House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 2 - Employee share schemes

Outline of Chapter

2.1 Schedule 2 to this Bill will amend Division 13A of the Income Tax Assessment Act 1936 (ITAA 1936) which deals with employee share schemes (ESSs). The amendments insert an alternative method (public offer price) for determining the market value of shares acquired under an ESS. This method will be used when a public offer is made in a listed public company and an offer of shares or unlisted rights to acquire shares, under an ESS, is made in association with that public offer.

Background to the legislation

What is the relevance of market value?

2.2 Division 13A of the ITAA 1936 sets out how employees are assessed on the shares and rights that they acquire under an ESS. The concept of market value is used to determine the discount received by the employee and the amount included in the employees assessable income. For example, if the share is a non-qualifying share, or if it is a qualifying share and the employee elects to have the discount assessed immediately, the discount equals the market value of the share minus the consideration paid.

2.3 Market value is also relevant for determining whether a scheme falls under Division 13A. To acquire a share under an ESS the consideration paid must be less than the market value of the share. In other words, there must be a discount which is assessable to the employee. Otherwise, assessment of the shares falls outside Division 13A and employees will not be eligible for certain concessions that are otherwise available.

2.4 Subdivision F of Division 13A sets out how to determine the market value of a share or right. Broadly, market value of a listed share or right is determined by reference to the weighted average of the prices at which the shares were traded during the one week period up to and including the day of acquisition (paragraph 139FA(1)(a)).

Why is the rule for determining market value being changed?

2.5 Where an ESS is associated with a public offer of shares in a public company, the weighted average price method of determining market value gives rise to uncertainty and an inequitable taxation treatment for employees. The alternative method (public offer price) for determining market value overcomes 2 problems:

•

It prevents the artificial discount which occurs where the weighted average price is greater than public offer price. Artificial discounts (created under the current law) are included in the employees assessable income. (Paragraph 2.24 explains how artificial discounts are created under the current law).

•

It also removes uncertainty as employees and employers will be able to assess if the scheme falls under Division 13A and is eligible for the concessions under this Division and the capital gains tax exemption for transferring shares held by a trust to an employee (section 130-90 of the Income Tax Assessment Act 1997 ). Employees will be in a better position to assess the tax implications of their investment decision as it will be easier to anticipate the amount of assessable discount.

Summary of new law

2.6 The amendments will provide an alternative method (public offer price) for determining market value where shares or unlisted rights are acquired by an employee in association with a public offer of shares in a listed public company. The discount which is assessable to the employee will be calculated using the more equitable public offer price, rather than the weighted average price.

2.7 The new method of calculating market value will apply only in certain circumstances. An ESS must be offered in association with a public offer of shares in a listed public company.

2.8 In other circumstances market value will continue to be determined under sections 139FA or 139FB of the ITAA 1936. This is because, in situations where shares are not acquired in association with a public offer, the weighted average price, or the arms length value, of shares reasonably reflects the market value. Market value calculated in this way gives rise to a realistic and equitable discount which is assessable to the employee.

2.9 No change to the law is necessary for ESSs offered in association with an initial public offer of shares. This is because market value is determined in accordance with public offer price via section 139FB of the ITAA 1936.

Comparison of key features of new law and current law

Detailed explanation of new law

2.10 Division 13A of the ITAA 1936 explains how employees are assessed on shares and rights acquired under an ESS. Division 13A applies if shares are acquired at a discount to their market value. To calculate the discount it is necessary to ascertain the market value of shares. Under the Division, the market value of listed shares on a particular day is determined with reference to the weighted average price of shares traded on the stock market during the week up to and including that day.

2.11 The employee is assessed on the difference between the market value of the shares or rights and the consideration paid or given in 3situations:

•

When the share is not a qualifying share (as defined by section 139CD). In this case, it is assessable in the year of acquisition (subsection 139B(2)).

•

When the share is qualifying and the taxpayer elects to have it assessed in the year of acquisition (section 139E).

•

When the share is qualifying and taxation is deferred until the cessation time (section 139CA) and the share is not disposed of within 30 days of the cessation time (subsection 139CC(4)).

2.12 Where shares or unlisted rights are offered to employees, in association with a subsequent public offer of shares in a listed public company, using the weighted average price under existing law as market value results in inequitable tax treatment for employees. This is because the weighted average price may be higher than the public offer price and produces an artificial discount which is assessable to the employee. Using the public offer price as market value provides a more equitable result because where an ESS is linked with a secondary or subsequent public offer of shares, the public offer price more appropriately reflects the true market value of the share or unlisted right.

When is the alternative method for determining market value used?

2.13 The alternative method, where the lowest price paid by members of the Australian public is taken to be the market value of a share, is used if:

•

an employee acquires a share or unlisted right in association with a public offer of shares; and

•

the company has been a listed public company for a period of 6 months before the public offer.

If these conditions are not satisfied, market value of a share is calculated in accordance with section 139FA using the weighted average price method. [New subsection 139FA(3), item 1 of Schedule 2]

When is a share acquired in association with a public offer?

2.14 A share is offered in association with a public offer of shares if the share is acquired within a period of 7 days before or after the first day on which shares are first acquired under the public offer. This condition ensures that shares acquired by employees at about the same time as the public will have their market value determined by reference to the public offer price. A period of 7 days, prior to and after the closing date for application for acquisition of shares under the public offer, allows for some flexibility where certain restrictions may prevent the ESS acquisitions occurring on the same day as the public offer acquisitions. [New paragraph 139FAA(1)(a), item 2 of Schedule 2]

2.15 A further test, which establishes an association with a public offer, is incorporated in the reference to certain rights attached to the share. Broadly, if the share acquired under the ESS has the same rights attached to it as the share acquired by the public the second test is satisfied. New paragraph 139FAA(1)(b) lists these rights. The practical effect of this test is to ensure that shares under the public offer are of the same class as those offered to employees under the ESS. Where shares acquired under the ESS are of a different class it would not be appropriate to use the public offer price because the shares are not linked or associated.

Why does the company have to be listed for 6 months?

2.16 The alternative method for determining market value will only apply to a subsequent issue of shares where the company has been a listed public company for at least 6 months immediately before the share is acquired. [New paragraph 139FAA(1)(d), item 2 of Schedule 2]

2.17 The 6 month rule ensures that employees who acquire shares in a company engaged in conditional trading immediately prior to a public float will not be able to use the public offer price to calculate the discount received. ^[F1]

2.18 It is not appropriate that the new method of calculating market value apply when unlisted companies make initial public offers. This is because current practice is that market value in these situations is already determined in accordance with the public offer price via section 139FB of the ITAA 1936.

The alternative method for determining market value will use the lowest price at which shares were sold under the public offer

2.19 The alternative method for determining market value ensures that the lowest price paid by at least 1,000 Australian residents, where the total cost of shares acquired by such persons was at least $1million is taken to be market value. [New subsection 139FAA(2), item 2 of Schedule 2]

2.20 The effect of the new subsection is that where shares under a public offer are offered at more than one price, the lowest price paid by a significant number of residents is taken to be the public offer price. For example, where institutional shareholders acquire shares at a higher price than retail shareholders, market value is determined by reference to the lowest price (i.e. the retail price).

2.21 New paragraph 139FAA(1)(c) also ensures that the lowest price is a realistic market value which has been accepted by a significant number of residents. The requirement that the total cost of shares must be at least $1 million again ensures the authenticity of the public offer.

What is a public offer of shares?

2.22 For the purposes of new section 139FAA , a public offer of shares is made in a company when the company or a person, who owns at least 20% of the shares with rights in respect of voting in the company, makes an offer to at least 10,000 Australian residents. [New subsection 139FAA(3), item 2 of Schedule 2]

2.23 The 20% ownership rule ensures that the public offer can only be made by a person (including a company) with a major holding in the company. The $1 million and the 10,000 residents rules ensure that the offer is a large public offering made widely to members of the Australian public. This requirement is to overcome the potential for making an offer of shares, for example, only to a limited section of the public with an artificially low public offer price so as to reduce the discount assessable under Division 13A of the ITAA 1936. The definition also excludes (from the 10,000 resident threshold) residents who are employees or existing share holders of the company.

Diagram 2.1: Calculation of assessable discount, under Division 13A, using public offer price

How will the change prevent the creation of an artificial discount?

2.24 When an ESS is offered in association with a public offer, the price paid by employees is usually lower than the public offer price. However, under the current law, the discount that is assessable is determined on the basis of weighted average price. The problem with the existing legislation is highlighted when the weighted average price exceeds the public offer price. An artificial discount accrues to employees who elect to be assessed on the discount received in the year of acquisition of the shares.

Example 2.1: How Division 13A currently creates artificial discounts

A listed public company makes a public offer of shares where the public offer price is $8.00. Shares are offered to employees under an associated ESS for $7.80. The assessable discount for employees who elect to be assessed in the year of acquisition is the difference between the market value of shares and the consideration paid or given (subsection 139CC(2)).

If there was at least one transaction on the stock market during the one week period up to and including the day of valuation, the market value of the shares acquired is the weighted average of the prices at which the shares were traded. If the weighted average price of the companys shares is $8.30 then the discount that will accrue to the employees will be:

Market value (i.e. weighted average price) - Consideration = Discount
$8.30 - $7.80 = $0.50


As the price paid by the employee was determined with reference to the public offer price, a discount of $0.50 is not commercially realistic as the weighted average price is $0.30 higher than the public offer price. This results in artificial income, of $0.30, accruing to the employee.

Under the new law, the employee will be assessed on the discount calculated by reference to the public offer price (rather than the weighted average price):

Market value (i.e. public offer price) - consideration = Discount
$8.00 - $7.80 = $0.20


This is a much more equitable result and realistically reflects the true market value of the share.

New method for determining market value may apply to only some shares acquired in association with a secondary or subsequent public offer of shares

2.25 As part of a public offer of shares, employees of a company may acquire a number of shares in the company at the public offer price and on the same terms as the shares offered to the public. In some cases, employees may, under an ESS, be eligible for a certain number of additional shares (at no cost to the employees). The number of additional shares an employee may be eligible for is determined by the number of shares the employee purchased at the public offer price. Division 13A will only apply to the additional shares as the purchased shares were not acquired at a discount to market value (i.e. the purchased shares were acquired at public offer price).

Example 2.2

The existing majority shareholder in Mousetrap Ltd makes a public offer of shares in Mousetrap Ltd. The purchase price for the shares is payable in 2 instalments. These are often known as instalment receipts (IRs). The first instalment, due on 15 August 2000, is $4.00. The second instalment, due on 15 September 2001, varies. If the instalment receipts are held by the person who acquired the shares under the public offer until 15 September 2001 the amount due is $2.80. In other cases the amount due is $3.00. The public offer price is the lowest price at which shares are offered to the public, i.e. $6.80.

Employees of Mousetrap Ltd may purchase shares at the same price as they are offered to the public. In addition, employees who purchase shares will receive, without cost to them, additional shares (1 for every5, with a maximum of 100) and, rights to loyalty shares (1 for every 10, with a maximum of 70). The additional shares are qualifying shares and the loyalty shares (which are actually rights) are qualifying rights.

Marg purchases 1,000 shares. The following timeline illustrates Margs transactions:

How will the change promote certainty for employees and employers?

2.26 By using the public offer price as market value it will be easier to anticipate the amount of discount assessable to the employee. This will encourage greater participation in ESSs as employees will be able to assess the tax implications of their investment decision. The commercial reality of most public offers made in Australia is that due to their size and value of shares sold, it will be clear at the outset that the requirements specified in the amendments will be satisfied. This certainty will allow employers to explain, in their employee share documents, the tax implications of employee participation.

2.27 The increased certainty will mean that employers will not have to consider the fringe benefit tax implications which would arise if the scheme fell outside the ESS provisions.

How does the change affect the market value of unlisted rights acquired under an ESS?

2.28 If an employee acquires unlisted rights to shares, the market value of the rights is calculated with reference to the market value of the share (section 139FC of the ITAA 1936). The new provisions provide that where an unlisted right is acquired under an ESS in association with a secondary or subsequent public offer, the market value of the unlisted right will be calculated by reference to the public offer price of the share. [New section 139FAA, item 2 of Schedule 2]

2.29 Existing section 139FC explains how to calculate the market value of an unlisted right to a share that may be acquired by exercising that right. The new section 139FAA deals with the concept of using public offer price where shares have been acquired under a public offer. The new subsections 139FC(2), 139FE(2) and 139FK(2) have been inserted to ensure that where the rights to the shares have been acquired, market value of those rights is calculated by reference to the market value (public offer price) of the shares as if the shares were acquired on the day that the rights were acquired.

2.30 In order for the new subsections to apply, the rights must be acquired within the period prescribed by the new section 139FAA and the shares to be acquired on exercise of those rights must have the same rights attached to them as the shares offered under the public offer (refer paragraph 2.15). For example, when the right is exercised, the share acquired as a result of the exercise of the right must have the same rights to dividends as other shares offered to the public.

Application and transitional provisions

2.31 The amendment will apply from 2 September 1999.

Regulation impact statement

Policy objective

2.32 The policy objective of the amendment is to insert an alternative method (public offer price) for determining the market value of shares acquired by employees. This method will be used when a public offer is made in a listed public company and an offer of shares or unlisted rights to acquire shares is made, to employees, in association with that public offer. The existing method of determining market value produces unintended consequences in the application of the law, giving rise to uncertainty and inequitable taxation treatment for employees.

Implementation option

Background

2.33 Division 13A of the ITAA 1936 sets out how employees are assessed on the shares and rights that they acquire under an ESS. The concept of market value is used to determine the discount received by the employee and the amount included in the employees assessable income. For example, if the share is a non-qualifying share, or if it is a qualifying share and the employee elects to have the discount assessed immediately, the discount equals the market value of the share minus the consideration paid.

2.34 Market value is also relevant for determining whether a scheme falls under Division 13A. To acquire a share under an ESS the consideration paid must be less than the market value of the share. In other words, there must be a discount which is assessable to the employee. Otherwise, assessment of the shares falls outside Division 13A and employees will not be eligible for certain concessions that are otherwise available.

2.35 Subdivision F of Division 13A sets out how to determine the market value of a share or right. Broadly, market value of a listed share or right is determined by reference to the weighted average of the prices at which the shares were traded during the one week period up to and including the day of acquisition (paragraph 139FA(1)(a)).

2.36 Where an ESS is associated with a subsequent public offer of shares in a listed public company, the weighted average price method of determining market value gives rise to uncertainty and an inequitable taxation treatment for employees. The new method for determining market value overcomes 2 problems:

•

it prevents the artificial discount which occurs where the weighted average price is greater than public offer price. Artificial discounts (created under the current law) are included in the employees assessable income; and

•

it also removes uncertainty as employees and employers will be able to assess if the scheme falls under Division 13A of the ITAA 1936 and is eligible for the concessions under this division and the capital gains tax exemption for transferring shares held by a trust to an employee (section 130-90 of the Income Tax Assessment Act 1997 ). Employees will be in a better position to assess the tax implications of their investment decision as it will be easier to anticipate the amount of assessable discount.

2.37 The amendment will also apply to unlisted rights acquired in these circumstances. This is because the market value of the right will be calculated with reference to the market value of the share.

Implementation Option

2.38 The only implementation option which achieves the policy objective is introducing a new concept of market value to apply in situations where an ESS is offered in association with a subsequent public offer of shares in a listed public company.

2.39 This option would require an amendment to Division 13A of the ITAA 1936 so that the market value in this situation is equal to the public offer price (the public offer price will reflect the lowest price paid by a broad range of people to acquire shares under the associated public offer).

2.40 The amendment is necessary only where an ESS is offered in association with a secondary or subsequent issue of shares. Where an ESS is associated with an initial public offer of shares in a company that is not yet listed, market value is determined in accordance with public offer price by virtue of section 139FB of the ITAA 1936. In situations where an ESS is offered but not associated with a public offer of shares then the weighted average market value reasonably reflects the market value of shares.

Assessment of impacts

Impact group identification

2.41 The proposal will affect the following groups:

•

employees who participate in the ESSs;

•

employers and their advisers who promote ESSs; and

•

the Australian Taxation Office (ATO).

Analysis of costs

Compliance costs

Employees

2.42 The compliance cost to employees will be minimal and will be limited to learning about the new method for calculating market value.

Employers

2.43 The compliance costs to employers and their advisers will be minimal and will be limited to explaining how the new method affects tax liability to potential participants in an ESS.

Benefits

Employees

2.44 Employees of companies who participate in an ESS will be in a better position to assess the taxation consequences of participation in the scheme before making the decision to participate. By using the public offer price as market value it will be easier to anticipate the amount of discount which will be assessable to the employee.

2.45 Employees will also receive a cash flow benefit from the proposal to the extent that the creation of artificial income is prevented and the assessment of any net capital gain is deferred.

Employers

2.46 The certainty provided by determining market value with reference to the public offer price will mean that the affected employers will not have to consider the fringe benefit tax implications which would arise if the scheme fell outside the ESS provisions. The greater certainty offered is also likely to encourage a greater number of employees to participate in ESSs in such situations.

Administrative costs

2.47 The ATO will not incur any additional costs beyond those already allocated to processing returns.

2.48 The amount of material needed to explain the change will be very small.

Government revenue

2.49 The number of ESSs offered in association with a second or subsequent public offer of shares is likely to be small. There will be a cost to the revenue in situations where the weighted average formula would have resulted in a higher assessable discount than the public offer price. The size of the impact is not known.

2.50 The cost to the revenue for the 2000-2001 year is estimated to be less than $1 million.

Consultation

2.51 Following the issue of Treasurers Press Release No. 54 on 2September 1999 the Government received representations regarding the proposed amendment. The Government has considered those representations in drafting the amendment. The representations supported the proposed amendments.

Conclusion

2.52 The proposal will provide more equitable tax treatment for participating employees and greater certainty for affected employees and employers.

2.53 It is expected that there will be some compliance costs but these will be offset by the benefits of increased certainty. Administrative costs for the ATO will be broadly unchanged.