By Michael Kohn and Lesley Naik*

Each year the average Australian worker will purchase shares in companies that they may know little or nothing about through the government’s compulsory superannuation scheme.

To be successful, direct investment in company shares usually requires knowledge of the company’s historic performance, growth potential and strategic direction.

An Employee Share Scheme (ESS) provides workers with an opportunity to make an informed decision about investing in a capital growth asset while continuing to benefit from the security of receiving a salary as an employee.

From an employer perspective, providing employees with a direct financial interest in the company can align the interests of the parties more closely and act as a strong motivator for employees to go above and beyond their position descriptions.

There is also an economic incentive for employers to use an ESS because the benefit is taxed in the hands of employees and is neutral to the Fringe Benefits Tax (FBT) liability of employers.

Employers may also be eligible for up to $1000 deduction per employee who participates in the ESS.

Once the decision has been made to issue shares in the business (or more specially, the company that operates the business) to employees, the employer should design the ESS by deciding the type of ESS interest and scheme. It is also good practice to provide employees with basic education about the main features of the ESS.

Secondly, the employer should review the ESS for compliance with the statutory conditions relevant to the applicable ESS.

Finally, the employer will be required to remit tax according to the rules that apply to the particular ESS that has been implemented.

ESS interests are usually offered to employees at a discount to the market value of the share or option. The standard taxation treatment of the acquisition of ESS interests involves the benefit that an employee derives from the ESS interest in the form of a discount (ESS benefit) being included in the employee’s assessable income and taxed accordingly.

An ESS benefit is not a reportable fringe benefit.

Design phase

In the design phase, the employer should decide: (a) what type of ESS interest it wants to offer its employees; and (b) what scheme it will use to implement the ESS interest.

An ESS interest is a beneficial interest in a share in the company or a right to acquire a beneficial interest in a share of the company (option) that is granted to employees (or associates of employees; eg family members) of the company or subsidiaries of the company. Once an employer has decided which type of ESS interest it is going to offer its employees, it should then consider the four ESS schemes.

A number of tax concessions are commonly available under the different schemes, therefore, it is important that the choice of scheme is considered carefully to avoid unnecessary taxation and ensure that it is delivered efficiently and at minimal cost to the business.

Taxed upfront scheme

The taxed upfront scheme is the default position for the tax treatment of an ESS. The ESS benefit is included in the employee’s total assessable income and taxed at the marginal rate. This type of scheme often applies to those employees who are ineligible for tax concessions as a result of failing to meet the conditions for participation in the remaining three schemes.

Taxed upfront scheme with deduction

Employers should ensure that an ESS is designed, where possible, to enable employees to benefit from the tax concession of an up to $1000 reduction in their assessable income. This concession will generally be available where:

•   The ESS relates only to ordinary shares

•   The employee is employed by the company or a subsidiary of the company at the time of acquiring the ESS interest

•   The ESS interest does not relate to certain companies with a principal business comprising the trading of shares, securities and investments

•   The ESS and any ancillary scheme providing financial assistance to acquire the ESS interest are offered on a non-discriminatory basis to at least 75 per cent of the permanent employees of the company

•   There is no real risk of forfeiture of the right to an ESS interest (risk of forfeiture is explained below)

•   The sum of the employee’s taxable income, reportable FBT, reportable superannuation contributions and total net investment loss for the income year does not exceed $180,000

•   Employees are not permitted to dispose of their ESS interests during the term of their employment or within three years of acquiring the interest (whichever is the earliest)

•   Employees will not hold more than five per cent of the shares in the company or hold more than five per cent of voting power (eligible scheme).

Taxed-deferred scheme

Where an employee acquires an ESS interest that is at real risk of forfeiture according to the terms of the ESS (and the scheme is an eligible scheme by virtue of meeting the other conditions listed above), the employee will be entitled to defer the assessment of tax until the deferred taxing poin’ occurs.

A right to purchase shares that will lapse if the employee ceases employment within 12 months or if the employee fails to meet certain performance hurdles, are examples of ESS interests that may be at real risk of forfeiture.

ESS interests granted under this type of scheme will be taxed on the occurrence of a deferred taxing point, which is the earliest of: the cessation of employment; the time when there is no longer a real risk of forfeiture and the scheme no longer genuinely restricts disposal of the shares; and seven years after the right was acquired.

The employee will be assessed on the market value of the shares (or stapled securities) at the time of the deferred taxing point (and not at the time of acquisition) minus the cost base.

Tax-deferred scheme (salary sacrifice)

In addition to meeting the conditions of an eligible scheme, for tax to be deferred on the basis of a salary sacrifice arrangement, the scheme must have the following features:

•   The ESS interests are shares (or stapled securities) acquired under a salary sacrifice arrangement

•   The ESS interests are acquired at a discount equal to the market value of the interests

•   The ESS interests are subject to a real risk of forfeiture

•   The employee has not received more than $5000 worth of ESS interests in the income year under the salary sacrifice arrangements.

The events that may trigger the deferred taxing point are the same as those that apply to a taxed-deferred real risk of forfeiture scheme. Similarly, the ESS interests will be assessed according to their market value at the time of the deferred taxing point.

Review phase

Employers should assess the chosen ESS closely for compliance with the statutory conditions that affect taxation.

In particular, the five per cent restriction on shareholding and voting power in eligible schemes can restrict the availability of a tax deduction in small to medium enterprises that have a small volume of shareholders.

An ESS can be structured to ensure that it meets the criteria of an Eligible Scheme as well as the requirements for tax deferral.

Tax remittance

Employers must issue an ESS statement to participating employees for the financial year in which the ESS benefit was derived by the employee or a deferred taxing point occurred.

Example: Cathy acquires 500 shares in her employer, Large Bank Ltd, under an ESS on October 18, 2013. The market value of the shares is $3400. Cathy paid $1200 to purchase the shares. As a result, she acquires the shares at a discount of $2200.

On July 2, 2014, Large Bank Ltd gives Cathy an ESS statement to help her complete the ESS section in her 2013 tax return. Large Bank Ltd lodges an ESS annual report containing ESS data for all its employees (eg number of shares issued and ESS Benefit) by August 14 following the applicable income year.

Employers must withhold tax at 46.5 per cent if an employee does not provide his or her tax file number and recover this withholding tax by subtracting the taxed amount from other amounts owed to the employee; eg salary.

Employers who provide ESS interests under a taxed upfront eligible scheme are entitled to a deduction equal to the amount of the employee concession, up to a maximum of $1000 per employee who participates in the scheme.

In summary

A well structured ESS can be a tax effective alternative to offering employee benefits (eg car, computer) under a more traditional fringe benefits scheme.

ESSs will not increase the FBT liability of employers because the benefit provided under the ESS will be taxed in the hands of the employee.

A number of tax concessions are also available to both employees and employers under certain ESSs, which make the schemes attractive options worth consideration by businesses looking to offer incentives to employees in addition to salary or wages.

This story originally appeared in Inside Retail Magazine. The August/September issue, featuring exclusive coverage of the 2013 Westfield World Retail Study Tour is available now. For more information, click here.

* For further information regarding the implementation of an ESS, contact Michael Kohn, partner and head of revenue law at Cornwall Stodart on (03) 9608 2160 or m.kohn@cornwalls.com.au.