House of Representatives

Explanatory Memorandum

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

Glossary

The following abbreviations and acronyms are used throughout this explanatory memorandum.

General outline and financial impact

Improvements to the taxation of employee share schemes

Schedule 1 to this Bill amends the Income Tax Assessment Act 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 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.

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.

Date of effect: This measure generally applies to ESS interests acquired on or after 1 July 2015.

Proposal announced: This measure was announced in the Industry Innovation and Competitiveness Agenda released on 14 October 2014.

Financial impact: This measure has the following financial impact:

Human rights implications: This Schedule does not raise any human rights issue. See Statement of Compatibility with Human Rights - Chapter 3, paragraphs 3.1 to 3.5.

Compliance cost impact: Low; estimated compliance cost of $1.28 million per year on business.

Summary of regulation impact statement

Regulation impact on business

Impact: This measure would improve the income tax arrangements for ESS interests by offering additional income tax concessions to employees. This is expected to make Australia a more attractive investment destination for businesses, particularly innovative small start-up companies, and allow them to be more competitive in recruiting and retaining talented employees.

Main points:

•

ESSs are a means to aligning the interests of employees and employers and can result in more productive working relationships, higher productivity and reduced staff turnover.

•

In 2009, the former Government made changes to the way that ESS interests are taxed. Recent consultations have revealed a number of obstacles that are currently inhibiting firms from using ESSs in Australia.

•

The regulation impact statement considers five options: maintaining the status quo, a deregulatory option, two regulatory options and a non-regulatory option.

•

The Government has announced amendments to the taxation of ESS interests - this decision is a combination of the two regulatory options presented, which are the preferred options.

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]

Chapter 2 - Regulation impact statement

Introduction

2.1 Employee share schemes (ESSs) are schemes in which employers issue shares (an ownership stake in the company) and/or options (the right to acquire shares in the company at a later date) to their employees at a discount^[1] on the market value. Firms offer these because they see the benefits of improving the alignment of employee and employer interests, encouraging positive working relationships, boosting productivity through increased employee commitment to a company, reducing staff turnover and encouraging good corporate governance.

2.2 ESS arrangements can be particularly valuable for cash constrained start-ups, who often lack the cash flow to pay internationally competitive salaries to their employees. ESSs offer an option for attracting and retaining talented people with appropriate remuneration, while ensuring sufficient capital is available to allow growth of the start-up. These schemes are often lucrative to employees, because they offer the employees with a financial share of the potential success of the company. As such, the Government provides a level of preferential tax and regulatory system benefits for ESS arrangements to stimulate their use.

Current arrangements

2.3 Under the current ESS system, Division 83A of the Income Tax Assessment Act 1997 (ITAA 1997) generally taxes any discount on the market value of an interest in shares or options provided to an employee under an ESS in the income year that it is acquired by the employee.

2.4 The tax treatment of an employee's ESS interest differs when there is a real risk that the employee will forfeit eligibility for the shares or options. A real risk of forfeiture in a scheme may include conditions where retention of the ESS interests is subject to performance hurdles, or a minimum term of employment^[2]. For example, if an employee is given an ESS interest by their employer, but the employee will lose those ESS interests if he/she leaves the company within five years, this could constitute a real risk of forfeiture. The same might be true if there is a performance hurdle that the employee must meet before being granted access to the ESS interests.

2.5 If there is no real risk that the employee will forfeit eligibility, discounts on ESS interests are taxable up-front to the employee. However, employees with adjusted taxable income of $180,000 or less are eligible for a tax exemption on the first $1,000 of discounts received each year on eligible ESS interests. If an eligible employee receives more than $1,000 of discounts in an income year, he/she will only be taxed on the discounts in excess of the first $1,000.

2.6 If there is a real risk of an employee forfeiting their discounted shares under the conditions of the ESS (or they are acquired through a salary sacrifice arrangement) then taxation is deferred until the earlier of:

•

removal of the risk of forfeiture such that the scheme no longer genuinely restricts disposal of interests (for example, a minimum tenure of performance hurdle is met);

•

cessation of employment; or

•

seven years from acquisition of the interest.

2.7 In situations where the tax is paid and shares or options are subsequently genuinely forfeited, a tax refund is available. However, as the refund provisions are not intended to protect the employee from downside market risk^[3], a refund is not available where shares are forfeited only because the value has fallen due to market forces. For example, a refund will not be available in instances where an employee chooses not to exercise their ESS options purely because the share price of the firm is not high enough to make the ESS options valuable to them. Where the taxpayer is not eligible for a refund, the taxpayer would instead have a capital loss under the capital gains tax provisions.

2.8 In order for an ESS to qualify for the above tax treatment, the shares or options issued under the ESS arrangement must satisfy eligibility requirements. These requirements aim to ensure, among other things, that participation in the scheme is widely available to employees, and that the concessions cannot be accessed by shareholders who are effectively able to exert control over the company's operations.

2.9 To be eligible:

•

the ESS interests must not result in any one employee owning more than 5 per cent of the shareholding or controlling more than 5 per cent of the maximum voting rights;

•

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

•

there cannot be a real risk of forfeiture; and

•

the shares must be held for a minimum of three years or until the employee ceases employment.

What is the problem?

2.10 The current taxation arrangements of ESSs arise from changes made in 2009 as part of the 2009 10 Budget. These changes include:

•

removing the possibility for employees to elect when tax would be paid on the discount on options provided under an ESS, and as a result, taxing all discounts on shares and options in the income year in which the shares and options are acquired, unless there is a real risk of forfeiting the shares or options, or they are acquired through a salary sacrifice arrangement;

•

capping concessional tax treatment for particular schemes as follows:

-

if discounts are taxed up front, only employees with adjusted taxable income of $180,000 or less remained eligible for a tax concession on the first $1,000 of discounts received each year on eligible ESS interests (previously, there was no income limit on the concession);

-

tax deferral in limited circumstances (where there is a real risk of an employee forfeiting their discounted shares under the conditions of the ESS or those that are acquired through a salary sacrifice arrangement) until the earlier of removal of the risk of forfeiture; cessation of employment; and seven years from acquisition of the interest;

•

introducing an annual reporting requirement and associated withholding arrangements by companies that participate in these schemes.

2.11 These changes were designed to more effectively target the tax concessions available for ESSs, bring the taxing point for ESS interests into line with the taxing point for other forms of remuneration and to minimise opportunities for tax avoidance and reduction. As part of this, there was a range of integrity measures introduced to address concerns of misapplication of the law and tax evasion in the ESS system (the ATO estimated that the pre-2009 ESS tax arrangements resulted in lost revenue of up to $100 million per year).

2.12 A post-implementation review of those arrangements was completed by the Treasury on 21 November 2013, which assessed that the ESS measure was broadly meeting its objectives. This largely related to the objectives of aligning the taxing point for ESS interests with that of other forms of remuneration and minimising opportunities for tax reduction through ESS. The review also noted that the introduction of new reporting requirements was meeting its objective of improving integrity.

2.13 With that said, the post-implementation review acknowledged that concerns had been raised that the changes to the tax treatment of ESSs made since the 2009 10 Budget may have a negative impact on some sectors of the economy. In particular, the following issues were identified as barriers to firms, particularly start-ups, wishing to utilise ESS arrangements:

•

the taxation point for options;

•

the amount of administrative burden required to establish and maintain an ESS; and

•

the complexity of the valuation methodology for options.

2.14 As a result of those concerns, the former Government commenced consultation with industry on the most effective measures to address the barriers faced by start-up companies. These consultations revealed that some of the problems were more pronounced than initially perceived.

2.15 Since the post-implementation review was completed in 2013, the current Government has indicated that addressing the issues outlined above is a priority. The Prime Minister announced on 18 December 2013 that the National Industry Investment and Competitiveness Agenda would consider, among other things, the current taxation arrangements for ESS.

2.16 The Government has continued consultations on this issue and their consultation process is referred to at various points in this Regulation Impact Statement, and outlined in further detail under Question 5: Who will you consult about these options and how will you consult them? below. There have been two main streams of concern that have arisen out of this current process. Firstly, many companies have argued that it is not reasonable to tax options until the employee takes action to realise or convert them to tradeable shares. Secondly, unlisted start-ups have argued that they face additional problems around both valuation and liquidity - as their shares are not listed, there are difficulties determining valuations cost effectively and there is not a ready market to enable liquidity to pay the tax.

2.17 Although the 2009 changes appear to have reduced the popularity of options issued under an ESS for all companies, the impact appears to have been felt more keenly by start-ups, which often lack the capacity to implement alternative ways to remunerate employees. This issue has been identified by both the former^[4] and current^[5] Governments as a key area for attention. Innovation is vital to Australia in order to improve living standards, create new business opportunities and be globally competitive. The development of a strong and innovative economy is an important ingredient in creating jobs and improving productivity.

2.18 Industry has indicated that the existing taxation arrangements are causing an increasing number of Australian start-ups to move overseas. This view has been put forward by a range of industry stakeholders over recent years.

2.19 Some ESS interests can also be unaffordable to the beneficiaries due to cash flow issues arising from the timing of the payment of tax. The current tax arrangements require tax to be paid in the income year in which options are effectively acquired, as opposed to the point of exercise or sale of the interest. Given that only a small proportion of start-ups will succeed, tax may be required to be paid on something that may never have a convertible or realised value to the employee. Stakeholders claim that these tax arrangements are inconsistent with global practice and this can result in talented employees choosing to work overseas instead of working in Australia.^[6]

2.20 Once established, there are further costs involved in the ongoing operation and administration of an ESS, a key cost being that a company valuation is required when additional shares or options are issued under an ESS. Stakeholders have advised that this can cost as much as $50,000 per valuation in Australia, compared, for example, with the United States where the cost is US$2,000 to US$5,000. Stakeholders have also advised that multiple valuations can be required each year depending on when shares and options become taxable. This often makes an ESS unaffordable to many capital intensive start-ups as they seek to focus their capital on the growth of the company. Other operating and administrative costs, such as the documentation required to establish an ESS, were also identified in the consultation process as being problematic.

How common are employee share schemes and how has the prevelance changed over time?

2.21 ESS reporting requirements were introduced in 2009, which has resulted in a substantial increase in the amount of ESS data that is reported to the Australian Taxation Office (ATO). Prior to 2009, very limited information existed on the prevalence of ESS arrangements in Australia.

2.22 Even since the introduction of reporting requirements, there is limited information available on the amount and value of ESS interests issued in Australia. This is largely because there is no readily available data on the value of interests when they are granted to the employee. Reporting generally occurs when the employee receives ESS income (for example, the employee converts their options to shares and sells those shares).

2.23 Given that reporting requirements only began in 2009, the reporting system is still in its early stages - it will take some more time before we are able to compare data over time and extrapolate trends in ESS usage.

2.24 Having said that, there are some data available that offer an insight into the popularity of ESS in Australia. In 2011-12, around 34,500 employees reported deferred ESS income totalling $912 million^[7]. This number includes income generated from both options and shares, and equates to approximately $26,500 per employee. The average benefit per employee has remained broadly consistent since the introduction of reporting requirements.

2.25 Since 2009, the number of employees reporting ESS income has increased significantly, which is probably due to the adoption of (and compliance with) reporting requirements by ESS users. A number of stakeholders, particularly in the start-up community, have stated that the tax treatment of ESS in Australia since 2009 has contributed to firms moving offshore. There have also been claims that the 2009 changes effectively put an end to the provision of options under ESSs in Australia. These assertions have been put to government on a number of occasions, however there is no readily available data on to quantify these claims.

Why is Government action required?

2.26 The problems identified with the existing ESS taxation arrangements can only be addressed by changing the legislation to make the use of ESS more attractive and accessible, particularly for start-ups.

2.27 Making ESS more attractive and accessible for businesses and their employees would encourage a flourishing start-up sector, which is an important element of ensuring Australia is a thriving hub for innovative industry.

2.28 International research suggests that companies in which employees have an ownership interest are more productive than those that do not.

Options for consideration

2.29 There are two main aims for this proposal:

•

For all companies, the aim is to ensure that they remain internationally competitive and reduce disincentives for employers and employees to participate in ESSs.

•

For start-ups, the aim is to minimise complexity and compliance costs associated with the tax law, and increase the incentives for the start-up sector to use ESSs.

2.30 In addition to 'status quo' and 'deregulatory' options, consultation has contributed towards the development of various options for reform. This process, commenced by the previous Government but taken forward under the current Government, has included the release of a discussion paper prior to the 2013 Federal election and a small number of submissions received in response to that paper. Further submissions were received from stakeholders in January and February 2014 under a new consultation process involving direct consultations with stakeholders and liaison with various Ministers, government agencies and departments.

2.31 This RIS examines five options.

Option 1: Maintain the status quo ['the do nothing option']

2.32 Under option 1, no changes will be made to the legislative arrangements that govern ESS. That is, the status quo will be maintained.

Option 2: Remove the ESS tax concessions ['the deregulatory option']

2.33 Under option 2, all concessions for ESS will be removed. One submission to the existing consultation process raised a similar suggestion, arguing that a diminishing number of companies are utilising the current ESS arrangements. The submission suggested that establishing alternative 'workaround' arrangements to avoid both the tax and regulatory imposts would deliver insignificant revenue while placing a burden on the economy.

2.34 Under this option, employers will not have to comply with the rules in Division 83A of the ITAA 1997. While the compliance cost savings for employers will be large, employers will not be able to access concessional income tax treatment for the shares and options that they provide to their employees.

2.35 In addition, ESS will also become subject to fringe benefits tax. Currently, where an ESS meets the requirements of Division 83A of the ITAA 1997, the legislation provides that it is not a fringe benefit and therefore not subject to fringe benefits tax. This is to avoid double taxation because ESS is taxed in the income tax system. However, if the tax treatment of ESS concessions was no longer covered under the income tax system, ESS would then be subject to fringe benefits tax. Any compliance savings to the employer from this would be lost and, in many cases, the ESS interest would be subject to a higher rate of tax than it is at present.

2.36 Furthermore, the environment external to the ESS arrangements, in which many of the existing 'workaround' arrangements operate, is also constantly evolving.

Option 3: Defer the taxing point for all companies, and address administrative concerns, while retaining existing integrity measures ['the first regulatory option']

2.37 This option would apply to all companies and involves a number of elements which, in combination, would reduce or delay the tax burden faced by employees receiving interests in ESSs at a discount and would reduce the costs associated with establishing and maintaining ESSs.

First element

2.38 The first element would reverse some of the changes to the taxing point for ESS interests made in 2009 (while retaining suitably adjusted reporting obligations to the ATO to maintain integrity)^[8]. The exemption for the first $1,000 of assessable discount on shares taxed up front for employees with assessable income exceeding $180,000 could be retained.

2.39 This would see the taxing point for options be deferred to the earliest of:

•

when the right is disposed of (other than by exercising it);

•

when the employment in respect of which the right was acquired ceases;

•

if the right is exercised, and the share acquired as a result has disposal restrictions attached to it or there are conditions that could result in the share being forfeited - the time when those restrictions or conditions expire;

•

if the right is exercised and there is no such restriction or condition - the time when the right is exercised; or

•

fifteen years after the right was acquired (currently seven years).

2.40 For shares, where there are no conditions that could lead to the shares being forfeited, the taxing point will continue to be the time of acquisition.

2.41 In other cases (if there are conditions that could lead to the shares being forfeited) the taxing point for shares is the earliest of:

•

when the share is disposed of;

•

the later of:

-

the time when the disposal restrictions expire; and

-

the time when relevant forfeiture conditions expire;

-

when the employment in respect of which the share was acquired ceases; or

-

fifteen years after the share was acquired (currently seven years).

Second element

2.42 The second element would address the difficulties that companies (particularly start-ups) face in valuing options where the taxing point occurs prior to the existence of an objective market price. There are two components to this.

2.43 The first component would involve amendments to the existing 'safe harbour' valuation tables, to update the tables to reflect current market conditions. A 'safe harbour' method is one that is endorsed by the ATO for use in tax affairs. The existing safe harbour valuation tables (in Division 83A of the Income Tax Assessment Regulations 1997) are used to value unlisted options, to ensure that they reflect current market conditions. However, these tables have not been updated since the 1990s and are based on outdated estimates of dividend yield, risk-free interest rate and volatility of share prices. As the tables have become outdated, they are not widely used. Other things being equal, this change would generally reduce the amount of income tax employees would be obliged to pay on unlisted options that were acquired at a discount.

2.44 The second component would involve the ATO working with industry to develop a simple valuation method that will streamline the process of establishing an ESS. A simple valuation method means that valuations could be conducted in house; thus minimising the expense and difficulty incurred in seeking an independent valuation. ASIC will also be consulted given their oversight of disclosure documents that involve the offer of securities.

Third element

2.45 The third element relates to existing disclosure requirements under the Corporations Act 2001, which have also been identified in consultation as a deterrent to start-up companies looking to issue shares under an ESS. While not designed to address ESSs specifically, the Corporations Act provides relief from disclosure requirements for offers totalling not more than $2 million that result in securities being issued or transferred to no more than 20 investors, within a 12 month period.

2.46 In addition, ASIC Class Order 03/184 provides limited relief for unlisted bodies from the requirement to produce a disclosure document when offering options through an ESS. ASIC has consulted on a range of matters, including broadening the classes of financial products that may be offered, and expanding the categories of persons who can participate in an ESS which qualifies for relief.

2.47 On 31 October 2014, ASIC released a new regulatory guide (Regulatory Guide 49 Employee incentive schemes, Class Orders and related documents) and new class orders. These documents are designed to reduce the compliance and red tape burden on firms offering ESS arrangements and enhance the benefits to employers and employees participating in ESSs.

Fourth element

2.48 The fourth element of option 3 would be to retain the current employer reporting and withholding requirements that were introduced in 2009. Employer reporting ensures that the ATO has a source of data to cross match against individuals' tax returns, while withholding allows tax to be collected that might otherwise not be.

Fifth element

2.49 There is currently a 'significant voting and ownership rights' limitation that restricts employees with a significant ownership in their employer from accessing the ESS tax concessions. The current limitation means that ESS tax concessions are not available to individuals with more than a 5 per cent ownership or voting right in the company. This option would increase that limit to 10 per cent and, as an integrity measure, ensure that all interests in the employer are taken into account when applying the test.

2.50 Increasing the ownership limit to 10 per cent will allow more employees of companies, particularly in the early development stage, to access the ESS tax concessions. Firms in the early development stage are often very small and a 10 per cent interest can often translate to a relatively small investment. A 10 per cent interest is also consistent with international practice for a 'portfolio interest', which is a generally accepted benchmark for a passive investment that is part of a wider portfolio of investments, as opposed to an active investment where the investor may exert some influence over the operations of the company.

Regulatory Cost

2.51 Table 1 shows the average annual regulatory costs for this option, 'the first regulatory option'. The total compliance cost incurred by industry is estimated at $0.3 million per year, which is comprised of:

•

the total set-up costs for existing ESS users of around $370,000, averaged (over ten years) at $37,000 per year; plus

•

the total set-up costs for new ESS users of around $520,000, averaged (over ten years) at $52,000 per year; plus

•

the total ongoing compliance costs for new ESS users of approximately $196,000 per year.

2.52 This is based on the assumption that firms currently offering an ESS would incur a one-off compliance cost (but no new ongoing costs) because of the new rules. This cost is based on an additional seven hours per firm spent on learning, communication, systems and record keeping.

2.53 It is estimated that new ESS users will incur a one-off start-up investment of 40 hours per firm (on average), spent preparing reports on ESS interests. It also assumes that reporting to the ATO and the employees of the business will take an average of 15 hours per firm (per year).

2.54 It is expected that updating the safe harbour valuation tables and the issuance of standard documents by the ATO will result in compliance cost savings. These compliance cost savings have not been calculated or included in this Regulation Impact Statement, as the details are yet to be agreed. These compliance costs will be considered once the policy and administrative details have been finalised.

2.55 A regulatory offset has been identified from within the Treasury portfolio. This offset relates to the Future of Financial Advice (FOFA) reforms.

Option 4: Provide the same four elements as Option 3, and add additional concessions for start-ups ['the second regulatory option']

2.56 Industry has argued that the 2009 changes to the taxing point are out of step with global practice and that they put Australian companies at a disadvantage in attracting and retaining the staff they need.

2.57 In addition to the elements outlined under Option 3, this option would provide an additional concession exclusively to start-ups, along the lines of concessions currently operating in the United Kingdom, in order to improve the international competitiveness of Australia's arrangements.

2.58 This option would allow eligible start-ups to issue options or shares at a small discount, and have the tax treatment of that discount deferred until disposal (for options) or exempt from tax (for shares). For options, any gains from the date of issue will be taxed under normal capital gains rules.

2.59 The amount of tax exempt discount able to be provided on options will be capped by requiring that the strike price of the option is greater than or equal to the market value of the underlying share on the date of issue (that is, the option is not 'in the money' when issued). Shares that are provided at a discount of no greater than 15 per cent will not be subject to income tax.

2.60 A key policy driver in providing such a concession would be to enhance the productivity of start-ups, by seeking to further align employer and employee interests through the use of ESSs. With this policy focus in mind, the concession could be restricted to unlisted companies with an aggregated turnover of no more than $50 million that has been incorporated for less than 10 years, as a proxy for defining a start-up.

2.61 To ensure that the concession operates to further align interests and is not simply used as a vehicle to indefinitely defer the payment of tax, appropriate integrity arrangements could include maximum limits on the amount of options and/or shares that an employee may hold in the company; exclusion of particular associates of directors or significant shareholders from participation in the scheme; ESS options and shares could be subjected to minimum holding periods of 3 years; and requirements could apply to employers to report on the number of ESS interests issued under this option.

Regulatory Cost

2.62 Table 2 shows the average annual regulatory costs for this option, the 'second regulatory option'. This option would result in the same compliance costs as option 3 plus the additional compliance costs associated with the small business concessions of $1.02 million. These additional compliance costs are comprised of:

•

the total set-up costs of around $2.09 million, averaged (over ten years) at $209,000 per year; plus

•

the total ongoing compliance costs of around $785,000 per year.

2.63 This is based on the assumption that preparing reports on ESS interests would be a one-off start-up cost involving an average of 40 hours per firm. It also assumes that reporting to the ATO and the employees of the business will take an additional 15 hours per firm (per year).

2.64 A regulatory offset has been identified from within the Treasury portfolio. This offset relates to the Future of Financial Advice (FOFA) reforms.

2.65 Options 3 and 4 combined have an estimated cost to revenue of $200 million over four years.

Option 5: Provide direct funding to start-ups to reduce the cost of establishing ESSs ['a non regulatory option']

2.66 A non-regulatory option may provide benefits to start-ups offering ESSs. One non-regulatory option that has been suggested is to provide funding to start-ups to assist them with the cost of setting up an ESS. This would provide direct benefits to start-ups but would not provide any direct benefits to employees of start-ups (or employees of larger companies).

What is the likely benefit of each option?

Option 1: Maintain the status quo

2.67 A 'do nothing' option is to be considered in cases where problems may be self-corrected by market mechanisms. As the perceived problems are caused by existing legislative requirements, maintaining the status quo will not resolve the issues.

Option 2: Remove the ESS tax concessions

2.68 Removing the existing ESS tax concessions would be likely to reduce the overall attractiveness of ESSs, which would be expected to lead to a decline in their use, removing some of the broad-based benefits associated with ESS. This may have impacts for the start-up sector - some stakeholders claimed that this sector in particular relied upon ESSs to remunerate or reward their staff while ensuring capital could be retained for reinvestment in the business. As a result, many start-up companies are likely to be discouraged from doing business in Australia and may be forced to look overseas for more favourable business conditions. The flow-on impact from this could be a material loss of innovative industry in Australia. Any regulatory savings achieved will likely be outweighed by new FBT compliance costs.

Option 3: The first regulatory option

2.69 The proposal to reverse, for all companies, key changes to the taxing point for options made in 2009 while retaining the integrity provisions would delay the taxing point for most employees and improve the attractiveness of participating in an ESS relating to options, including for employees of start-ups. This proposal would address the significant concerns raised by all companies during the consultations that the incentives for using ESSs in Australia are not strong enough.

2.70 This would provide an incentive for all existing firms to utilise ESS arrangements as a form of remuneration to their employees and could entice new firms into structuring in a way that allows them to benefit from the ESS tax concessions. This change would make Australia's taxation of ESS options more competitive internationally and encourage more firms and employees to do business in Australia. There would be expected flow-on benefits from this, including job creation and increased employee productivity, company performance and innovation in the Australian economy.

2.71 This option is also attractive in that it would also avoid introducing into the law arbitrary boundaries to identify those eligible for changes to the taxing point. Many in the consultation process indicated that start-ups are difficult to define in a way that is useful in the tax law. In fact, a number of stakeholders (1 in 4 submissions) were resistant to the idea that any response be limited to just start-ups.

2.72 Retaining certain reporting requirements within this adjusted framework would minimise scope for losses to Commonwealth tax revenue through evasion or avoidance. Consultation revealed that many stakeholders (although admittedly not everyone) accept such reporting as a reasonable mechanism for tracking compliance with the law.

2.73 There are expected to be medium implementation compliance costs arising from this option. Businesses will need to learn about the changes. In particular, they may have to adhere to three different sets of rules to determine taxing points for options; these are the pre-2009 rules (for schemes established during that period and regulated by the arrangements relevant at that time), the 2009-2015 rules (for schemes set up under the existing ESS arrangements and regulated by those arrangements), and the post-2015 rules (for schemes yet to be established under any new arrangements).

2.74 However, businesses and individuals who have schemes under more than one set of rules are expected to have systems in place and be familiar with the pre-2009 rules. They may also have to develop a communication strategy to inform their employees, and make changes to their systems to track the different taxing point. However, these companies will already have the foundations for ESS.

2.75 All ongoing impacts are expected to be minor. Individuals who are offered an ESS interest after the changes are introduced will need to learn about the changes and evaluate how they may be affected.

Option 4: The second regulatory option

2.76 While option 3 would address the key concerns raised by all companies, there may be a need to provide additional concessions to start-ups in order to improve their competitiveness in an international context.

2.77 In relation to the proposed concession for start-ups, businesses will need to determine if they are eligible to qualify. Individuals will also need to learn about this change and determine if they work for an eligible start-up. These changes are expected to have medium implementation compliance costs.

2.78 This option requires the formulation of a proxy to determine eligibility for the concessional tax treatment. This can be difficult to do in a simple and objective way, particularly given that there is no one agreed definition of a start-up. It is important to note that using a simple and objective proxy is an imperfect way to target eligibility however introducing additional tests and criteria to determine eligibility will often involve increased administrative and compliance costs, which are not desirable.

2.79 It has become clear that start-ups face additional challenges in accessing ESS arrangements and many have argued that they deserve additional concessions. The concessions under this option would provide an incentive for eligible firms to offer ESS to their employees and is expected to translate into a higher utilisation of ESS in Australia. This would allow employers to maintain more cash in the firm for the development of the business and provide employees with a financial interest in the success of the company.

2.80 This concession will make Australia's tax arrangements for start-up firms more competitive when compared with our major trading partners, and encourage both new and existing firms to develop business ideas domestically. The flow-on benefits from this concession could be substantial and result in a more innovative and productive Australian economy. Innovation is important in Australia to improve living standards and contribute to economic growth.

2.81 Ongoing compliance costs are expected to be low. Start-ups with an ESS will need to indicate via their reports to the Australian Taxation Office whether they are a start-up. An individual with shares from an ESS and who is employed by an unlisted start-up that utilises this concession may need to complete additional labels on the individual income tax return.

Option 5: Provide direct funding to start-ups to reduce the cost of establishing ESSs

2.82 Providing funding to start-ups to implement ESSs would not address the cash flow problems that employees face in paying tax on discounts received before they are able to find the cash to pay that tax. This option would reduce the costs to start-ups of setting up an ESS but would not by itself increase the popularity of ESSs with their employees. This is because direct funding to start-ups does not change the taxing point, which is the key concern of these companies.

2.83 This proposal should not give rise to any additional compliance costs, as no changes in regulation would occur. Companies that chose to implement a new ESS, thus incurring additional costs of implementation and ongoing administration, would be provided with funding for their expenses incurred. However, their employees would continue to pay tax on their ESS interests in the year of acquisition (unless there is a real risk of forfeiture).

Summary

2.84 For both options 3 and 4, the benefits to companies and their employees of more concessional tax treatment of ESSs are expected to outweigh additional compliance costs on businesses and employees flowing from those changes. Implementing options 3 and 4 would be expected to address the main concerns raised by stakeholders since the 2009 amendments, including the problematic taxing point for ESS options and the additional difficulties faced by start-up companies.

Consultation

2.85 The Government announced on 21 January 2014 that it would commence direct consultations with interested stakeholders in relation to the existing ESS arrangements for start-ups.

2.86 During these consultations, stakeholders expressed concern that the current arrangements for ESS in Australia are complex, costly and create a barrier or disincentive for many start-ups to set up an ESS; so much so that start-up companies, like larger and more established corporations, often need to seek legal, financial and accounting advice to establish an ESS.

2.87 These arrangements put Australian start-ups at a competitive disadvantage in international markets, by making it harder for start-ups to attract and retain the skilled employees needed to grow the company (who generally tend to consider work opportunities offered within a global marketplace).

2.88 The purpose of stakeholder consultation on the taxation of ESSs, which was undertaken in January and February 2014 (and referred to earlier in this RIS), was to better understand the impacts of the current rules for ESSs on start-ups. An open invitation was placed on the Treasury website inviting stakeholders to nominate to participate in that consultation process^[9], meaning that consultation was not necessarily restricted to the start-up community. This invitation was subsequently forwarded to known stakeholders, both from the start-up and tax advising community.

2.89 Face-to-face and teleconference roundtable meetings were held with around 90 individual stakeholders in total. There were 57 submissions received from stakeholders, in addition to the 18 submissions that had been received in response to the previous government's discussion paper. The key issues identified in that consultation process have been noted earlier, under Question 1: What is the problem you are trying to solve?

2.90 There is consensus from submissions that the current tax rules impede the use of ESS in Australia and that this provides a deterrent to attracting and retaining the internationally-mobile staff that they need to grow their business, with flow-on impacts for decisions to commence and retain operations in Australia; that the costs of setting up ESSs for start-ups are very high and that any solutions adopted should therefore seek to minimise costs and keep complexity to a minimum; and that it is expensive and conceptually difficult to determine the market value of start-ups (or unlisted companies more generally) for the purpose of valuing employees' interests in ESSs. However, there was no consensus about a range of matters, including those most deserving of assistance or concessions, and any method for identifying such a group.

2.91 On 14 October 2014, as part of the Industry Innovation and Competitiveness Agenda, the Government announced that it will improve the taxation arrangements for ESS, to make Australia's tax system more competitive by international standards and allow innovative Australian firms to attract and retain high-quality employees in the international labour market.

2.92 Firstly, employees (of all companies) who are issued with options will generally be able to defer tax until they exercise the options (convert the options to shares), rather than having to pay tax when they receive the options.

2.93 Secondly, eligible start-ups will be able to issue options or shares to their employees at a small discount, and have that discount exempt (for shares) or further deferred (for options) from tax. Criteria will be applied to define eligible start-ups, including turnover of not more than $50 million, being unlisted and being incorporated for less than 10 years. There will also be a minimum three-year holding period for employees to be eligible for this concession.

2.94 The Government's policy also includes increasing the maximum time for tax deferral (for tax deferred ESS interests) from 7 years to 15 years and doubling the maximum individual ownership limit from 5 per cent to 10 per cent of a company.

2.95 Since the announcement, Treasury has met with industry stakeholders on a range of issues. In general, the announcement has been well received by industry, who have been aware of the problems with the tax arrangements of ESS for some years now. There have been some concerns, mainly around the eligibility conditions for the start-up concession. The eligibility criteria were chosen to provide targeted assistance to start-ups, while avoiding complexity and not opening it up to all companies, which would come at a significant cost to Government revenue.

2.96 Draft legislation, regulations and explanatory material to enact the Government's announced amendments were released and consultations were held on this material. As part of the consultation process, Treasury and the ATO held a series of targeted consultation meetings with industry stakeholders to ensure that the draft legislative materials achieve the policy intent of the Government's announced policy.

2.97 The consultation meetings indicated that the draft legislation is on track to deliver the Government's announced policy. That said, there were a number of policy issues raised, with some stakeholders seeking Government decisions to extend the eligibility for the start-up concession to capture biotech and other companies that don't meet the eligibility criteria. Some stakeholders believe that the concession should not exclude listed companies or firms that have been incorporated for more than 10 years. In addition to this, some stakeholders sought additional concessions for employees engaged in ESS arrangements. However, these policy issues would likely come at an additional cost to Government revenue, which may be difficult to achieve in the current budget environment.

2.98 In consultations, stakeholders sought to clarify some operational aspects of the legislation that may have resulted in unintended consequences. These queries related to the 50 per cent capital gains tax (CGT) discount for assets held for more than 12 months and the application of the eligibility criteria (for the start-up concession) to investments by venture capital funds. Following these queries, the Government has clarified that:

•

the 50 per cent CGT discount will generally be available to options issued under the start-up concession where the options have been held for at least 12 months but the resulting shares are sold within 12 months of exercise; and

•

certain investments by venture capital funds in start-ups will be excluded from the aggregate turnover and other grouping tests when determining eligibility for the start-up concession.

2.99 Treasury has been involved in discussions with the ATO and ASIC in relation to the development of standard documents and the updating of the safe harbour valuation tables. The ATO are running separate consultations with industry to develop standard documents and update the safe harbour valuations.

2.100 The compliance cost estimates that were presented in the early assessment regulation impact statement (RIS) have been updated to reflect a change in methodology by the Office of Best Practice Regulation (OBPR). OBPR have advised that a new hourly labour rate should be used, which slightly decreased the compliance cost estimates of this proposal. No further changes were made to the compliance cost estimates. The information and assumptions used in estimating the compliance costs are still up-to-date. The consultations that have occurred since the release of the early assessment RIS provided the opportunity for stakeholders to comment on the compliance cost estimates, however no issues were raised with these figures.

2.101 The early assessment RIS was finalised following the Government's announcement in October 2014, and uploaded onto OBPR's website on 15 January 2015.

Conclusion

Recommended option

2.102 Consultation made it very clear that there was no one agreed view regarding how to define the target group for which any additional assistance or concessions could be provided. Further, it became clear that it was unlikely that any one single policy response would address all identified concerns. Indeed, even start-up companies themselves, at different stages of development, did not necessarily agree a single outcome.

2.103 However, there was a very strong view put that the 2009-10 changes to taxing points for ESS interests had impacted on the decisions of parties to offer ESSs (particularly those relating to options) to their employees.

2.104 Options 3 and 4 are the preferred options as they address the majority of concerns raised by stakeholders. The sum of these two options is the Government's announced policy. Notably, this policy would address the problematic taxing point for options for all companies. For eligible startups, an additional concession will be offered, which will assist them in developing their businesses in Australia.

2.105 While there have been some concerns raised by stakeholders in relation to the Government's announced policy, most of the suggested amendments would come at a further cost to revenue. In the current Budget environment, it would be difficult to provide additional concessions, given the associated cost to Government revenue.

2.106 ESS tax concessions are designed to promote the use of ESS because of the positive benefits that can arise out of ESS arrangements. Many of these benefits arise as a result of the alignment of interests between employees and their employer. ESS tax concessions should be designed to complement other forms of targeted government assistance -small businesses and entrepreneurs also receive other forms of government assistance including the Entrepreneurs Infrastructure Programme, the R&D tax concession and the small business CGT exemption.

Implementation

2.107 The legislation to implement the Government's announced policy will be considered in light of feedback from the consultation process.

2.108 Some stakeholders have put forward very strong views that early commencement of policy options is desirable, however others have suggested that a delayed start date would be acceptable if it would result in a better policy outcome.

2.109 The Government intends to bring the changes into effect for shares and options issued from 1 July 2015. To facilitate this timeline, the legislation is currently scheduled to be introduced into Parliament in the autumn sitting of 2015.

2.110 The ATO are working to develop and approve standardised documentation for use by companies to reduce the amount of 'red tape' and streamline the establishment and administration of ESSs.

2.111 The effectiveness of the selected proposal in meeting the objective of increasing growth in the start-up sector will be measured by the change in take-up of ESSs among small to medium sized business entities (SME) over the coming years. This proposal may also lead to an increased number of SMEs. Such metrics could be examined in a subsequent review. It is proposed to undertake such a review of the new arrangements after five years from the date of commencement of the legislation, to examine whether the arrangements have achieved their objectives. In addition to considering those objectives, this could also include examination of the extent to which the legislation:

•

gives effect to the Government's policy intent, with compliance and administrative costs commensurate with those foreshadowed in the Regulation Impact Statement for this proposal;

•

is expressed in a clear, simple, comprehensible and workable manner;

•

avoids unintended consequences of a substantive nature;

•

takes account of actual taxpayer circumstances and commercial practices;

•

is consistent with other tax legislation; and

•

provides certainty.

2.112 Industry feedback on these amendments will be a good barometer of the success of the policy, particularly in relation to the measures that the ATO are progressing to streamline the process of establishing and maintaining an ESS.

Chapter 3 - Statement of Compatibility with Human Rights

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Improvements to the taxation of employee share schemes

3.1 This Schedule is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011.

Overview

3.2 Schedule 1 to this Bill amends the Income Tax Assessment Act 1997 to improve the taxation of employee shares schemes by:

•

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

•

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

•

supporting the Australian Taxation Office 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 employee share scheme.

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

Human rights implications

3.4 This Schedule does not engage any of the applicable rights or freedoms.

Conclusion

3.5 This Schedule is compatible with human rights as it does not raise any human rights issues.

Index

Schedule 1: Improvements to taxation of employee share schemes