Review of employee share schemes for start-up companies
The discussion paper is entitled "Employee Share Schemes and Start-up Companies: Administrative and Taxation Arrangements" ("Paper"). It was released as part of the work that the Federal Government committed to under "A Plan for Australian Jobs: The Australian Government's Industry and Innovation Statement".
The review as outlined in the Paper is being undertaken in light of concerns that the current tax, legal and administrative arrangements for ESS in Australia are complex, costly and create a disincentive for many start-up companies to establish an ESS. This is the first major review to be undertaken in relation to ESS since the tax reforms introduced in 2009, which introduced new tests for accessing concessional tax treatment and new reporting requirements.
Companies often need to seek legal, financial and accounting advice to establish an ESS, and together with ongoing operational and administration costs, this can make an ESS unaffordable for many start-up companies. Those companies are typically cash-poor but are keen to make non-cash benefits, such as interests under an ESS, available to their employees.
In a globally competitive labour market, it is perceived that this puts Australian start-up companies at a competitive disadvantage by hampering their ability to attract and retain skilled and experienced employees.
The Paper discusses various potential reforms for addressing the problems faced by start-up companies in establishing ESS. These potential reforms include introducing:
- a definition of "start-up company"; and
- concessional tax treatment for ESS interests held by employees of start-up companies.
The Federal Government has made it clear that it is not looking to make general changes to the ESS arrangements or looking to extend any of the above reforms to unlisted companies more generally.
Proposed definition of a start-up company
The Paper acknowledges that while there is a general acceptance of the characteristics of a start-up company, there is no current legal definition.
The Paper proposes that a "start-up company" be defined as a company which:
- has 15 employees or fewer
- has an aggregated turnover of less than $5 million and is not a subsidiary, owned or controlled by another corporation
- has been in existence for up to five, or perhaps seven years
- is not undertaking an excluded activity (which may include, for example, property development, finance, insurance, construction, mining exploration and agriculture), or is providing new products, processes or services based on the development and commercialisation of intellectual property
- is unlisted, and
- has the majority of its employees and assets in Australia.
It is proposed that employees of start-up companies that meet this definition would receive tax concessions on any ESS interests granted to them while their employer falls within the definition, even if the start-up company subsequently "grows" out of the proposed definition. The Paper also suggests that there could be a process by which a company can apply to a Federal Government body to determine whether it meets the above definition.
Concessional ESS tax treatment alternatives
Generally, where certain conditions are met, employees that acquire shares, options or other forms of equity under an ESS are taxed (at marginal income tax rates) on any difference (or "discount") between any amount paid by the employee to acquire those shares or options, and the market value of those shares or options at a particular point in time. Under current tax laws, that point in time is the moment the employee acquires the shares or options, unless certain conditions are met which allow for that taxing point to be deferred.
In very general terms, the proposed alternatives for taxing interests acquired under an ESS offered by a start-up company are to:
- defer the taxing point – the discount would be calculated and taxed at the earliest of when the employee exercises an option, cessation of employment, or 7 years after the shares or options were acquired. Under this alternative there would be no $1,000 tax-free concession applicable as the taxing may be deferred for a significant period of time
- defer the payment of tax – the discount would be calculated and taxed at the time of acquisition, but the tax would only be payable when the share is sold or the option is exercised. Under this alternative an employee would not be required to pay tax if an option is not exercised or the share is not sold. Further, there would be no $1,000 tax-free concession applicable as the taxing may be deferred for a significant period of time
- lower the tax rate applicable to the discount – the discount would be calculated and taxed at the time of acquisition, but would be taxed at a discounted rate, perhaps 15%, with potential for a $1,000 tax-free concession also to apply, or
- increase the available tax concession – currently, employees can receive a tax-free discount (calculated at acquisition) of up to $1,000 each year (subject to other eligibility criteria), and it is proposed that this could be increased to $5,000 for employees of start-up companies.
The perceived advantages, and disadvantages, of each alternative differ for each group of stakeholders.
The main concern for employees receiving interests under an ESS is to not have tax payable before they have realised the value of their shares, that is, when they have sold them or had an opportunity to sell them.
Employers that are start-up companies also share this concern, to ensure that their employees can be effectively incentivised through an ESS, but those companies are also interested in reducing the need to engage financial experts to conduct costly share valuations at a time when they are cash-poor.
The Federal Government has broader concerns, including:
- the effect of the different alternatives on tax revenue
- the ease with which each alternative can be administered by the Australian Taxation Office
- the integrity of the tax concessions (that is, how easy it will be for companies to organise or re-organise their affairs in order to access the tax concessions), and
- moving towards its overall goal of reducing the cost and complexity of ESS arrangements for start-up companies to help make them more competitive.
Other potential reforms explored in the Paper
The Paper also explores the following areas of potential reform:
- simplifying the valuation methods used to determine the market value of unlisted securities issued under an ESS – these would be aimed at reducing the costs and complexities associated with existing valuation methods, and
- reducing ESS design and implementation costs and complexities by examining whether standardised documents or templates could be developed for basic ESS. It is recognised in the Paper that some steps had been previously taken by the Federal Government to introduce standardised documentation, but that there had been little use of those standard documents in the past.
Securities law issues and start-up companies
The Paper recognises that tax is only one consideration when establishing an ESS. Another important consideration is compliance with securities laws, including the disclosure requirements in the Corporations Act 2001 (Cth) ("Act").
As an ESS involves the offer of a financial product, the company making the offer must meet the disclosure requirements in the Act, which may include issuing a prospectus document, unless:
- the offer falls within certain exemptions within the Act, such as the "small scale offerings" or "senior manager" exemptions, or, if this is not possible
- the offer falls within the relief provided by the Australian Securities and Investments Commission's ("ASIC") Class Order 03/184.
Start-up companies that want to make offers under an ESS are unlikely to be able to rely on the relief within Class Order 03/184, which only provides limited relief for unlisted entities. On this point, the Paper indicates that ASIC is currently reviewing ASIC Class Order 03/184 with a view to consulting about whether the scope of relief available to unlisted entities, such as start-up companies, should be broadened.
However, if the definition of a start-up company that is ultimately introduced includes a requirement that such a company employ 15 or less employees, then companies that fall within that definition will almost always be able to rely on the "small scale offerings" exemption within the Act in the first instance, and may not need to consider whether relief can be accessed under Class Order 03/184.
So what's next?
Submissions on the various tax concession alternatives and other issues raised in the Paper are currently being accepted by the Federal Treasury, but the closing date for submissions is not yet known.
After submissions have been received, Federal Treasury officials will meet with stakeholders with a view to reporting back to the Federal Government on the outcome of consultations and the review by December 2013.
What should start-ups do?
Start-up companies should consider having their say on the Paper's discussion topics by making a submission to the Federal Treasury, and if interested, indicating in their submission that they are willing to participate in the consultation that is to take place later this year.
Whether any change in the Federal Government after the Federal election has any impact on this process is unknown.
In light of this, start-up companies should keep an eye on developments in this area.
ESS disclosure requirements in the ASX Listing Rules
At the other end of the spectrum, a proposed new ASX Listing Rule will increase the disclosure requirements for ASX listed companies that purchase securities on behalf of their directors.
ASX Listing Rule 10.14 generally requires shareholder approval to be obtained by a listed company before a director can acquire securities under an employee incentive scheme. However, no shareholder approval is required if the securities are purchased on-market under the terms of an employee incentive scheme that provides for such purchases.
The exemption to ASX Listing Rule 10.14 can enable listed companies to buy shares for their executives without the requirement to make a timely disclosure of the details of any such acquisition or to seek shareholder approval prior to any purchase.
Those shares, along with other remuneration details, must later be disclosed as part of the company's remuneration report. That report is subject to a non-binding shareholder vote at the company's annual general meeting, and a significant "no vote" can start a company down the path of a potential spill of its board of directors.
In summary, the proposed new ASX Listing Rule 3.19B will require a listed company to disclose any purchases which fall within the exemption to ASX Listing Rule 10.14, namely on-market purchases of securities on behalf of directors under an employee incentive scheme.
Within five business days after the purchase, the company will need to provide the ASX with certain information, including:
- the total number of securities purchased
- the average price per security, and
- the name of the director (or any related party) on behalf of whom the securities were purchased.
This proposed new disclosure requirement is expected to take effect from 1 January 2014.
What should listed companies do?
ASX listed companies should make sure they are aware of the purposed change and stay alert for confirmation that the change will come into effect on 1 January 2014.
In the lead up to then, listed companies should review and make any necessary adjustments to their corporate governance practices to ensure they are ready to fully comply.
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