Employee share option plans (ESOP) usually have deferred taxation.
Employee Share Option Plans
Employee Share Schemes consist of two types: ESPs – Employee Share Plans and ESOPs – Employee Share Option Plans.
In the last episode – episode 421 – we discussed employee share plans (ESPs) where you receive shares and pay upfront taxes.
In this episode, Rajan Verma from Velocity Legal in Melbourne will discuss employee share option plans (ESOPs) with you.
Here is what we learned but please listen in as Rajan explains all this much better than we ever could.
To listen while you drive, walk or work, just access the episode through a free podcast app on your mobile phone.
Employee Share Option Plans
Employee Share Option Plans – or ESOPs – give you an option to receive a share. That option might vest in the future, or it might not. Hence, taxation occurs only at the vesting point. Or in other words: The taxation point is at the point of vesting.
Why ESOPs
ESOPs can be useful if the company wants to use the plan to encourage employees to stick around for a few years, or attach KPIs to the right to boost performance.
In practice, ESPs are more common for larger public companies that offer small parcels of shares to all their staff routinely. ESOPs make more sense for selective issues to senior management, particularly in the SME space.
Taxation
The same basic rules apply as for Employee Share Plans (ESPs). You start with an ‘all-in’ approach. That is the default mode.
And then you look for a modification. The big modification for ESOPs is that the right to the share hasn’t vested yet.
If there’s a real risk that the employee might lose the option (for example, if KPIs aren’t met), deferred taxation typically applies to the ESOP.
Availability
An ESP needs broad availability to qualify for the AUD 1,000 concession. 75% of permanent employees with 3 years’ tenure need to receive the shares to qualify.
But this doesn’t apply to options. For ESOPs there are no requirements around who gets an ESOP.
The start-up concession is available for ESOPs and doesn’t require 75% availability. So, for selective issuance to management, opt for options to defer taxation and utilize startup concessions.
Issues for both ESPs and ESOPs
There are five issues both ESPs and ESOPs face:
1 – Working out the discount
Working out the discount is easy for publicly listed shares, but much more difficult for SMEs.
The law includes a complex calculation table for valuing options under an ESOP. But you still need to know what the underlying share is worth.
You can alleviate this by utilizing the start-up concession and adopting a net tangible asset approach. However, if start-up concessions aren’t an option, a costly business valuation may be necessary.
2 – Implementation
For both ESPs and ESOPs you need to develop plan rules and documentation. That can be costly to prepare, although the ATO has some standard documentation that might assist.
Have a shareholders agreement that binds the employee shareholders. And clarify what happens to the shares and options when employees leave the company.
3 – Tracking
You have to actively track outstanding options and Key Performance Indicators (KPIs) if you issue an ESOP.
And once somebody becomes a shareholder, you need to track their details and holdings like as you do for any other shareholder.
4 – Minority Rights
Once employees become shareholders, they have rights. Even if they are just a small minority. The minority oppression rights in the Corporations Act 2001 protect minority shareholders. So the ESS might affect the management of the company.
Alternatives
While ESPs and ESOPs can be useful, the ESS rules are complex. There are two alternatives:
A – Phantom Equity Plan
A phantom equity plan or bonus plan calculates bonuses based on business profitability, paying participants as if they own equity. These bonuses are treated like regular salary, easily terminated if the employee leaves the business.
B – Loan Funding
ESS rules only apply if shares or options are issued at a discount. You can avoid having a discount by providing a loan to employees to enable them to purchase shares in the company for value. But this only works for the very first issue while the employee is not a shareholder yet and hence Div 7A doesn’t apply yet.
Closing Comment
Get tax advice before you announce an Employee Share Plan (ESP) or an Employee Share Option Plan (ESOP).
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Disclaimer: Tax Talks does not provide financial or tax advice. All information on Tax Talks is of a general nature only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.