares are

transferred from the employee, the forgiveness would not occur whilst the

employee is a shareholder.

In relation to (2), the Commissioner ruled in Taxation Determination TD

2008/14:

“1. In this context 'because' means by reason that. The reason

must be a real and substantial reason for the payment, loan or

debt forgiveness concerned,1 even if it is not the only reason or

not the main reason for the transaction.

2. The test for determining whether the event falls within the

relevant provisions of Division 7A is a reasonable person's

conclusion which is an objective test requiring a weighing up of all

the circumstances to determine whether the reason is real and

substantial.

…

21. Paragraph 109C(1)(a) applies if a taxpayer is a shareholder,

or an associate of a shareholder, when a payment is made. No

causal relationship between the payment and the entity's status as

a shareholder or associate is required.




22. Paragraph 109C(1)(b) does require a causal relationship. The

word 'because' is not defined in the Income Tax Assessment Act

1936 . It is defined in The Australian Oxford Dictionary, 1999,

Oxford University Press, Melbourne as 'for the reason that; since'.

This directs attention to the question of whether the fact that the

entity was in the past a shareholder or associate is a reason for

the payment being made.

23. However, the Commissioner considers that to be a cause of

the payment, a reason must be real and substantial and not

merely remote or insignificant. Whether a reason is real and

substantial is a question of fact and degree determined on

balance, according to the facts and circumstances.”

One argument to deal with (2) will be that any forgiveness of the loan

should not be characterised as occurring by virtue of the employee having

been a shareholder, on the basis that:

the forgiveness occurs pursuant to the terms of the loan rather

than the terms of shares;

whilst the loan is provided to enable an employee to become a

shareholder, this of itself should not be sufficient to characterise

the forgiveness of the loan to have occurred by virtue of the

employee having been a shareholder.

Support for this conclusion is found in ATO ID 2003/316. Whilst that ATO

ID is in the context of FBT, its reasoning that any benefit arising from the

forgiveness of a limited recourse debt arose in respect of rights obtained

from the loan agreement rather than from the employment relationship is

equally applicable here. That is, the forgiveness of the loan occurs

pursuant to rights acquired in respect of the loan (and not shares) rather

than from the shareholder relationship.

FBT

As noted above, the ATO in ATO Interpretative Decision ATO ID 2003/316

has indicated that no fringe benefit should arise upon the discharge of a

limited recourse loan where the shares were transferred to a company in

satisfaction of the loan and in accordance with the loan, such that no FBT

was payable. This was on the basis that the benefit did not arise with

respect to the employment relationship, but rather arose due to the limited

recourse features of the loan

Regard should also be had to ATO ID 2003/317, which provides that a

“debt waiver benefit” should not arise where an employee discharges the

loan through the transfer of their shares to the lender where the shares




have a lesser value than the loan balance. The rationale for this is on the

basis that a “waiver” does not arise where, under the terms of a loan

agreement, a lender accepts a transfer of shares in full satisfaction of the

loan balance.

Commercial debt forgiveness provisions

There are specific rules which apply to a borrower which has benefited

from a debt forgiveness. A debt is taken to be forgiven if the debt, or part

of a debt, ceases to be payable because the obligation to pay the debt or

part of it is ‘released or waived, or is otherwise extinguished’. Where a

debt is forgiven, it is applied to reduce certain losses and cost bases of a

taxpayer.

If the loan is drafted appropriately as being limited recourse (including in

the event of default), the debt forgiveness rules should be of no practical

application. This is because no net forgiven amount should arise, as the

notional value of the loan (being the lesser of the outstanding amount and

the market value of the shares – s.245-60(2)) should generally be at least

equal to the proceeds paid by the employees for the loan.

The employee

The ATO has expressed the view in a number of product rulings, and

more recently in ATO ID 2013/64, that a borrower’s cost base in an asset

will be reduced under s.110-45(3) where the asset has (i) been acquired

through limited recourse financing and (ii) that loan is not repaid in full due

to those features.

Thus, if the shares were acquired for $100 and $50 is “forgiven”, the cost

base is reduced from $100 to $50 – whilst this may give rise to the correct

economic outcome so as to ensure the employee does not realise a

capital loss in the absence of an economic loss, the position would seem

far from clear technically.

Bad leaver If the plan has “bad leaver” provisions whereby shares may be bought

back from an employee at less than market value, consideration may be

required as to how this can be achieved without the employee being taxed

as if they had received market value consideration.

For example, a buy-back by the company (putting to one side whether any

part of the disposal proceeds would be a dividend) will give rise to deemed

market value disposal proceeds.40 However, a transfer to a share trust or

another nominated shareholder pursuant to an option agreement should

40 Refer s.159GZZZQ(2).




generally not give rise to deemed market value consideration, on the basis

the employee entered into the arrangement on an arm’s length basis.

3.4 Converting shares

Converting share plans (also known as flowering shares) generally operate as follows:

Step Detail

1 Converting shares issued to participating employees for market value. The terms of the

convertible preference shares will set out the terms of the conversion (i.e., convert into

a certain shares on the occurrence of certain events).

Prior to conversion, the converting shares have no dividend or voting rights, or rights to

participate in the surplus assets of the company.

Depending on the market value of the converting shares, a loan may be provided to

fund the acquisition.

2 The converting shares convert into shares before a Liquidity Event occurs if the

performance/time conditions are satisfied.

If the performance/time conditions are not satisfied, the converting share are

redeemed/cancelled for nominal value.

One reason a converting share plan may be favoured over a loan plan is to allow the number of

shares to be acquired by the employee linked to performance hurdles. That is, the number of shares

ultimately received by the employee is not set on Day 1.

The key tax issues include:


Determining the

market value

As for a loan plan, the key issue is to determine the market value of the

shares, as any discount to market value will result in either upfront or

deferred taxation with no CGT discount.

Thus, it will be necessary for the company to have a defendable market

valuation to support the plan. In this regard, the performance/time

conditions will be critical in undertaking the valuation of the converting

share, which has no dividend/voting/capital rights at the time of issue.




CGT consequences As for a loan plan, the expectation is that the converting share is subject to

the CGT provisions only.

Is the conversion a CGT event?

CGT event C2 happens if the ownership of an intangible asset ends by the asset (relevantly):

being redeemed or cancelled;

expiring;

being abandoned, surrendered or forfeited; or

if the asset is a “convertible interest” – being “converted”41.

Normally, the conversion mechanism occurs by the converting share being

split, and the rights of the converting share being varied so that the rights

attaching to the converting share will, at the time of conversion, be

equivalent to the rights attaching to the ordinary shares. The conversion

does not take place by way of a cancellation, buy-back or redemption.

In respect of the share split, this should not of itself cause a CGT event to

arise42. Further, the Commissioner of Taxation has ruled that where a

bundle of rights attaching to a share are varied (including where a share is

converted from one class to another), then provided there is no

redemption or cancellation of the share, there is no disposal of the share

for CGT purposes43.

However, as the converting share should constitute a “convertible interest”

for tax purposes44, it is necessary to consider whether CGT event C2

arises by virtue of a conversion occurring.

The conversion of the converting share should not give rise to

CGT event C2 simply because the converting share is a convertible

interest for tax purposes: In this regard, a threshold requirement for CGT

event C2 to occur is that your ownership of the intangible asset “ends”,

with the foregoing paragraphs in s.104-25(1) then outlining the manner in

which the ownership of the CGT asset comes to an end. In other words,

the ownership of the converting share must end because the converting

share is converted – it is not enough for CGT event C2 to occur because a

conversion has occurred. Under the typical conversion mechanism for the

converting share, the ownership of the converting share does not come to

an end, because consistent with TR 94/30, the variation of rights attaching

to the converting share does not constitute a disposal for CGT purposes

41 Refer s.104-25(1) of the ITAA 1997. 42 Refer s.112-25 of the ITAA 1997. 43 Refer Taxation Ruling TR 94/30 paragraph 8. 44 Refer s.974.75 Item 4 and Taxation Determination TD 2007/26 which provides that a share in a company is capable of

constituting a convertible interest. In addition, TR 94/30 does not explicitly consider the convertible interest provisions.




and s.112-25 specifically provides that a share split does not constitute a

CGT event.

Date of acquisition for CGT purposes

For CGT purposes, the employee will be taken to have acquired the

converting share on the date of issue. Further, the additional converting

shares held from the share split arising on the conversion should be taken

to have been acquired when the original converting share was issued45.

As discussed above, the converting share should constitute “convertible

interests” for tax purposes. In this regard, s.130-60(2) provides that you

are taken to have “acquired” shares when the “conversion” of the

convertible interest happens. However, in CR 2005/32, the ATO ruled that

where the conversion does not result in CGT event C2 occurring,

Subdivision 130-C (which contains s.130-60(2)) is of no application:

“54. Because CGT event C2 does not happen on the conversion of the

SAINTS to ordinary shares, Subdivision 130-C does not apply. (Subdivision 130-C only applies if there is an acquisition of an asset by

conversion of a convertible interest).”

A similar outcome was reached in CR 2006/68:

“76. As CGT event C2 does not occur on the conversion of the SPS to

Ordinary Shares, Subdivision 130-C of the ITAA 1997 has no effect. This is due to the fact that the operation of Subdivision 130-C of the ITAA 1997 requires the acquisition of an asset through conversion,

which does not occur upon conversion of the SPS.”

Accordingly, based on the views of the ATO outlined above, s.130-60(2)

should not apply to “reset” the date of acquisition of the ordinary shares

acquired on the conversion of the converting share because CGT event

C2 does not occur.

Loan Similar issues as outlined above for the loan plan should apply.

In respect of FBT, where the converting shares have no dividend rights

(i.e., prior to conversion), then FBT will likely apply as the otherwise

deductible rule will not be satisfied (see ATO 2009/7).

Value shifting

consequences

See discussion above in section 2.6 regarding the startup provisions.

45 Refer Item 1 of the table to s.130-20(3).



3.5 Phantom plan

The phantom plan is essentially a right to a cash bonus in the future, that is calculated by reference to

the performance of the company’s shares, which is assessable to the employee when received with

no CGT discount.

Compared to all other plans outlined above, it is simple to implement, but will not achieve CGT

discount and has a cash cost for the company.

The most contentious issue had been whether the right to the bonus was itself subject to FBT, but the

current state of play seems to be that FBT should not apply:

The definition of “fringe benefit” excludes certain things such as “a payment of salary or wages.“

In the context of the ESS provisions, ATO ID 2010/142 ruled that “indeterminate rights” granted to

employees were not subject to FBT where it was cash settled (an “indeterminate right” being

typically where the company can cash settle a right). This was on the basis that the right will be

viewed as one of a series of steps in the payment of salary or wages; and will not be viewed as a

separate benefit to the payment of salary or wages which are excluded from the definition of

fringe benefit by paragraph 136(1)(f) of the FBTAA

Further, in TR 2010/6 when considering the tax consequences of issuing bonus units under an

employee benefits trust arrangement, the Commissioner made the following comments:

“78. The Commissioner does not consider the term ' payment of salary or wages' to be

confined to the actual discharge of any liability on the part of the employer or another person

to pay salary or wages to an employee. If entitlements to receive salary or wages constituted

fringe benefits, Parliament's purpose in excluding salary or wages from fringe benefits tax

would be stultified and systemic double taxation might result. Consequently, it is evident from

the context and object of the FBTAA that the creation of an obligation to pay (and the

corresponding entitlement to be paid) a sum of money that, when discharged, amounts to the

payment of salary or wages to an individual as employee, is also incapable of being a fringe

benefit. Thus debts on account of salary and wages are not fringe benefits as defined.

79. Where an employee is granted a right in the form of a bonus unit under an employee

benefits trust arrangement as described at paragraphs 4 to 6 of this Ruling, the grant of that

right will not be a 'fringe benefit' for the purposes of the FBTAA.”

The comments made by the Commissioner in ATO ID 2010/142 and TR 2010/6 are the appropriate

outcome – namely that a right to a bonus that is taxed as salary and wages should not also be subject

to FBT.



Appendix 1



Appendix 2

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