3.1
This chapter examines the effectiveness of the Tax and Superannuation Laws Amendment Employee Share Schemes) Act 2015 (2015 Act), also referred to in this report as the ‘2015 reforms’, and the impact on the Income Tax Act Assessment Act 1997 (Income Tax Assessment Act).
3.2
The 2015 Act was designed to provide tax incentives to support start-up companies and bolster innovation, competitiveness and entrepreneurship. The Committee heard evidence that the 2015 reforms were welcome, but suggestions were received to further refine the tax treatment of ESS.
3.3
The Law Council told the Committee that ‘the start-up concession is certainly in terms of tax an outcome that works’ and explained further that:
it deals with two fundamental problems. The first is taxation at cessation of employment […] The second is the taxation gain as a capital gain rather than ordinary income. In terms of the market that it is seeking to develop, the essence of that structure is well designed. […] The take-up of it has not been as strong as it should have been.
3.4
Atlassian noted that despite the disadvantages of the Australian treatment of ESS interests, ‘the tax treatment of options granted under the start-up concession is more favourable than the non-statutory scheme in the US that is broadly available to employees. As such, it can be considered a point of advantage for Australian start-ups.’
3.5
To assist the Committee to explore any limits of the 2015 reforms to ESS tax treatment and/or explain the limited uptake of ESS, witnesses provided evidence about the difficulties encountered with current provisions of the Income Tax Assessment Act particularly to do with:
the definition of a start-up;
the limits on concessions and employee ownership; and
the cessation of employment as a taxation point.
Definition of a ‘start-up’
3.6
The Law Council commented that despite the 2015 reforms being considered to be ‘a welcome and very helpful reform’, the use of the concession has been limited by the restrictive definition of ‘start-up’ in the Income Tax Assessment Act.
3.7
As noted by KPMG Australia, to be considered a start-up for tax concession purposes, a company must:
have no equity interests listed on a stock exchange;
have an aggregated turnover of less than $50 million;
have been incorporated for less than 10 years; and
be an Australian resident company.
No equity interests listed on a stock exchange
3.8
Section 83A.33 of the Income Tax Assessment Act provides that the start-up concession is not available if a company, or any of its subsidiaries or holding companies, have equity interests listed on any approved stock exchange. This means that any company that has shares listed on the ASX, for example, will not be eligible for the concession.
3.9
Some stakeholders consulted during the development of the
Tax and Superannuation Laws Amendment (Employee Share Schemes) Bill 2015 (2015 Bill) suggested the start-up concession should not exclude listed companies. This measure was not retained as ‘these policy issues would likely come at an additional cost to Government revenue, which may be difficult to achieve in the current budget environment.’
3.10
Evidence to this inquiry indicates that such support continues. For example, Employee Ownership Australia suggested that ‘listed companies that are otherwise able to meet the definition of a “start-up” company should be able to apply these concessions.’
3.11
Guerdon Associates noted that there is a false assumption that ‘a listed company is in a more advanced stage of development than an unlisted company,’ and explained:
It is true that companies are often listed to access capital, but often this is because there are no private sources of capital available after the house has been mortgaged twice, and family and friends are in as deep as they care to go, and the start-up needs more capital as it has outgrown the garage. The Australian private capital market is small compared to sophisticated, deep and wide private capital markets in the US and to an extent the UK, leaving little choice but to turn to listed company markets.
Aggregated turnover of less than $50 million
3.12
The 2015 Act limits access to tax concessions to businesses that have a turnover of no more than $50 million per year.
3.13
Concerns were raised that the current requirement to have an aggregated turnover of less than $50 million to be considered a start-up for tax purposes was too restrictive.
3.14
Guerdon Associates suggested that this ‘arbitrary $50 million limit will encompass most start-ups’ but excludes entrepreneurial, high growth companies that may have high turnover but ‘a long gestational period’, such as Xero, NearMap, Afterpay, and Zip Co.
3.15
Right Click Capital noted that the aggregated turnover limit restricted the participation of e-commerce or marketplace businesses, which can post high turnovers but have high cost of goods sold. It advocated for increasing this limit to $100 million or $150 million to ‘encourage our fast-growing companies to accelerate their growth [and provide] a greater contribution to our economy through employment, exports and company tax.’
3.16
PricewaterhouseCoopers (PwC) was concerned that:
the qualifying conditions around the aggregated turnover test can make it difficult to assess whether a company is a start-up. The test should only relate to wholly owned groups or entities that can be shown to be controlled by the entity as per the definitions of control under the Corporations Laws.
Exclusion of established companies
3.17
The 2015 Act provides that companies that are 10 or more years old cannot be considered a start-up for tax concession purposes.
3.18
Minter Ellison suggested that this 10-year limit be removed as ‘there do not appear to be good policy reasons for imposing this requirement.’ They recommended the Committee consider alternative requirements such as a maximum number of employees.
3.19
KPMG Australia also suggested that the limit be removed as ‘companies have different trajectories for growth. The fact that some companies take longer to achieve growth compared to others should not disqualify them from benefiting from this regime.’
3.20
King & Wood Mallesons advised that this requirement could prevent genuine start-ups from accessing this concession if, for example, a participant wanted to use a previously dormant company to start a new business.
3.21
Stripe, a global technology company, stated that the 10-year limit ‘put a damper on high growth start-ups.’
3.22
In the second reading speech for the 2015 Bill, the then Minister for Small Business, the Hon Bruce Billson MP, commented on the start-up eligibility criteria:
These eligibility criteria mean that the concession is targeted towards small and start-up firms. The innovators we are committed to encouraging are those who often face additional liquidity and valuation obstacles that larger firms do not. The eligibility criteria will also limit and manage the cost to revenue at a time of fiscal repair.
Valuation rules
3.23
To offer an ESS, companies need to determine the market value of the ESS interests they want to provide.
3.24
The Australian Taxation Office (ATO) provides approved market valuation methods for start-ups. Using one of these methods increases the certainty for start-ups that the valuation will be accepted. This is referred to as a ‘safe-harbour’ valuation.
3.25
As advised by the ATO, the approved market valuation methods can be used for:
ESS interests that are in the form of shares and where the discount does not exceed 15 per cent of the market value of the share at the time it is acquired; and
ESS interests that are in the form of options where the exercise price of the options is at least equal to the market value of the underlying shares.
3.26
The Law Council described these ‘safe harbour valuation rules’ as ‘very helpful’, but expressed concern that ‘they are limited in scope and apply only to start-ups.’
3.27
Issues can arise for unlisted companies that don’t qualify to use the safe-harbour valuation method (such as mature small or medium businesses), as the nature of such companies means their shares can be particularly difficult to value. For example, Pitcher Partners noted:
Unlisted companies have no liquid secondary market for their shares and therefore do not have a simple means to determine their market value at any point in time. In order to determine the tax consequences of issuing ESS interests, a costly valuation needs to be obtained every time these are issued in order to properly comply with the tax regime (e.g. to quantify what discount, if any, the ESS interests are issued at).
3.28
Pitcher Partners suggested that the “safe harbour” contained in the Legislative Instrument –Income Tax Assessment (ESS 2015/1) be extended to companies that are unlisted with an aggregate turnover of less than $50 million, consistent with the requirements in subsection 83A-33(5) of the Income Tax Assessment Act.
3.29
Further, the Committee found that it was not necessarily clear how the valuation rules that are designed for outside investors necessarily help protect employees. The shares or options are often granted without having to be paid for upfront. In start-ups, valuation processes are not meaningful especially in the early stages.
3.30
In listed entities, the valuation information is publicly available. And the very nature of being an employee presents opportunities to understand the financial health of a company that others do not have. In summary, the valuation requirements provide little meaningful protection, while costing much in time and money.
Limited tax incentives
3.31
The issue of limited tax incentives was another hindrance that was brought to the Committee’s attention and that helps to explain the relatively low uptake of ESS in Australia.
The $1,000 upfront tax concession limit
3.32
If an employee receives shares or options at a discount pursuant to an ESS scheme, and they have an adjusted taxable income of $180,000 or less, they are eligible for a tax exemption on the first $1,000 of discounts received each year.
3.33
The amount of this concession was last changed around 1996, when it was increased from $500 to the current level of $1,000 for shares or rights acquired after 1 July 1996. It is not indexed, which Treasury notes ‘is not uncommon for thresholds in the tax system.’
3.34
Fortescue Metals Group commented that $1,000 ‘is now too small a value to represent a meaningful incentive to most employees.’ They also noted that as the discount is applied to employees earning $180,000 or less, this limit ‘disadvantages the segment of the employee population who could most reasonably benefit from a higher level of incentive.’
3.35
Fortescue Metals Group suggested that the limit be increased to $5,000, to match the tax-deferred salary sacrifice plan limit.
The $5,000 tax-deferred salary sacrifice plan limit
3.36
Employees receiving shares at a discount that are acquired under a salary sacrifice arrangement can access deferred tax rules under the Income Tax Assessment Act, provided they receive no more than $5,000 worth of shares in an income year.
3.37
This limit was introduced in 2009 to ensure ‘that deferral of tax under the salary sacrifice arrangements is limited, providing a relatively more attractive concession for low- and middle-income earners.’
3.38
Shareworks by Morgan Stanley suggested that the $1,000 and $5,000 limits have led to decreasing popularity of these plans and do not ‘strike true with regards to perceived value for individuals anymore.’ They recommended increasing the limits to ‘further foster employee ownership and thus drive plan participation.’
3.39
Employee Ownership Australia similarly noted:
Unfortunately, the $5,000 salary sacrifice cap is too limiting…This has inhibited the ability of employees to make meaningful savings through employee salary sacrifice plans. As a result of those changes, there has been a marked decline in the broad-based participation in salary sacrifice plans with many companies closing down their plans.
3.40
Guerdon Associates considered that the COVID-19 pandemic ‘has brought a focus on the salary sacrifice arrangements that could be improved for the benefit of the economy’ and that employees ‘would be prepared to sacrifice more than $5,000 and even up to 100 per cent of their salary to assist their employer avoid layoffs.’
3.41
Guerdon Associates suggested that the Government could support businesses during the COVID-19 crisis and its immediate aftermath by temporarily removing the $5,000 cap until 30 June 2023, adding that this would also allow the Government to test the impact of this measure on revenue and growth.
3.42
In relation to concerns regarding potential revenue loss or leakage, the Law Council suggested that ‘the potential for revenue leakage is…overstated,’ adding that this was due to:
the impact of workarounds and offers simply not being made. In many instances the tax deferral conditions for shares are being achieved through the introduction of short-term forfeiture conditions or, alternatively, the addition of so-called cash out options.
Ten per cent limit on ownership through an Employee Share Scheme
3.43
The Explanatory Memorandum to the 2009 Bill noted that an interest provided to an employee via an ESS must not exceed five per cent for tax concessions to apply. It stated:
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 one employee owns more than five per cent of the voting rights, interests between the company and that shareholder are already aligned, and no tax concession is appropriate or warranted.
3.44
One of the changes introduced by the 2015 reforms was an increase to the limit on individual employee ownership of a company through an ESS from five per cent to 10 per cent. The change was designed to ‘help some founders and provide a boost for critical workplace team members.’
3.45
Succession Plus noted that the 10 per cent ownership limit ‘can serve to prevent SMEs from accessing the taxation concessions’ and ‘prevents employee or management buyouts from occurring under Division 83AA.’ They suggested such prevention is problematic as ‘despite the taxation limits, [ESS] do produce more viable succession outcomes.’
3.46
The Committee notes that the Standing Committee on Employment, Education and Workplace Relations recommended in its 2000 Shared Endeavours report that public policy should be formulated so as to ‘facilitate employee buyouts and succession planning.’
Cessation of employment as a taxation point
3.47
Currently, ESS interests can become subject to the deferred tax rules in Division 83A of the Income Tax Assessment Act when the holder of the interest ceases employment with the relevant company. This rule was introduced in 1995, with the rationale being ‘to provide some level of tax integrity to ensure that the discount for certain companies is taxed at some point, but also to achieve a balance in encouraging the take-up of employee share schemes.’
3.48
Several witnesses suggested that Australia’s taxation arrangements with respect to the point at which ESS interests are taxed were ‘no longer best practice’ and less favourable than arrangements overseas, resulting in Australian firms being at a disadvantage when competing for global talent.
3.49
Stripe, a technology company operating a global equity stock plan in over 15 countries, pointed to the deferred taxation point at cessation of employment as a ‘key hurdle’ affecting their ‘growth in Australia and ability to hire’.
3.50
Similarly, Atlassian commented that Australia had a ‘comparative disadvantage’ compared to the USA’s tax system, and suggested removing the taxation event on cessation of employment, to prevent ‘departing employees either desperately seeking means to fund the tax liability or entirely foregoing their interests due to inability to shoulder the tax consequences’ or alternatively staying in ‘a job that no longer suits them or their employer.’
3.51
This issue was considered as part of the 2015 Bill inquiry, where the Committee noted that ‘the present system of taxation on cessation of employment seems to be an anomaly internationally, and might provide an opportunity for further reform.’
3.52
StartupAUS advised that tax ‘treatment of options on terminating employment was the single biggest issue identified by respondents’ to their survey, due to employees potentially having to pay tax on incentives before receiving any benefit from them.
3.53
Succession Plus stated:
The deferred taxation rules (Division 83A) serve to tax employees (on a deferred basis) without them having access to income/equity to fund the tax payment - we have several clients where this taxation impact will be far greater than the employees annual salary and may in fact force them to sell some shares to fund the taxation liability.
3.54
The Australian Small Business and Family Enterprise Ombudsman concurred with these comments and noted that ‘the cash payment triggered on leaving may discourage workers from joining a firm and encourage existing workers to stay with the firm for the wrong reason.’
3.55
Pitcher Partners said that such difficulties can result in companies limiting the range of employees to whom they are prepared to offer shares, undermining ‘the potential benefits of broader participation in the ESS.’
3.56
The effects of COVID-19 were also raised as a rationale for abandoning cessation of employment as a deferred taxation point, due to increased redundancies and decreased share values. For example, Employee Ownership Australia commented:
…the current crisis has seen a significant number of employees made redundant. This has resulted in a large number of employees being considered “good leavers” and triggering a taxing event on their ESS awards due to cessation of employment. Therefore, there is an increased incidence of tax on cessation of employment in ESS. Secondly, the sharp fall in the share market means that employees who ceased employment prior to the crisis are likely to have triggered a taxing event on cessation of employment at a significantly higher share price.
3.57
PwC commented that ‘market volatility’ was ‘inevitable’ and ‘has been a major issue adversely affecting a significant number of taxpayers over a great number of years’, adding that it was not strictly a COVID-19 problem
3.58
In contrast, Treasury advised that ‘the provisions are around ensuring that there's a connection between the employer and the employee, and then, if the employee does leave, that connection has gone.’
Retirement
3.59
The American Chamber of Commerce in Australia (ACC) expressed particular concern about ‘Australian retirees being taxed unfairly where unvested or not fully vested ESS interests are taxed upon termination of employment,’ whereas ongoing employees can defer tax until their interest is fully vested.
3.60
The ACC advised that in the USA retiring employees are permitted to retain ESS rights or shares and defer taxation until they become fully vested and the value can be determined.
3.61
In their view, this taxing of unvested interests ‘further marginalises older Australians by discouraging their participation in ESS arrangements as they get closer to retirement, or their ability to retire.’
3.62
The taxation of unvested interests was also raised as an issue for retiring business owners. Employee Ownership Australia suggested that any tax imposed on retiring business owners, particularly when they are transferring the business to existing employees, should be on a concessional basis as the deemed market value of their interest may not represent the value that they receive.
Income tax withholding
3.63
If cessation of employment is removed as a taxation point, it may affect employers’ ability to fulfil reporting requirements for an ESS, as they may not necessarily know when employees dispose of their shares.
3.64
The introduction of a voluntary tax withholding mechanism could simplify arrangements for employers, ensure tax collection and make the tax rules more consistent with those of international trading partners.
3.65
Minter Ellison noted:
We have received feedback from our clients, both domestic and multinational, that they are struggling with the lack of withholding mechanism and believe that such a mechanism would materially improve the effectiveness of administering an ESS and (in the case of multinational companies) ensure a 'level playing field' with participants in other countries.
3.66
Shareworks by Morgan Stanley advised that to manage associated withholding tax obligations, the USA captures federal and state tax utilising year-to-date income to determine individual tax obligations at the point of exercise or conversion of rights into shares.
3.67
Ernst & Young noted that ‘employers in the UK, US and New Zealand are entitled to tax deductions in relation to grants of ESS interests made to employees.’ Ernst & Young considered this to be ‘appropriate tax policy as ESS interests are considered part of an employee’s remuneration.’
3.68
PwC suggested there should be ‘further consultation on the benefits and disadvantages of the introduction of employer tax withholding for ESS awards which vest.’
Committee comment
3.69
Evidence presented to the Committee indicated that the current taxation arrangements for ESS are too complicated and restrictive, despite the well-received 2015 reforms. Some adjustments were suggested to support Australian businesses in their uptake of ESS.
3.70
Based on available data and evidence received, the Committee has recommended a number of changes to the taxation treatment of ESS to increase its usage and decrease costs for Australian businesses, and in turn increase business support, especially for start-up companies, and general competitiveness, productivity and innovation. Improved data reporting, which has been identified as affecting the accurate measurement of ESS usage in Australia, may also highlight the need for further reforms.
3.71
The Committee acknowledges that some submissions called for more extensive changes to the definition of a ‘start-up’, for example, by removing the exclusion on companies that are more than 10 years old. However, the Committee came to the conclusion that the intent of the 2015 reforms should be preserved, to support start-ups in their first years of existence, when they are most fragile.
3.72
However, the Committee considers that given Australia’s unique capital funding environment, it would be appropriate to extend the start-up tax concessions to all listed companies.
3.73
The Committee also considers it appropriate to reduce inconsistencies between taxation and corporations laws by removing the aggregated turnover test.
3.74
The Committee notes that some submissions to this inquiry called for an increase to the turnover limit of $50 million per year. The Committee considers that this cap is arbitrary and causes unintended consequences. As such, the Government should consider removing the cap.
3.75
The Committee recommends that the following changes be made to the definition of a ‘start-up’ for tax concession purposes:
The definition be extended to listed companies that otherwise fulfil the criteria to be considered a ‘start-up’.
The aggregated turnover test be removed to relate to wholly owned groups or entities that can be shown to be controlled by the entity as per the definitions of control under the Corporations Act 2001.
3.76
The Committee notes there are concerns that obtaining valuations for the purpose of complying with ESS rules is time consuming, costly and overly complex, particularly for unlisted businesses.
3.77
It was suggested that the ‘safe harbour’ market valuation methods were helpful and could be used more widely to alleviate the difficulties of small and medium businesses in obtaining valuations.
3.78
The Committee considers that it would be appropriate to extend the ‘safe harbour’ valuation methods to small and medium unlisted companies that have a turnover of less than $50 million but do not otherwise come within the definition of a start-up.
3.79
The Committee recommends that the definition of ‘safe harbour’ valuation contained in Legislative Instrument – Income Tax Assessment (ESS 2015/1) be extended to all unlisted companies.
3.80
The Committee agrees that the $1,000 annual limit on shares that employees can receive without paying income tax is overdue for an increase, given this limit was set in in 1990s and its value is now out of date.
3.81
The Committee considers this limit should be increased to $50,000 to match the current salary sacrifice limit, and the wage requirements also be removed.
3.82
The Committee recommends increasing the $1,000 limit in section 83A.35(2)(a) of the Income Tax Assessment Act 1997 to $50,000.
3.83
The Committee is concerned that tax becomes payable upon an employee receiving an ESS interest, although there may be no benefit realised at that point. The Committee is of the view that a system whereby tax is paid either as a dividend return to the employee or once the shares are sold would be a much simpler system that would encourage a greater uptake, particularly by employees.
3.84
The Committee recommends that the Government remove the taxation point on the cessation of employment by removing sections 83A-115(5) and 83A-120(5) of the Income Tax Assessment Act 1997.