Employee Share Schemes (ESS) and Employee Share Option Plans (ESOP) are a simple tax planning tool that can drive of growth in both start-ups and established businesses. The benefits are threefold:

  • It’s a great method to incentivise employees to help your business grow by making them part-owners of the business – while costing the company no cash;
  • Employees stay with the company longer – especially key executive staff or salespeople; and
  • It can provide significant tax benefits to the employee.

It is important that the employer understands the tax implications for the employee. While it can be a great motivator, it can be a rude shock if the wrong scheme is used and the employee gets a large tax bill.

A business needs to understand the potential schemes it can use and what tax concessions they may be eligible for.

What is an ESS and ESOP?

Employee Share Scheme (ESS)

In an ESS, the scheme gives an employee a ‘right’ to purchase shares, known as a subscription, in the company they work for. The employee will be invited to subscribe for the shares at a certain price.

The company may choose to set a subscription price at fair market value, a nominal amount or somewhere in the middle. Any restrictions on the shares and any discount to market value will inform how the employee is taxed.

Employee Share Option Plan (ESOP)

In an ESOP, a Company grants an option to purchase shares in the Company. The difference between an option and a right, is that an option does not grant them any of the rights a shareholder has, such as rights to vote, dividends and assets on winding up. Rather, an option holder can exercise the option at a future date to subscribe for shares.

Options appeal to employees because they are non-binding and do not have to be exercised, but more crucially, because the price of the option is fixed in the agreement. If a stock option is granted from two years from today and the Company’s performance and share price drop of significantly, the employee can decide that they don’t want to purchase the shares. Conversely if the Company is highly successful and the stock price rises, the employee may end up paying less for the share than what the shares are actually worth now.

Options also appeal to employers, as issuing options does not dilute the current shareholdings. This may be important when a founder is starting to approach a 50% shareholding and wishes to retain control by not diluting rights of investors and keeping the company financial performance confidential.

Just like with issuing shares, the company can choose the share subscription price in the option, which is known as the ‘strike price’.

Other variants

The possibilities are endless when developing an ESS or ESOP, for example:

  • A premium share plan allows for employees to purchase shares at above market value;
  • A phantom share plan allows for bonuses to be pinned to the rise or fall of the share price;
  • Using an employee share trust; and
  • Using non-ordinary shares, such as dividend only shares.

Each are possible and come with their own benefits, though the need for tax planning becomes much higher.

Tax Implications

Both the ESS and ESOP can have tax benefits for the employee if correctly exercised. There are essentially four tax treatments available:

  • Upfront taxation – employee is subject to tax on the discount when the shares are issued;
  • Deferred taxation – employee is subject to tax on the discount at a later date; or
  • Start-up concessions with upfront taxation – the tax payable on the upfront taxation is ignored and the employee is only subject to tax when a CGT event occurs (i.e. a sale of the shares); or
  • The $1,000 discount – some schemes may be eligible to discount of up to $1,000 is certain criteria are met.

For start-ups and young businesses, the strong preference should be for using the start-up concessions if possible.

Start-Up Concessions

By far the most valuable tax treatment for ESS’s and ESOP’s is the start-up concessions.  As with all generous tax concessions, there are strict criteria that must be satisfied:

  • The Company must not be listed on a stock exchange;
  • The Company must be less than 10 years old;
  • All companies in the group must have less than $50m turnover (the grouping provisions can be complex);
  • Company must be an Australian tax resident.

Further restrictions are needed for the plan itself:

  • The interest (shares or options) must be held for 3 years, though some exemptions can apply;
  • Each employee is limited to 10% shareholding when the interests are issued;
  • The interest must relate to ordinary shares; and
  • Either;
    • If shares are used, the discount to market value is a maximum of 15%; or
    • If options are used, the strike price must be equal to market value on the date the options are issued.

When the company and scheme meet this criteria, employees are then taxed on the capital gain on the profit from a sale of the shares and not on the upfront cost of purchase. Employees may be eligible for the 50% CGT discount and issuing the interests to a family trust to split any capital gain.


What to do if you aren’t eligible for the start-up concessions

The start-up concessions are the most desirable scheme if the company is eligible. If they are not available to the company, the company should explore other methods to tax effectively give equity to employees.

Upfront taxation isn’t necessarily bad. Schemes can require that market value is paid for the shares or options, so there is no assessable discount. In many cases, the subscription can be funded by a loan from the company interest free – though care should be taken around Division 7A and deemed dividends.

Alternatively, deferred taxation schemes can be beneficial for more established businesses. They are not recommended for businesses that expect to have significant growth such as start-ups.

Whichever plan you choose, you need to ensure the company and employees understand the tax implications before establishing the scheme.

Chamberlains team of Tax specialists can advise you on the best scheme for you and your employees and guide you through the complete process. Our team have prepared simple schemes for start-ups that have just commenced, SME’s looking to renumerate a key executive and large businesses creating complex and international plans. Contact us today for a free initial consultation.