Employee stock options tax treatment and tax issues
This paper by Partner Sarah Bernhardt discusses a number of current and emerging issues in relation to employee option plans. We all know that 'remuneration' income is taxed at marginal rates of tax, whereas only 50 percent of 'capital gains' made by individuals are taxed at marginal rates of tax, provided the 12 month holding period rule is satisfied.
The question then is, are gains on employee options characterised as remuneration income or capital gains? Division 13A of the Income Tax Assessment Act all future statutory references will be to this Division, unless otherwise stated has the effect of treating any 'discount' on the grant of employee options as remuneration income which is taxed at marginal rates of tax.
However, Division 13A generally provides an employee with a choice of whether to pay tax on this 'discount' in the year that the options are granted up-front tax method or to defer the taxing time, generally until the year the options are exercised deferred tax method.
Importantly, the calculation, timing and characterisation of an employee's tax liability can differ depending on which of these methods is used. Under the up-front tax method an employee pays the tax liability on the 'discount' on the grant of options in the year the options are granted. The 'discount' on the grant of options is generally calculated pursuant to tables contained in the Tax Act which have employee stock options tax treatment and tax issues to the deemed market value of the shares at the time the options are granted, the exercise price of the options, the maximum life of the options and any consideration paid for the grant of the options.
I will talk some more about how options are valued for tax purposes later in this paper. For present purposes, all I need you to note is that options are likely to have a deemed taxable value even if the exercise price of the options is equal to the employee stock options tax treatment and tax issues value of the shares at the time the options are granted.
If the up-front tax method is used, no further tax would generally be payable on the options until the sale of shares acquired on exercise of the options, at which time capital gains tax would apply.
Only 50 percent of the gain would be required to be included in income provided the employee had held the shares for at least 12 months. The deferred tax method generally allows an employee to postpone any tax liability on the options until the earlier of the time when:.
The amount that is subject to tax when the deferral ceases is calculated by reference to the market value of the shares at that time, rather than by reference to the market value of the shares at the time the options were granted. This amount is taxed as remuneration income, not a capital gain, and therefore the 50 percent CGT discount does not apply. Thus, a consequence of claiming the deferral concession on options is that any increase in the value of the options until the deferral ceases is fully taxed without the 50 percent CGT discount applying.
If the employee then chooses to continue to hold the shares after the options are exercised, capital gains tax will also apply to the later disposal of those shares. However, in order to avoid double taxation, the employee is deemed to have an up-lift in their cost base of the shares to take into account that tax will have already been paid on some of the gain made on the options.
The possible differences between the up-front and deferred tax methods are best shown by way of an example calculation. It is important to note that this benefit only arises if the shares acquired on exercise of the options are held for at least 12 months after exercise. Further, as this benefit only arises if the up-front tax method is used, the benefit needs to be weighed against the cash flow costs of paying tax on the options in the year of grant.
As the shares acquired on exercise of the options are not held for at least 12 months after the options are exercised, the same net gain is made regardless of which tax method is used. This would generally mean that it would be more advantageous to use the deferred tax method as there would then employee stock options tax treatment and tax issues be the cash flow costs of paying tax in the year the options are granted.
As indicated in the above example, the main differences between the two tax methods are the year in which tax is payable and the characterisation of the gain as ordinary income or a employee stock options tax treatment and tax issues gain.
Whether an employee will be better off using the up-front tax method or the deferred tax method will depend on many factors, including:. Unfortunately an employee is generally required to make a choice between the tax methods by the time they lodge their tax return for the year in which the options are granted, notwithstanding the fact that the majority of the above factors will not be known to an employee for some significant time after that.
Generally, the only things about the choice of tax method that can be said to an employee with any certainty are as follows. My experience to date has indicated that, despite the recent introduction of the 50 percent CGT discount, most option recipients still tend to use the deferred tax method, with the possible employee stock options tax treatment and tax issues of options where the taxable value is relatively low generally as a result of the exercise price being at a premium to the market value of the shares at the time of grantor where there is a possibility of 'blue sky' in the share price eg, start ups.
This is particularly so where the exercise of the options is subject to the satisfaction of performance conditions. No doubt this is due to the fact that most Australian employees tend to take the view that they would prefer a definite tax deferral rather than a cash flow cost of paying some tax now that may or may not result in a tax advantage to them in the future.
In this paper to date I have been assuming that an option recipient will generally have a choice between the two tax methods. However, if the options are not in fact 'qualifying rights' under Division 13A, then the taxpayer will be required to use the up-front tax method.
So lets now look at the pre-requisites for options to be 'qualifying rights'. First, the option must be acquired under an employee share scheme section CD 2. The satisfaction of this condition is often a 'no brainer' as all it generally requires is that the option be acquired in respect of employment or services provided by the taxpayer or an associate of the taxpayer section C. The main circumstances where I have seen this definition being an issue in practice are where the employee has paid market value consideration for the shares or options refer section C 3or where there is some question as to why an employee may have received options.
I will consider this issue in more detail when I look at the possible tax implications of replacing out of the money options. The second condition is that the company in which the taxpayer has an option to acquire a share must be the employer of the taxpayer or the holding company of the employer section CD 3.
This means that up-front tax will automatically apply if, for example:. The third condition is that the options must be options to acquire ordinary shares section CD 4but there is no definition of employee stock options tax treatment and tax issues is meant by 'ordinary'. This is rarely an issue in an Australian public company context, but can sometimes be problematic where you are dealing with options in an overseas company that does not have a similar concept to 'ordinary shares'.
The last two conditions are that the employee must not hold a legal or beneficial interest in more than 5 percent of the shares in the company 5 percent holding test nor must they be in the position to cast or control the casting of more than 5 percent of the maximum number of votes that may be cast at a general meeting employee stock options tax treatment and tax issues percent voting test section CD 6 and 7.
These tests are done at the time the options or shares are acquired. In the employee stock options tax treatment and tax issues of shares, it is clear whether the tests will be breached. For example, if an employee already has 3 percent of the shares in the employer and acquires a further 3 percent shares, the tests will be breached. However what about the situation where an employee already has 3 percent of the shares in the employer and is offered options to acquire a further 3 percent of the shares?
It is clear that the 5 percent holding test will not be breached in this case. However, it is not as clear whether the 5 percent voting test will be breached. If there are no pre-conditions to be satisfied to exercise the rights ie the rights are 'vested' from the outsetthe employee may be considered to be in a position immediately after acquiring the options to cast more than 5 percent of the votes by exercising the options, and therefore be in breach of the 5 percent voting test.
If, on the other hand, there are vesting conditions to be satisfied before the options can be exercised it seems likely that the 5 percent voting test would not be breached. The last thing to note about the qualifying conditions is that, unlike shares, 'qualifying rights' do not have to satisfy the 75 percent offer test which requires that at least 75 percent of the permanent employees must be, or have been, entitled to acquire shares or rights in the employer at a discount.
This can lead to some interesting opportunities to design plans which allow a select group of employees to acquire interests in an employer company without the need for the company to have offered its shares at a employee stock options tax treatment and tax issues to its general employees.
Interestingly, Division 13A allows a continued tax deferral on such shares post vesting, provided the shares are subject to certain restrictions, notwithstanding the fact that such a deferral would not have been available if the shares were originally acquired without first acquiring a right to acquire such shares.
I mentioned earlier that the 'discount' on the grant of options is generally calculated pursuant to tables contained in the Tax Act which have regard to the deemed market value of the shares at the time the options are granted, the exercise price of the options, the maximum life of the options and any consideration paid for the grant of the options.
It is these tables that tell us, for example, that an option with an exercise price equal to the market value of the share at the time the option is acquired, and a maximum 5 year life, has a deemed taxable value of I understand that these tables are based on an economic model for valuing options which attempts to value the 'inherent' benefit in options being effectively like a limited recourse interest free loan.
Some of the practical issues I have encountered with these valuation rules employee stock options tax treatment and tax issues the following. An employee will acquire a 'right to acquire shares' under Division 13A when another person creates that right employee stock options tax treatment and tax issues them section G. Generally, an offer of options would only create a right to accept an offer of a right to acquire shares, rather than creating a right to acquire shares Fraunschiel v FCT 89 ATC Thus, where you are dealing with a more traditional Australian option plan that envisages the employer making an offer of options to the employees, the employees accepting that offer, being followed by the actual grant of the options by the company, there employee stock options tax treatment and tax issues be an issue as to whether an employee may in fact acquire a 'right to acquire shares' at the time they accept the offer, rather than the later date that the options are actually granted.
If this was correct, and employees accepted the offer on different days, they could potentially have different taxable values of their options depending on the share price movements around the acceptance time. In practice, one possible way around this issue would be for the option plan documentation to make it clear that, notwithstanding an acceptance of an offer, an employee would have no right to acquire shares until such time as the options are actually granted.
If, instead of the more normal offer and acceptance process, employees are just told that they have been granted options which can occur with certain US based employee option plansthen this could be seen as analogous to a gift. The likely implication of this is that the employee could dissent to the gift but, if they choose not to dissent, they are arguable treated as having acquired the options at the earlier date the options were granted, notwithstanding employee stock options tax treatment and tax issues fact that they may not have known they have been granted the options until a later time FCT v Cornell 73 CLR at An employee may pay tax on their options without their options ever having been transferred or exercised.
This could occur, for example, where the employee has used the up-front tax method, or they have used the deferred tax method but have had a 'cessation event' under that method other than a transfer or exercise of the options eg termination of employment, where the options don't lapse on termination. In these circumstances, if the options later lapse, section DD provides for an ability to claim a refund of tax paid on the options regardless of the statutory time limits that normally employee stock options tax treatment and tax issues amendments if the following conditions are satisfied.
This could occur, for example, if the options lapse as a result of non-satisfaction of performance conditions, or if the employee allows the options to lapse at the end of their term because, for example, the exercise price is greater than the market price of the shares at that time.
However, it would be unlikely to occur where, for example, the options were cancelled for consideration. The time at which this second requirement must be satisfied is unclear.
There are at least 2 possibilities:. In my view, the first possibility is the better view. Otherwise, an employee who leaves their employment and loses their options later would be unable to amend their return because at the time that they 'lose' the option, the company is no longer their employer. It is important to note that this second requirement means that the refund rules are not available to an employee whose options are granted to an associate, or to an employee who has transferred their options after grant.
This is notwithstanding the fact that the employee will have been taxed on those options under Division 13A, in the first case — in the year the options were granted and, in the second case — in the year the options were transferred. This means that, if there is a risk that the options may not be exercised, it would generally be preferable for the options to stay in the name of the employee, rather than being granted or transferred to an associate.
As I outlined at the beginning of this employee stock options tax treatment and tax issues, any 'discount' on the acquisition of employee options is going to be taxed to the employee as remuneration income, without the 50 percent CGT discount applying. However, if an employee were to accept up-front tax on their options for example, because they expected that the future increase in the value of the underlying shares would be significantly greater than the deemed taxable value of the optionshow could the employee ensure that they are entitled to claim the 50 percent CGT discount on the increase in the value of the shares over the deemed taxable value of the options?
I mentioned earlier that, if it is unlikely that an employee will be able to access the 50 percent CGT discount in the future, then the deferred tax employee stock options tax treatment and tax issues is most likely to be the preferred route.
I also mentioned that, if the options are non-transferable, then the employee is only likely to be able to access the 50 percent CGT concession in the future if they are prepared to hold the shares for at least 12 months after the options are exercised. This is because the relevant asset that is being disposed of would be the shares, not the options, and the likely acquisition date of those shares for CGT purposes would be when the options are exercised and the shares issued see Item 2 of section of the ITAA and TD16 and I understand that there may be some advisers who take the view that the shares are possibly acquired for CGT purposes at some time prior employee stock options tax treatment and tax issues the time when the options are exercised, but I am not sure of the technical basis for such an argument.
Maybe it has something to do with the fact that section arguably only applies where employee stock options tax treatment and tax issues asset is acquired other than as a result of a CGT Event, whereas shares acquired on exercise of options could be seen as being acquired a result of CGT Event C2 happening to the options.
Of course, holding the shares for at least 12 months after exercise of the options would generally involve an employee being required to fund the exercise price of the shares for that 12 month period.
A possible way around this practical problem would be if the options employee stock options tax treatment and tax issues transferable. This is because the 50 percent CGT discount should then be able to be accessed by disposing of the options, provided the options have been held for at least 12 months. The issue then becomes whether employee option plan rules should be allowing for options to be transferred? If you were drafting new employee option plan rules then, in my view, it would be prudent to at least allow the flexibility for the options to be transferred, even if only in limited circumstances.
Apart from the possibility that this may then enable an employee who has elected for up-front tax on their options to access the 50 percent CGT discount in the future without having to hold the shares for 12 months after the exercise of the options, such a clause could also have the commercial advantages of allowing an employee to cash in on the increase in the value of their options without having to fund the exercise price, and also allow employees who want to hold the underlying shares in an associated entity's name eg, for asset protection reasons to have the shares actually issued directly to the associated entity without the need for possible brokerage costs in transferring the shares from the employee to the entity, following exercise of the options.
The following issues should be considered in the context of drafting option plan rules to provide the flexibility for the transferability of options. Generally, the deferred tax method automatically applies unless the employee elects to use the up-front tax method Tax Election. It is important to remember however that a Tax Election would apply to both employee shares and options from any employer acquired in the same tax year — ie it is not possible to make a Employee stock options tax treatment and tax issues Election that will only apply to the acquisition of one employee stock options tax treatment and tax issues the other.
As no doubt you know, exempt share plans are often designed to take advantage of a limited tax exemption on the acquisition of shares which is only available to employees who elect for up-front tax to apply. In my experience, it is not uncommon to see the application form for participation in such a plan to include an automatic election for up-front tax. This is presumably done on the grounds that the majority of participants in such plans are often 'blue collar' workers who may forget to make the requisite tax election unless it is included as part of the application form.
However, if the company allows all employees to participate in such a plan, notwithstanding that some of those employees may have received employee options or deferred employee shares in the same tax year as they have participated in the exempt share plan, then it will be critical for the company to adequately communicate to such employees, before they lodge their tax return for the year the shares and options are acquired, that they may want to revoke the tax election that was included in the application form for participation in the exempt share plan.
Of course this often employee stock options tax treatment and tax issues the follow on administrative complications of ensuring that such employees remember that they will employee stock options tax treatment and tax issues required to pay tax on their exempt plan shares in the year that the restrictions on disposal of those shares cease to apply generally 3 years from acquisition.
It is for these reasons that employers should seriously consider whether it might be advisable to exclude option or deferred share plan participants from participating in an exempt share plan in the same tax year in which they have received options or deferred shares, especially if the exempt share plan is operated on a salary sacrifice basis, rather than just a freebie.
However, if this were to be done, care would need to be taken to ensure that the company still satisfied the 75 percent offer test that is a pre-requisite for the tax exemption being available to other recipients in the exempt share plan.