House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Minister for Small Business, the Hon Bruce Billson MP)

Chapter 1 - Improvements to the taxation of employee share schemes

Outline of chapter

1.1 Schedule 1 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to improve the taxation of employee share schemes (ESSs) by:

•

reversing some of the changes made in 2009 to the taxing point for rights for employees of all corporate tax entities;

•

introducing a further taxation concession for employees of certain small start-up companies; and

•

supporting the Australian Taxation Office (ATO) to work with industry to develop and approve safe harbour valuation methods and standardised documentation that will streamline the process of establishing and maintaining an ESS.

1.2 These changes will improve the tax treatment of ESS interests so as to facilitate better alignment of interests between employers and their employees, and to stimulate the growth of innovative start-ups in Australia by helping small unlisted companies be more competitive in the labour market.

Context of amendments

Policy background

1.3 In recognition of the concerns that have been raised by stakeholders in relation to the tax treatment of ESS interests, the Government announced on 18 December 2013 that it would focus on potential measures to encourage innovation, including the taxation and regulation of ESSs. Following this announcement, the Government conducted public consultations on ESSs and start-ups for two weeks commencing 28 January 2014. Consultations were conducted in Melbourne and Sydney, and teleconferences were held for those unable to attend the meetings.

1.4 In developing its reforms, the Government drew on these consultations, advice from the Prime Minister's Business Advisory Council and a study prepared by the Business Council of Australia in July 2014. 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.

1.5 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.

1.6 The Government is also committed to reducing the compliance burden faced by small businesses, and will make it easier and cheaper for businesses to set up and maintain an ESS.

1.7 Consultation was undertaken on an exposure draft between 14 January 2015 and 6 February 2015. This consultation included roundtable discussions held in Canberra, Melbourne and Sydney. Around 50 submissions were received on the exposure draft.

1.8 The Government heard a wide range of views during consultation on the exposure draft with most stakeholders very supportive of the reforms. Following consultations, the Bill and supporting documents have been amended to address technical concerns and clarify policy on the small start-up concession. Stakeholders will welcome the changes that mean the recipients of the small start-up concession, as it applies to options, will also be able to benefit from the 50 per cent capital gains tax discount in a wider range of circumstances; and contributions from certain large venture capital investors will not rule out eligibility for the small start-up concession.

1.9 The ATO also carried out consultations with interested stakeholders on the development of safe harbour valuation methods and standardised documentation to streamline the process of establishing and maintaining an ESS for small start-up companies. Submissions were invited between 14 January 2015 and 6 February 2015 with follow-up discussions to be held in March and April 2015.

Current taxation treatment

1.10 An ESS is a scheme under which shares, stapled securities or rights (including options) to acquire them (ESS interests) in a company are provided to an employee or their associate in relation to the employee's employment.

1.11 Some companies encourage employees to participate in ESSs by offering employees shares, stapled securities or rights (including options) to acquire them (ESS interests) at a discount. ESS income tax rules apply to this discount.

1.12 For ESS interests acquired after 30 June 2009, the ESS tax rules contained in Division 83A of the ITAA 1997 apply.

1.13 Division 83A contains specific rules about how tax applies to ESS interests. These rules apply to shares, stapled securities and rights to acquire them (including options), that have been provided to employees at a discount under an ESS.

1.14 If ESS interests have not been granted at a discount, the benefits given to employees may be taxed under other provisions of the tax law, such as capital gains tax.

Types of employee share schemes

1.15 From 1 July 2009, there are four different types of ESS that can be offered to employees:

•

Taxed-upfront scheme: the default position - if the scheme does not meet the conditions for concessional tax treatment, employees will be taxed on the discount on the ESS interests in the income year the ESS interests were provided to them.

•

Taxed-upfront scheme: eligible for reduction - subject to certain conditions being met by both the ESS and employees, concessional tax treatment is available for employees who have received ESS interests under a taxed-upfront scheme if they also meet an income test. The concession allows employees to reduce their taxable discount income by up to $1,000.

•

Tax-deferred scheme: salary sacrifice - subject to certain conditions being met by both the ESS and employees who have acquired ESS interests under salary-sacrifice arrangements, these ESS interests will be taxed in the income year that the deferred taxing point occurs.

•

Tax-deferred scheme: real risk of forfeiture - subject to certain conditions being met by both the ESS and employees who have acquired ESS interests when there is a real risk of forfeiture under the conditions of the scheme, these ESS interests will be taxed in the income year that the deferred taxing point occurs.

1.16 The type of scheme offered will generally determine the tax treatment of the ESS interests provided to employees. ESS interests can be provided to employees under more than one type of scheme.

General conditions for concessional tax treatment

1.17 To qualify for concessional tax treatment as detailed above, the ESS and the employee must meet all the following conditions:

•

the ESS interests acquired by employees must be in their employer or a holding company of the employer;

•

when an employee acquires the interest, all ESS interests available for acquisition under the scheme must relate to ordinary shares; and

•

the ESS interests provided must not result in either of the following immediately after acquisition:

-

an employee owning more than five per cent of the shareholding in their employer; or

-

an employee controlling more than five per cent of the maximum voting rights.

Taxed-upfront schemes

1.18 The default position is that ESS interests will be taxed in the income year that the ESS interest is received.

Eligible for the reduction

1.19 Some employees are entitled to reduce the amount included in their assessable income if they meet certain conditions.

1.20 In addition to the above general conditions, employees must meet other specific conditions to qualify for the up to $1,000 reduction. These conditions are:

•

the employee must not have a real risk of forfeiting the ESS interest under the conditions of the scheme;

•

the scheme must be operated so that all the employees must hold the ESS interest (or any share acquired on exercise of an ESS interest that is a right) for three years or until the employee ceases employment; and

•

the scheme must be offered on a non-discriminatory basis to at least 75 per cent of the company's Australian-resident permanent employees with at least three years of service.

1.21 The employee must also meet the income test to access the up to $1,000 reduction. Under the income test, the employee's taxable income (after adjustments) for the income year must be $180,000 or less.

1.22 Employees will not be eligible for the upfront or deferred tax concession if:

•

the predominant business of the employing company that the employee acquires ESS interests in, is the acquisition, sale or holding of shares, securities or other investments (directly or indirectly);

•

they are employed by the company that conducts that business; and

•

they are also employed by a subsidiary of that company or a holding company of the company that conducts that business, or a subsidiary of a holding company of the first company that conducts that business.

Tax-deferred schemes

1.23 If an ESS and employees who have acquired the ESS interests under the scheme meet certain conditions, the ESS interests will be taxed in the income year that the deferred taxing point occurs.

Tax-deferred scheme - salary sacrifice

1.24 In addition to the general conditions, the following conditions must be met for the scheme to be considered a tax-deferred scheme - salary sacrifice:

•

the ESS interests are shares (or stapled securities) that are acquired under a salary-sacrifice arrangement from their employer or a holding company;

•

when the shares (or stapled securities) are provided, the discount must equal the market value of the shares (or stapled securities);

•

the rules governing the scheme must expressly state that the deferred tax arrangement applies to the scheme;

•

at least 75 per cent of the Australian-resident permanent employees with at least three years' service are, or at some earlier time had been, entitled to acquire ESS interests in their employer or a holding company under an ESS; and

•

any rights acquired under the scheme must be subject to a real risk of forfeiture.

1.25 For the tax to be deferred, an employee must not receive more than $5,000 worth of shares (or stapled securities) during the year, under salary-sacrifice arrangements from their employer or a holding company of their employer.

Tax-deferred scheme - real risk of forfeiture

1.26 In addition to the general conditions, the following conditions must be met for the scheme to be considered a tax-deferred scheme - real risk of forfeiture:

•

the employee must have a real risk of forfeiting the ESS interest under the conditions of the scheme or forfeiting the share resulting from the exercise of the ESS interest; and

•

if the ESS interest is a share, at least 75 per cent of the Australian-resident permanent employees with at least three years' service are, or at some earlier time had been, entitled to acquire ESS interests in their employer or a holding company under an ESS.

Deferred taxing point

1.27 If the employee is provided with ESS interests under a deferral scheme and they meet certain conditions, they will be assessed for tax purposes in the income year that the deferred taxing point occurs. The amount assessed will be the market value of the ESS interests at the deferred taxing point, reduced by the cost base of the interests.

For shares

1.28 The deferred taxing point for a share or stapled security is the earliest of the following times:

•

seven years after the employee acquired the share;

•

when the employee ceases the employment they acquired the share in relation to; or

•

when there is no real risk of forfeiture and the scheme no longer genuinely restricts the disposal of the share.

For rights

1.29 The deferred taxing point for a right is the earliest of the following times:

•

seven years after the employee acquired the right;

•

when the employee ceases the employment they acquired the right in relation to;

•

when there is no real risk of forfeiting the right and the scheme no longer genuinely restricts disposal of the right; or

•

when there is no real risk of forfeiting the right or underlying share, and the scheme no longer genuinely restricts the exercise of the right or disposal of the resulting share.

Summary of new law

1.30 An ESS is a scheme where shares or rights in a company are provided to an employee in relation to their employment. A share provides a shareholder with an ownership interest in a company. A right is the right to acquire a share in a company at some point in the future.

1.31 The ESS tax rules help ensure employee taxpayers are taxed consistently regardless of the forms of remuneration they receive.

1.32 However, the rules also specifically aim to improve the alignment of employee and employer interests. In recognition of the economic benefits derived from ESS arrangements, the rules provide for tax concessions for employees participating in ESSs.

1.33 International research suggests that companies in which employees have an ownership interest are more productive than those that do not. In addition, ESSs are used in many countries as a way of attracting and retaining high-quality staff for innovative small start-up companies by providing them with a financial share of the potential upside from success of the company.

1.34 ESS tax concessions are provided to facilitate the alignment of the interests of employees and employers, which encourages: positive working relationships, boosts productivity through greater employee involvement in the business, reduces staff turnover and encourages good corporate governance.

1.35 In Australia, certain changes introduced in 2009 to the income tax treatment of rights acquired through an ESS detracted from the goal of commercialising innovative ideas in Australia.

1.36 Schedule 1 to this Bill makes improvements to the taxation of ESSs by:

•

reversing some of the changes made in 2009 to the taxing point for rights for employees of all corporate tax entities;

•

introducing a further taxation concession for employees of certain small start-up companies; and

•

supporting the ATO to work with industry to develop and approve safe harbour valuation methods and standardised documentation that will streamline the process of establishing and maintaining an ESS.

1.37 While this Schedule reverses certain changes that were made in 2009 to the taxing point for rights, key integrity changes have been retained.

1.38 For eligible start-up companies, this Schedule provides additional concessions where the shares or rights are provided at a small discount and are generally held by the employee for at least three years. Discounts on shares will not be subject to income tax, and discounts on rights will generally be treated as capital and deferred until sale of the resulting share.

Reversing and improving certain parts of the 2009 reforms

1.39 Currently, where an ESS right is subject to deferred taxation, the taxing point occurs at the earliest of one of the following times:

•

when the employee ceases the employment in respect of which they acquired the right;

•

seven years after the employee acquired the right;

•

when there are no longer any genuine restrictions on the disposal of the right (for example, being sold), and there is no real risk of the employee forfeiting the right; or

•

when there are no longer any genuine restrictions on the exercise of the right, or resulting share being disposed of (such as by sale), and there is no real risk of the employee forfeiting the right or underlying share.

1.40 This Schedule amends the second and fourth of those taxing points so that the taxing point occurs at the earliest of one of the following times:

•

when the employee ceases the employment in respect of which they acquired the right;

•

fifteen years after the employee acquired the right;

•

when there are no longer any genuine restrictions on the disposal of the right (for example, being sold), and there is no real risk of the employee forfeiting the right; or

•

when the right is exercised and there is no real risk of the employee forfeiting the resulting share and there is no genuine restriction on the disposal of the resulting share (if such risks or restrictions exist, the taxing point is delayed until they lift).

1.41 This Schedule will allow rights schemes which do not contain a real risk of forfeiture to access tax deferred treatment where the scheme rules state that tax deferred treatment applies to the scheme and the scheme genuinely restricts an employee from immediately disposing of the right.

1.42 Further, this Schedule makes a number of additional refinements and improvements to the 2009 reforms, including by extending the maximum deferral period for shares received under an ESS, make changes to the maximum ownership and voting rights limitations and changing the rules relating to the refund of income tax on forfeited shares or rights rules.

Small start-up companies

1.43 Employees of certain small start-up companies may receive the start-up tax concession, if their employer and the scheme meet a number of conditions.

1.44 The start-up concession provides that an employee does not include a discount on ESS interests in their assessable income.

Reducing compliance costs

1.45 The Schedule also supports the ATO to work with industry to develop and approve safe harbour valuation methods to improve certainty and reduce compliance costs in maintaining an ESS.

1.46 The Schedule does this by introducing a new power for the Commissioner of Taxation (Commissioner) to approve market valuation methodologies. Approved methodologies will be binding on the Commissioner but the taxpayer remains able to choose another methodology if he or she believes the alternate methodology is more appropriate in their circumstances.

1.47 The ATO will also work with industry and the Australian Securities and Investments Commission to develop standardised documentation that will streamline the process of establishing and maintaining an ESS. The standard documentation will be issued under the Commissioner's general powers of administration.

Comparison of key features of new law and current law

Detailed explanation of new law

Schedule 1 to this Bill makes various amendments to the ITAA 1997 (primarily Division 83A) to:

•

alter one of the taxing points for ESS interests that are rights so that it applies not at the point at which a right can be exercised but at the point at which it is exercised (subject to the share obtained by exercising the right not being further subject to a real risk of forfeiture or genuine restrictions on sale);

•

increase the maximum deferral period from 7 years to 15 years for ESS interests subject to deferred taxation;

•

make other improvements to certain parts of the 2009 reforms;

•

introduce a further concession for employees of certain start-up companies so that the discount on issue is either exempt from income tax (for shares) or deferred until exercise or sale under capital gains tax rules (for rights); and

•

allow the Commissioner to approve market valuation methodologies that are binding on the Commissioner.

Reversing and improving certain parts of the 2009 reforms

Employee share scheme deferred taxing points

1.48 The deferral period for ESS interests covered under deferred taxation schemes is limited by the ESS deferred taxing points to ensure fairness, continue to align the interests of the employer and employee, and preserve the integrity of the tax system by preventing unlimited deferral of tax on employment remuneration.

1.49 The maximum deferral period has been increased from seven years to 15 years for ESS interests that are either shares or rights. [Schedule 1, item 19, subsections 83A-115(6) and 83A-120(6)]

1.50 The deferred taxing point relating to the exercise of an ESS interest, which is a right, has also been altered so that it now applies when an employee exercises the right rather than when the employee can exercise the right. However, the existing exceptions continue to apply if the share obtained from exercising the right is subject to a real risk of forfeiture or genuine restrictions on sale. In this situation, the deferral will continue to be the time at which those risks and restrictions are lifted if this occurs after exercise. [Schedule 1, items 20 to 22, subsection 83A-120(7)]

1.51 When an employee exercises a right includes situations in which the right is automatically exercised as a result of a contractual obligation between the employee and the provider of the ESS interest or because the features of the right result in its automatic conversion into shares when certain pre-conditions are met.

Allowing further access to deferred taxation

1.52 This Schedule also provides that certain rights schemes that do not contain a real risk of forfeiture can access deferred taxation treatment.

1.53 An ESS interest an employee can acquire under an ESS is subject to deferred taxation if:

•

the scheme is a scheme in which employees can access ESS interests that are rights;

•

the scheme genuinely restricts the employee immediately disposing of those rights; and

•

the scheme rules expressly state that the scheme is subject to deferred taxation. [Schedule 1, item 18, subsection 83A-105(6)]

1.54 The other general eligibility conditions for an employee to access a taxation concession in relation to an ESS interest must also be satisfied.

1.55 The requirement to include statements in the plan rules has been introduced to clearly differentiate the scheme from other schemes where the intent is not to be subject the interest to the deferred taxation arrangements.

1.56 However, acknowledging the compliance difficulties with making alterations to certain plan rules in relation to internationally operating schemes, a statement in the document offering an employee the opportunity to participate in the ESS would be sufficient to fulfil this requirement. For further details on how the requirement can be met - see page 44 of the Explanatory Memorandum to Tax Laws Amendment (2009 Budget Measures No. 2) Bill 2009.

Changes to the maximum ownership and voting rights limitations

1.57 One of the general eligibility conditions for an employee to access an ESS taxation concession is that the employee (and their associates) must not already have a material ownership stake or voting rights in their employer or a holding company of their employer (if the ESS interests are issued in the holding company).

1.58 This limitation encourages the benefits of the ESS to be spread widely among employees. The concession is intended to encourage employees with small or no ownership in their employer to take up an interest in the company. It is considered that if an employee is able to exercise more than a certain percentage of the voting rights or owns a certain percentage of shares in their employer, interests between the company and that shareholder are already sufficiently aligned, and no further tax concession is appropriate or warranted.

1.59 Further, this acts as an integrity rule that prevents employees from misapplying the concession in order to buy a business or indirectly access company profits through the ESS rules. The concession is intended to apply in respect of the employee/employer relationship and not in relation to the company/shareholder relationship.

1.60 This Schedule makes changes to the maximum ownership and voting rights limitations by doubling the existing 5 per cent test to 10 per cent, and for integrity reasons ensuring all interests in the employer (including interests employees have a right to acquire, interests acquired from the exercise of previous ESS interests and interests acquired outside of an ESS arrangement) as well as interests held by associates are taken into account in applying the test.

1.61 The interest provided to an employee must not result in the employee (along with their associates) having effective ownership of greater than 10 per cent of their employer, and not controlling more than 10 per cent of the maximum voting rights in the employer. [Schedule 1, item 11, subsection 83A-45(6)]

1.62 In determining the employee's effective ownership and voting rights, the employee must take into account the holdings they could obtain by exercising rights they have over shares in their employer (regardless of whether those rights are ESS interests acquired under an ESS or not) and the holdings of their associates. [Schedule 1, items 11, 26 and 27, subsections 83A-45(7) and 83A-305(2)]

1.63 These changes will generally allow employees to obtain a greater ownership share in their employer through ESS interests whilst ensuring the fairness and integrity of the tax system by preventing the misuse of ESS arrangements.

Changes to the refund of income tax for forfeited shares and rights

1.64 The law provides for a refund of income tax paid in relation to discounted ESS interests in certain circumstances where those interests are forfeited and the employee has already been taxed on the discount.

1.65 These provisions provide a refund of income tax in circumstances where the employee had no choice but to forfeit the ESS interest. The refund provision also applies where the employee chose to cease employment but does not apply where the conditions of the scheme were constructed to protect the employee from market risk.

1.66 Under such circumstances, the forfeited ESS interest is treated as having never been acquired, and the employee can claim a refund of income tax by seeking an amendment to their income tax assessment to remove income previously included in their assessable income. There is no time limit on amending an assessment to exclude an amount from a taxpayer's assessable income for a share interest which is forfeited, or for a right which was lost without being exercised.

1.67 As the refund provisions are not intended to protect the employee from downside market risk, a refund will not be available where the share interest is forfeited due to a choice of the employee (except when that choice was to cease employment), or a condition of the scheme which has the direct effect of protecting the employee from market risk.

1.68 This Schedule ensures that a choice not to exercise a right or to let a right be cancelled is also a choice that does not prevent the application of the refund provisions. For example, if an employee decides to let a right lapse, and has previously paid income tax as a result of acquiring the right, the employee will be entitled to a refund provided the scheme has not been structured to directly protect the employee from downside market risk. [Schedule 1, items 28 to 30, section 83A-310]

Concessions for interests in small start-up companies

1.69 Employees of certain small start-up companies may receive the start-up tax concession if their employer and the scheme meet a number of conditions.

What is the small start-up concession?

1.70 The start-up concession provides that an employee does not include a discount on ESS interests acquired in their assessable income if the scheme meets certain conditions and their employer meets certain conditions. [Schedule 1, item 6, section 83A-33]

1.71 In relation to shares, the discount is not subject to income tax and the share, once acquired, is then subject to the capital gains tax system with a cost base reset at market value. Further information on the capital gains tax interaction with the ESS rules can be found in paragraphs 1.209 to 1.214 of the Explanatory Memorandum to Tax Laws Amendment (2009 Budget Measures No. 2) Bill 2009.

1.72 In relation to rights, the discount is not subject to upfront taxation and the right is then subject to capital gains tax with a cost base equal to the employee's cost of acquiring the right. [Schedule 1, items 4, 5 and 34, subsections 83A-30(2) and 130-80(4)]

1.73 There will be no capital gains tax on the exercise of rights and the resulting acquisition of shares (due to the availability of a capital gains tax rollover). However, upon exercise, the exercise price of the rights will form part of the cost base of the resulting shares.

1.74 The employee will generally include any capital gain in their assessable income (as part of working out their net capital gain or loss) on disposal of the resulting shares.

1.75 The capital gains tax discount rules (in Subdivision 115-A of the ITAA 1997) have been modified in relation to ESS interests that are rights to acquire shares and that benefited from the small start-up concession. When determining the acquisition time for a share that has been acquired by way of exercising a right that was an ESS interest subject to the small start-up concession, the time of acquisition for capital gains tax discount purposes is the time at which the right was acquired, and not the time at which the share was acquired. This will ensure that the capital gains tax discount is available so long as the right and underlying share are sequentially held for 12 months or more. [Schedule 1, item 31, item 9A in the table in subsection 115-30(1)]

1.76 The small start-up concession applies to the exclusion of all other ESS taxation rules. That is, those eligible for the small start-up concession cannot access either the $1,000 up-front concession or the deferred taxation concession. [Schedule 1, items 9 and 14, paragraphs 83A-35(2)(c) and 83A-105(1)(ab)]

What ESS qualifies for the small start-up concession?

1.77 The small start-up concession is only available if the ESS, the company in which the interest is issued, the employer and the employee meet certain conditions.

General conditions

1.78 The first set of conditions are the general conditions that apply to all ESS concessions, namely the:

•

employment condition;

•

ordinary shares conditions;

•

integrity rule about share trading companies condition; and

•

maximum ownership and voting rights condition (as amended - see paragraphs 1.57 to 1.63). [Schedule 1, items 6 and 11, paragraph 83A-33(1)(b) and section 83A-45]

1.79 Further background on these conditions can be found in the Explanatory Memorandum to the Tax Laws Amendment (2009 Budget Measures No. 2) Bill 2009 and are summarised at paragraphs 1.17 and 1.22.

Conditions of the scheme

1.80 The following conditions apply to the scheme:

•

the scheme must meet the existing minimum holding period condition (see paragraph 1.20); and

•

if the scheme relates to shares, the scheme must meet the existing broad availability condition (see paragraph 1.24). [Schedule 1, items 6 and 11, paragraph 83A-33(1)(c) and subsections 83A-45(4) and (5)]

1.81 Further background on these conditions can be found in the Explanatory Memorandum to the Tax Laws Amendment (2009 Budget Measures No. 2) Bill 2009.

1.82 This Bill makes slight improvements to the existing minimum holding period condition by allowing the Commissioner to reduce the minimum holding period in situations in which all employees are effectively required to exercise and/or dispose of their ESS interests. For example, where there is an initial public offering of the company, or the company is subject to a full trade sale and employees have agreed to a 'tag along' clause in relation to holding of minority interests. The Commissioner in applying the discretion will need to have regard to whether, when employees acquired their interest, there was a genuine intention for the interests to be held for the minimum holding period. [Schedule 1, items 11 and 41, subsections 83A-45(5) and 995-1(1)]

Employer conditions

1.83 To access the concession, no equity interests in the company in which the ESS interest is in, can be listed on an approved stock or securities exchange.

1.84 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 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. [Schedule 1, item 6, subsection 83A-33(2)]

1.85 To access the concession, the ESS interests need to be in a company that was incorporated less than 10 years at the end of the most recent income year before the ESS interest was acquired. In relation to this requirement, it is the company's income year that is the relevant income year. [Schedule 1, item 6, subsection 83A-33(3)]

1.86 For integrity reasons, all companies in the corporate group also need to have been incorporated less than 10 years and not have their equity interests listed on an approved stock or securities exchange at the end of the most recent income year before the acquisition date. In relation to these requirements, it is the company's income year that is the relevant income year.

1.87 To access the concession, the ESS interests need to be in a company that has an aggregated turnover (an existing concept within the ITAA 1997 - see section 328-115) not exceeding $50 million for the income year prior to the income year in which the ESS was acquired. [Schedule 1, item 6, subsection 83A-33(4)]

1.88 In applying any of the grouping rules relating to the listing requirement, the 10 year requirement or the aggregated turnover threshold, any investment by a tax exempt entity which is a deductible gift recipient or an eligible venture capital investment by a venture capital limited partnership, early stage venture capital limited partnership or Australian venture capital fund of funds is to be ignored. The effect of this is that if the only investment by one of those entities is the investment to be ignored, then those entities will not be either a holding company of the company in which the interest is issued or connected with the company in which the interest is issued. [Schedule 1, item 6, subsection 83A-33(7)]

1.89 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. [Schedule 1, item 6, subsection 83A-33(6)]

1.90 These four conditions ensure that the concession is appropriately targeted to genuine small Australian start-up companies, consistent with the policy objective.

ESS interest conditions

1.91 To access the concession, the ESS interest must:

•

in the case of a share - be acquired with a discount of not more than 15 per cent of the market value of the share when acquired; and

•

in the case of a right - have an exercise price (or strike price) that is greater than or equal to the market value of an ordinary share in the issuing company at the time the right is acquired. [Schedule 1, item 6, subsection 83A-33(5)]

1.92 This condition ensures the concession only applies in situations in which the ESS interest is issued at a small discount to the employee. This will ensure the measure is appropriately targeted, is not open to abuse (eg through salary packaging arrangements), and fiscally sustainable.

Example 1.1: Shares

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.

Example 1.2: Rights

Tim is issued with 10,000 'out of 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 $1.50 per right (which is more than 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.

Safe harbour market valuation methodologies

1.93 This Schedule also supports the ATO to work with industry to develop and approve safe harbour valuation methods to improve certainty and reduce compliance costs in maintaining an ESS.

1.94 This Schedule does this by introducing a new power for the Commissioner to approve market valuation methodologies that can be used by taxpayers to comply more easily with the law.

1.95 The Commissioner may, by legislative instrument, approve a method for determining the market value of an asset or non-cash benefit for income tax law purposes. [Schedule 1, item 46, section 960-412]

1.96 The Commissioner may approve a valuation methodology subject to any condition or conditions the Commissioner thinks appropriate.

1.97 The legislative instrument is disallowable by either House of Parliament.

1.98 An approved methodology is binding on the Commissioner so long as any relevant conditions have been complied with by the taxpayer. This means, if a taxpayer uses the approved methodology, the taxpayer may rely on that method as reflecting the market value of the asset or non-cash benefit being valued.

1.99 While the new approved safe harbour valuation methodology applies more broadly than ESS, it is anticipated that the Commissioner will initially only exercise this new power with regard to ESS arrangements for small unlisted corporate tax entities only.

1.100 The Commissioner is expect to give consideration as to whether this power can reduce the compliance costs for taxpayers in other circumstances, having regard to revenue and integrity issues that approving valuation methodologies may create.

Consequential amendments

Cross references to the maximum ESS ownership and voting rights limitations

1.101 Cross references to the ESS maximum ownership or voting rights limitations in other provisions of the tax law have been updated to reflect the new reset test. [Schedule 1, items 24, 25, 35 and 36]

Cross references to the ESS provisions

1.102 Cross references to the ESS provisions in other provision of the tax law have been updated to reflect the amended provisions. [Schedule 1, items 1, 32, 33, 42 and 43]

Updates to guide material and internal section referencing

1.103 Guide material has been updated to reflect the new changes to the taxation arrangements applying to ESS interests. Internal section referencing has also been updated to reflect the amendments to Division 83A. [Schedule 1, items 2, 3, 7, 8, 10, 12, 13, 15 to 17, 23 and 45]

Temporary and foreign residents - capital gain tax

1.104 The temporary and foreign residents capital gain tax concessions have been modified so that they do not apply in relation to ESS interests subject to the new start-up concession. This ensures using the capital gains tax system as the primary taxing regime for these ESS interests does not provide certain employees with additional and unintended concessionary treatment. [Schedule 1, items 37 to 40, sections 768-915, 768-955 and 855-45]

Technical amendment - interaction of ESS rules and fringe benefits tax

1.105 A technical defect in Division 83A has been identified where certain ESS interests that are issued at a discount to market value, are for the purposes of reducing compliance costs, deemed to have a market value which results in the discount for Division 83A purposes being nil. However, the unintended effect of such a deeming is for the ESS interest to then fall outside the scope of Division 83A and instead be subject to fringe benefits tax where the deemed value does not apply.

1.106 Schedule 1 to this Bill, amends Division 83A to ensure that such an ESS interest remains within the scope of Division 83A. However, because of the deemed market value and resulting nil discount, Division 83A will not include any amount in the assessable income of any employee, and will simply operate to set the cost base of the interest for capital gains tax purposes, which will generally remain the primary taxing code for these interests. [Schedule 1, items 47 to 50, paragraph 83A-105(1)(a) and subsection 83A-315(1)]

Application and transitional provisions

1.107 The amendments apply to ESS interests acquired on or after 1 July 2015. [Schedule 1, item 44]

1.108 The current law continues to apply to ESS interests acquired before 1 July 2015.

1.109 The Commissioner's safe harbour market valuation methodologies will apply from the date specified by the Commissioner in a legislative instrument.

1.110 The technical amendment applies to the 2011-12 income year and later income years to align with existing amendment periods. The technical amendment is beneficial to taxpayers. [Schedule 1, item 51]