Employee share schemes

• Overview
• Scope of the new rules
• Timing and amount of employees’ income
• Timing and amount of employers’ deduction
• Effect of deduction and payments on available subscribed capital
• Exempt schemes
• Technical, consequential and transitional matters

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OVERVIEW

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Employee share schemes – arrangements for companies to provide shares and share options to their employees – are an important form of employee remuneration in New Zealand and internationally. Although the design and the accounting treatment of these plans have evolved considerably over recent decades, the tax rules applying to them in New Zealand have not been comprehensively reviewed during that period and are now out of date.

Employee share schemes can have beneficial economic effects and it is important that the tax rules do not raise unintended barriers to their use. In some circumstances, the current rules can result in over-taxation; in others they result in under-taxation.

The current system impedes the use of employee share schemes in a number of ways.

• There is considerable uncertainty about how the current rules apply to taxation of employees and employers, which may deter firms from offering these schemes.
• The cost to an employer of providing shares directly to an employee is not explicitly deductible. Non-deductibility creates over-taxation, which is a disincentive to using employee share schemes. Arrangements which currently do allow employers to take deductions for shares provided directly, or indirectly by other companies, produce deductions which do not reflect the amount or timing of the income recognised by the employee.

The current treatment of some sophisticated employee share schemes can result in employment income being treated as tax-free capital gains and so escaping taxation. This undermines the fairness of the tax system.

The Bill proposes new core rules for determining the amount and time of derivation of income and incurring of expenditure under an employee share scheme. The objective of the proposals is neutral tax treatment of employee share scheme benefits. That is, to the extent possible, the tax position of both the employer and the employee should be the same whether remuneration for labour is paid in cash or shares. Generally these rules will apply to benefits where the taxing point under current law has not occurred before the day 6 months after the enactment of the Bill.

The Act also currently provides a concessionary regime to encourage employers to offer shares to employees under certain widely-offered employee share schemes (commonly referred to as “exempt schemes”). Income derived by employees under these schemes is exempt from tax and there is a deemed 10% notional interest deduction allowed to employers who provide loans as part of such schemes. The law governing these schemes is out of date, complex and no longer fit for purpose. In addition, it not consistent with our broad-base, low-rate (BBLR) income tax system.

Accordingly, the Bill also proposes a simplified set of rules for these exempt schemes, with a greater level of exempt benefit able to be provided and more flexibility in the design of these schemes. The Bill aims to clarify that employers offering exempt benefits will not be entitled to a deduction for the cost of providing those benefits. The retention of the tax exemption for exempt schemes is an exception to the neutrality principle, but is justified on compliance cost grounds.

The Bill also proposes a number of consequential and miscellaneous changes, and provides transitional arrangements for existing schemes.

The proposed new rules for employee share schemes have been developed through a public consultation process beginning with the release of the officials’ issues paper Taxation of employee share schemes in May 2016 and further consultation in September 2016.

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SCOPE OF THE NEW RULES

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(Clauses 11, 12, 14 and 41)

Summary of proposed amendment

The proposed new income and deduction rules will apply to arrangements where employees receive shares as part of their remuneration package. There are a number of qualifications and carve outs to the definition of “employee share scheme” to ensure the rules are appropriately targeted.

Application date

The new rules will generally apply to benefits provided under employee share schemes which are not taxed under the existing rules within 6 months of enactment of the Bill. There is further detail of the transitional arrangements below.

Key features

The proposed new rules will apply to benefits provided under arrangements that involve issuing or transferring shares to past, present and future employees[5] or shareholder-employees (or their associates) of the issuing company (or a group company).

However, they will not apply to arrangements that require employees to:

(a) pay market value for the shares on the “share scheme taxing date” (described in more detail below, but generally the date on which the employee holds the shares like any other shareholder);

(b) put at risk shares they acquired for market value, where the scheme provides no protection to the person against a fall in the value of the shares.

They will also not apply to exempt schemes (which have their own specific rules, discussed below).

Background

The definition of “employee share scheme” is a key component of the rules.

The core employee share scheme rules in the Income Tax Act 2007 currently apply to “share purchase agreements”. These are agreements to dispose of or issue shares to an employee, entered into in connection with the employee’s employment or service, whether or not an employment relationship exists when the employee receives a benefit under the agreement.

Under current rules there is some uncertainty as to whether this definition encompasses arrangements entered into before a person commences a formal employment relationship and has received a PAYE income payment.

This definition also excludes shareholder-employees to the extent to which they choose not to deduct PAYE.

There is no policy rationale for excluding these classes of recipients of employee share scheme benefits.

Detailed analysis

Clauses 11, 12 and 14 propose that under sections CE 1(1)(d), CE 2, and CE 6 – 7D, a benefit received under an employee share scheme is income of a person. Similarly, clause 41 proposes a new section DV 27 that governs what deductions are available when a person is party to an employee share scheme.

Clause 14 proposes a definition of “employee share scheme” in new section CE 7. The definition is initially fairly wide.

It is an arrangement with a purpose or effect of issuing or transferring shares in a company to a person who will be, is, or has been an employee (or shareholder-employee) of that company or of another company in the same group. It also includes the provision of shares to an associate of the employee or shareholder-employee, if the arrangement is connected with that person’s employment or service.

The use of the term “arrangement” covers all aspects of a scheme, for example, direct transfers of shares, loans to buy shares, bonuses, put and call options and transfers to trusts etc. The definition also covers past, present and future employees, and includes shareholder-employees.

However, an employee share scheme does not include an arrangement that requires an employee, shareholder-employee or associate to:

(a) pay market value for the shares on the “share scheme taxing date” (described in more detail below, but generally the date on which the employee holds the shares like any other shareholder); or

(b) put at risk shares they acquired for market value, where the scheme provides no protection to the person against a fall in the value of the shares.

The definition of employee share scheme also excludes exempt schemes (which have their own specific rules, discussed below).

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TIMING AND AMOUNT OF EMPLOYEES’ INCOME

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(Clauses 11, 12, 14 and 41)

Summary of proposed amendment

The proposed amendments ensure the timing and amount of employees’ income from employee share schemes is consistent with other forms of employment income.

Application date

The new rules will generally apply to benefits provided under employee share schemes which are not taxed under the existing rules within 6 months of enactment of the Bill. There is further detail on the transitional arrangements below.

Key features

Clauses 11, 12 and 14 provide that benefits provided under an employee share scheme (usually in the form of shares) are assessable income for an employee at the earlier of the date when:

• the benefits are either transferred or cancelled for consideration; or
• the employee share scheme beneficiary owns the shares in the same way as any other shareholder. They will not own the shares in the same way as any other shareholder if (for example) the employee is required to forfeit the shares if they choose to leave the company, or the employee is entitled to be compensated for a decline in the value of the shares.

This is referred to as the “share scheme taxing date”. No change is proposed to the tax treatment of straight-forward employee share options, which already reflects this principle, in that the employee is not taxed until the option is exercised.

The amount of the benefit should be the amount received for the transfer or cancellation, or the value of the shares at the share scheme taxing date. It should be reduced by the amount paid (if any) for the benefit.

The proposed rules require matching between the employee’s income and the employer’s deduction, so the rules outlined above also determine the amount and time of the deduction to the employer (the employer’s deduction is discussed further below).

Background

Any reward for services is generally taxable as income, under the ordinary definition. However, the application of the common law of income tax to the provision of rewards in the form of property, for example shares or options, has sometimes been problematic.

For that reason, since 1968, New Zealand tax law has contained special provisions relating to the taxation of employee share scheme benefits. Currently these are contained in sections CE 1 – CE 4, CE 6 and CE 7.

Under current law, shares provided under an employee share scheme are taxable when the employee acquires the shares. Section CE 6(2) provides that:

• shares acquired pursuant to an option are treated as acquired when the option is exercised. This means that an employee is not taxed on the grant or vesting of an option, but on its exercise; and
• shares acquired by a trustee for the benefit of an employee (that is, a specific employee) are treated as acquired by the employee, even if the employee may be required to forfeit the shares.

The second of these rules leads to outcomes that are neither tax-neutral nor consistent with the taxation of employee share options.

The proposed new rules prevent these inconsistent outcomes by deferring the time at which an employee recognises income from an employee share scheme in certain situations. In examples 2 and 4 above, under the new rules, both Jim and Jane would be taxed on the value of the shares once the employment condition is satisfied (in Jim’s case) or the employer’s right to acquire the shares for $1,000 no longer exists (in Jane’s case).

Detailed analysis

Timing of income

The time when the employee is taxable is defined as the “share scheme taxing date”, and is defined in proposed section CE 7B (clause 14 of the Bill).

Unless an employee first transfers its share scheme benefits to a non-associate, or the company cancels them, the share scheme taxing date is when:

• there is no real risk that beneficial ownership of the shares will change, or that the shares will be required to be transferred or cancelled;
• the employee is not compensated for a fall in the value of the shares; and
• there is no real risk that there will be a change in the terms of the shares affecting their value.

If the benefits are cancelled or transferred to a non-associate before these events occur, then the share scheme taxing date is at the time of the cancellation or transfer.

In determining whether there is a risk of a change of ownership, transfer or cancellation, certain rights and requirements do not affect the employee’s status as the economic owner of the shares under the scheme (proposed section CE 7B(2)) and are ignored. They are rights or requirements:

• for transfer for market value;
• not contemplated by the employee share scheme;
• that have no real risk of occurring;
• that are of no real commercial significance; or
• that also apply to shares not subject to the employee share scheme.

The following series of examples illustrate how these proposed rules will work in practice for common types of employee share schemes.

Amount of income

The amount of income to the employee will be the value of the shares at the share scheme taxing date (or the transfer price if transferred to a non-associate, or the amount paid for cancellation, if cancelled by the employer) less the amount paid for them. Even where benefits are conferred on or transferred to an associate of an employee, it is always the employee who is taxed on the income. If the amount paid exceeds the value of the shares, the difference is deductible to the employee (proposed new section CE 2(3) in clause 12 and proposed new section DV 27(3) in clause 41).

Apportionment for overseas service

The proposed new rules contain an expanded income apportionment formula (proposed section CE 2(5) and (6) in clause 12). The expanded formula applies to all employees (rather than only transitional residents as in current section CE 2(9)). It excludes from taxable income employee share scheme benefits which accrue while a person is neither New Zealand resident nor deriving New Zealand source income. The extent of such accrual is determined by first establishing the entire period over which the benefit accrues, and then determining the proportion of that period during which the person is non-resident and not deriving New Zealand source income from their employment. The period of accrual ends once the rights vest, rather than when the income arises. So, for example, in the case of an option, the period of accrual ends once the options are exercisable rather than when they are actually exercised.

The employee share scheme income is treated as non-residents’ foreign source income (which is not taxable income) to the extent of this proportion.

Transfers to associates

No change is proposed for the treatment of transfers to associates. Such transfers are ignored for purposes of calculating the employee’s share scheme income.

Rollover relief for transfer to new scheme

If a person’s employee share scheme rights are cancelled and replaced with rights in a different scheme, the value of the replacement rights is not included in the person’s income arising due to the cancellation of the original scheme (proposed sections CE 2(2)(c) in clause 12 and CE 7D in clause 14).

The benefit provided by the replacement scheme will be taxed appropriately by applying the proposed new rules to that scheme

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TIMING AND AMOUNT OF EMPLOYERS’ DEDUCTION

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(Clauses 23 and 41)

Summary of proposed amendment

The Bill proposes to provide a deduction to employers providing employee share benefits which matches the income to employees in timing and quantity. Deductions currently available for other payments need to be disallowed where those payments would otherwise lead to a double deduction.

Application date

The proposed changes will have the same application date as for the provisions applying to the taxation of employees – that is, they generally apply to benefits provided under employee share schemes which are not taxed under the existing rules within six months of enactment of the Bill.

Key features

The proposals will allow a deduction to employers equal in amount and timing to the income derived by an employee under the new rules. It would explicitly preserve deductions for the costs of running an employee share scheme, and for the cost of any bonus associated with a share scheme paid to an employee. No other deductions will be allowed.

Background

The principle of neutral tax treatment of employee share scheme benefits supports employers being entitled to a deduction for the value of the benefit provided. The fact that the issue of shares by a company does not involve an explicit cash cost does not affect this principle. That is, there is a transfer of value to the employee from the other shareholders, which arises whether that value is transferred as cash or as shares in the company.

Under the corporate tax system, where company expenses are deducted by the company as a separate taxpayer from its shareholders, this cost must be recognised in the calculation of income by the company rather than the shareholders on whose behalf it is earned.

Ways to create a deduction do exist. For example, payment of a bonus to the employee which is used to fund a full value share acquisition, contributions to an employee share trust or reimbursement to a parent company. However, the tax treatment of these transactions can be uncertain, and structuring to achieve these should not be necessary (they just incur unnecessary transaction costs).

There is also the potential for the amount and timing of the deduction created by these transactions to not correctly reflect the economic cost to the company of providing the employee share scheme benefits.

Detailed analysis

An employer is denied a deduction for provision of employee share scheme benefits (proposed section DV 27 in clause 41), except for:

• costs incurred in administering or managing the scheme (proposed section DV 27(4)). These costs include legal and accounting fees incurred in setting up the scheme, as well as on-going management fees. Deductibility of these costs will be left to the usual tests, e.g. the capital/revenue test. Costs incurred by an employee share scheme trust will be treated as incurred by the employer or issuing company, as a result of the new provision treating an employee share scheme trust as a nominee;
• the amount of the employee’s income, which is treated as a cost incurred at the same time as the employee recognises the income (proposed section DV 27(6)-(8)). Deductibility of this cost will depend on meeting the usual tests; and
• amounts which are taxable to the employee as employment income other than as employee share scheme benefits (proposed section DV 27(5)). This is intended to preserve a deduction for the cost of paying a bonus where the payment of the bonus is part of the terms of an employee share scheme.

Accordingly:

• payments to fund an employee share scheme trust to acquire shares, or to reimburse a parent for providing shares, will not be deductible; and
• as a practical matter, employers will need to either prohibit employees from transferring their rights to a non-associate before the share scheme taxing date, or place a requirement on employees to inform them of the time and amount paid in such a transfer, in order to correctly calculate their deduction.

In order to prevent double deductions, when shares are provided to an employee and a deduction has been taken for that provision other than in accordance with to the new section, the deduction under the new section is reduced by the earlier deduction (proposed section DV 27(8)(b)).

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EFFECT OF DEDUCTION AND PAYMENTS ON AVAILABLE SUBSCRIBED CAPITAL

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(Clauses 7 and 10)

Summary of proposed amendment

The new rules seek to tax any benefit conferred on an employee by the issue of shares in an employee share scheme in the same way as an equivalent cash payment followed by an acquisition of shares in the issuing company. Consistent with this principle, the proposed rules provide for an increase in the employer’s available subscribed capital (ASC) by the amount deemed to be paid (plus actually paid) for the shares. The proposed rules also cater for the situation where the employer is not the company issuing the shares.

This is a taxpayer-friendly measure to ensure employee share schemes are not disadvantaged as a form of remuneration compared with an equivalent cash transaction, which would generally give rise to an ASC increase.

Application date

The ASC rules will apply to the provision of shares which are taxed under the new rules.

Key features

The ASC proposals deal with the effect of employee share scheme transactions on the employer and (if different) the company issuing the shares.

The amount of the deduction to the employer will give rise to additional ASC for both the employer and, if the shares issued are in the parent of the employer, the parent. In the latter case, any reimbursement paid to the parent will reduce the subsidiary’s ASC but will not increase the parent’s ASC. If the employer has income from the issue of the shares, that will reduce its ASC.

The proposals also ensure that the acquisition of shares as part of an employee share scheme can be treated as an acquisition of treasury stock, regardless of whether the shares are acquired by the company itself and not cancelled, or are acquired by a trustee who is treated as a nominee of the company.

Background

To ensure neutrality between provision of benefits under an employee share scheme and an equivalent cash transaction, as well as providing for the income and deduction consequences, the new rules must provide for changes to a company’s ASC.

To do this, the proposed rules provide for an increase in the employer’s ASC by the amount deemed to be paid (plus actually paid) for the shares. The proposed rules also cater for the situation where the employer is not the company issuing the shares (this is common where the employer company is a subsidiary and the employee receives shares in the parent company).

Additionally, in order to cater for the common practice of acquiring employee share scheme shares from other shareholders rather than by a fresh issue of shares, it is also necessary to ensure that the treasury stock regime can apply sensibly to employee share schemes.

Detailed analysis

Under clause 10, if the employer is also the company whose shares are provided, then the employer’s ASC will be:

• increased by:
  • the amount received for the provision of the shares (under existing section CD 43(2)(b)); and
  • the amount of its deduction for the provision of the shares (under proposed section CD 43(6E)(a));
• decreased by the amount of any income arising if it has income because the value of the shares provided is less than the amount received from the employee (under proposed section CD 43(29)).

If the employer is not the company whose shares are provided, then its ASC will be:

• increased by the amount of its deduction for providing the shares (proposed section CD 43(6E)(a));
• decreased by the amount of any income arising if it has income because the value of the shares is less than the amount received from the employee (proposed section CD 43(29));
• decreased by the amount of any reimbursement paid to the share provider (proposed section CD 43(6H)).

The adjustment should be made to the employer’s share class most similar to the shares provided under the scheme. If the decrease due to reimbursement exceeds the increase arising due to a deduction, and the excess is greater than the ASC of the relevant share class, the reimbursement amount is to that extent taxed as a dividend (proposed section CD 43(6I)).

If the shares are provided by the ultimate parent of the employer, the ASC of the parent company will be:

• increased by:
  • the amount paid by the employee for the shares (under existing section CD 43(2)(b)); and
  • the amount of the employer’s deduction for the provision of the shares (proposed section CD 43(6E)(b));
• decreased by the amount of any income arising to the employer if it has income because the value of the shares provided is less than the amount received from the employee (proposed section CD 43(29)); and
• unaffected by any amount paid to it by the employer (proposed section CD 43(20B)).

Treasury stock

If an employee share scheme trustee acquires shares for the purposes of the scheme, it is proposed that those shares will be treated as acquired by the share issuer (proposed section CE 6). The amount paid to the selling shareholder for their acquisition will be a dividend, unless one of the exceptions to dividend treatment applies.

If the shares are held by the trustee, the treasury stock rules will apply to them. Amendments are proposed to the treasury stock rules so that they apply more clearly in such a case.

Proposed measures in clause 7 make it explicit that the treasury stock regime can apply to an acquisition by an employee share scheme trust, just as if the shares were acquired by the company and not cancelled (amendments proposed to section CD 25(1)(a)).

It is proposed that the shares are allocated to an employee within one year of their acquisition, their acquisition and re-issue will be ignored by the share issuer (but not an employer who is not the share issuer) for ASC purposes (amendments proposed to section CD 25(2)(b)). Note that the shares would only have to be allocated to the employee under the scheme to qualify for treasury stock treatment, they do not have to be transferred to the employee.

It is proposed that shares which are allocated to an employee within a year and then forfeited are treated as acquired by the company at that time for the amount the trustee paid for them when originally acquired (proposed section CD 25(7)).

It is proposed that shares which are not allocated within one year be treated as having been acquired on market and cancelled (also amendments proposed to section CD 25(2)(b)).

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EXEMPT SCHEMES

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(Clauses 25, 31, 42 and 248)

Summary of proposed amendment

The Income Tax Act 2007 currently provides a concessionary regime to encourage employers to offer shares to employees under certain widely-offered “share purchase schemes” (commonly known as “exempt schemes”).

The current rules are out of date, complex and no longer fit for purpose. They also do not fit within New Zealand’s broad base, low rate framework. The proposed amendments:

• modernise and simplify the criteria for these schemes, including removing employers’ 10% notional interest deduction;
• increase the monetary threshold for the schemes (which has not been increased since 1980); and
• address the current ability for employers to claim unintended deductions for the cost of providing the exempt share benefit to employees.

Application date

It is proposed that the amendments will generally apply from the date of enactment. However, clause 42 (new section DV 28), which denies employers a deduction for the cost of acquiring shares provided under an exempt scheme, applies from the date of the Bill’s introduction.

Key features

The proposed amendments, seek to simplify and clarify the legislation relating to exempt schemes, while retaining many of the key features of the original schemes and their tax treatment. In many cases, the requirements will be relaxed. Where the original policy is no longer appropriate or unintended consequences have arisen, the proposed amendments address this.

Under the proposed amendments, shares provided to employees under schemes that meet certain criteria (described below in the detailed analysis) will be exempt income to the employees. Benefits provided under schemes that qualify for the current tax-exempt treatment will simply continue to qualify under the new legislation, but such schemes will be entitled to provide the same level of exempt benefit as new schemes.

For all exempt schemes, from the date of introduction of the Bill, employers will be explicitly denied a deduction for the cost of providing the shares (other than scheme management and administration costs) and the 10% notional interest deduction will be repealed from the date of enactment.

The automatic exemption from fringe benefit tax (FBT) for loans provided under exempt schemes in section CX 10(2) will continue.

Background

Since the 1970s, the Income Tax Act has contained a concessionary regime to encourage employers to offer shares to employees under certain widely-offered employee share schemes. The concession is on the basis that the schemes are designed to increase employee engagement at all levels of the company and align employee and shareholder incentives. They may also assist employees to develop and improve financial literacy skills.

There are currently two main tax benefits available under the regime.

1. Exemption for employee: The value of a benefit received by an employee under a concessionary scheme is not taxable to the employee.
2. Deemed interest deduction for employer: The employer is given a deemed deduction of 10% notional interest on loans made to employees to buy shares. This is additional to any deduction for actual interest incurred on money borrowed to finance the scheme.

Another benefit under the regime is that interest-free loans made under an exempt scheme are automatically exempt from FBT. The FBT-exempt status of the loans is a limited benefit. In most cases such loans would be FBT-exempt in any event, as “employee share loans” (that is, any loan provided by an employer to an employee to purchase its shares under an employee share scheme). The only real benefit of the specific FBT exemption is that the interest-free loan can be FBT-exempt regardless of the company’s dividend paying policy.

To qualify as an exempt scheme, currently the scheme must meet all the following criteria.

• The cost to employees of shares made available for purchase must not exceed their market value at the date of purchase (but may be less).
• The amount that an employee spends on buying shares under the scheme (or a similar scheme) must not exceed $2,340 within a three-year period.
• Every full-time permanent employee must be eligible to participate in the scheme on an equal basis with every other full-time permanent employee. If the scheme applies to part-time employees or to seasonal employees, they must also be eligible to participate on an equal basis with every other part-time employee or every seasonal employee.
• Any minimum period of service which may be required before a full-time permanent employee becomes eligible to participate must not exceed three years (or the equivalent of three years full-time service).
• Loans to employees for the purchase of shares must be free of all interest and other charges.
• The repayment of loans by employees is to be by regular equal instalments at intervals of not more than one month over a period between three and five years from the date of the loan.
• A trustee must hold the shares on trust for the employee for a period of restriction (generally at least three years).

The benefits of the regime do not apply to shares given to directors of the company or a person who (with any associated person) holds 10% or more of the issued capital of the company.

On the expiry of the restrictive period, the employee has two options. First, the employee can opt to have the shares transferred from the trust to them. Secondly, the employee can opt for the trust to buy the shares back at the market value (but not more than the price paid by the employee).

Problems with the current law

There are various issues with the current regime:

• the regime is complex and inflexible;
• the tax benefits of the regime are uncertain and poorly targeted;
• the regime does not explicitly limit the amount of tax-free benefit that can be conferred;
• there are some minor drafting issues with the legislation; and
• the maximum amount an employee can pay for shares ($2,340 over a three-year period) has not been adjusted since 1980, and this means as a practical matter that the benefits available under the regime are very limited. Adjusted for wage inflation, the figure would now be around $13,000.

Detailed analysis

Income tax exemption for shares provided under exempt schemes

Clause 25 (new section CW 26B) provides that amounts derived from exempt schemes are exempt income.

While a tax exemption for employment income does not fit generally within New Zealand’s broad-base, low-rate (BBLR) tax framework, given there is a limit on the amount of benefit that can be provided under the scheme ($2,000 per employee per annum) and the scheme has to be offered to almost all employees, it is appropriate to retain the tax exemption to minimise compliance costs.

The amendments propose retaining the exemption, but with a limit on the tax-free benefit that can be provided.

The existing law achieves the tax exemption by deeming the benefit derived under an exempt scheme to be zero (section CE 2(7)). The proposed amendments locate the exemption in subpart CW, which is a more appropriate part of the Income Tax Act for an exemption.

Employer deduction for shares provided under exempt schemes

There are currently several potential deductions associated with exempt schemes:

1. the 10% notional interest deduction with respect to employee share loans;
2. costs associated with setting up and running the scheme; and
3. in some cases, the direct or indirect costs of acquiring shares for the scheme.

Clause 31 repeals the 10% notional interest deduction in 1 above. The original policy rationale for this benefit is unclear and it is inconsistent with our BBLR tax framework.

Clause 42 proposes a new section DV 28 which denies a deduction for any costs associated with exempt schemes, other than administrative and management fees associated with setting up and running the scheme. This ensures that the unintended deductions identified in item 3 above are no longer available, but the deductions identified in item 2 are still available, subject to the usual limitations. This is consistent with the general deductibility provision for employee share scheme benefits in proposed new section DV 27 that only allows a deduction for administrative and management fees and for the provision of employee share scheme benefits to the extent that the benefit is assessable income to the employee.

Meaning of exempt scheme and criteria for qualifying for exemption

The proposed amendments have been designed to ensure existing schemes that meet the criteria described below can continue to operate without unnecessary disruption. Therefore, to the extent possible the existing rules have been retained and simply clarified.

It is proposed that existing exempt schemes approved by the Commissioner under previous legislation (for example, section DC 12 of the Income Tax Act 2007), would continue to be “exempt schemes” and be eligible for the tax exemption, provided they continue to meet the existing criteria as modified by the increase in the benefit level in proposed section CW 26C(2).

See proposed section CW 26C(1)(a).

The underlying policy of the criteria is to ensure:

1. the scheme is genuinely offered to the vast majority of employees on equal terms – for example, it cannot just be targeted towards executives;
2. related to 1, all employees have to be able to afford to participate in the scheme, not just the more highly paid employees – this is achieved by limiting the cost of the shares that can be offered, requiring employers to provide financing for any cost or because the employee does not have to pay anything for the shares;
3. there is a limit on the benefit that can be provided tax-free; and
4. the scheme is genuinely a share scheme and not just a mechanism to provide tax-free cash to employees (this is why there is a restriction period).

Criteria

To achieve this policy, all the following proposed criteria must be met in order for a scheme to be exempt.

• The cost to employees of shares made available for purchase must not exceed their market value at the date of purchase but may be less (proposed section CW 26C(2)(a)).
• The maximum value of shares provided under an exempt scheme is $5,000 per annum (proposed section CW 26C(2)(b)).
• The maximum discount an employer can provide to an employee is $2,000 per annum (proposed section CW 26C(2)(c)). This means that the most an employee can spend buying shares per annum is $3,000 ($3,000 plus the $2,000 discount means a maximum value of $5,000 worth of shares). This equates to a maximum cost of $9,000 over three years.
• 90% or more of full-time permanent employees who are not subject to securities law of other jurisdictions must be eligible to participate in the scheme. If the scheme applies to part-time employees or to seasonal employees, the same threshold applies (proposed section CW 26C(3)(a)-(c)). Currently, all full time employees must be eligible to participate.
• If the scheme has a minimum spend requirement, the amount can be no more than $1,000 per annum (proposed section CW 26C(3)(d)). This is the updated equivalent of section DC 13(4) and increases the $624 per three year figure.
• Any minimum period of service which may be required before an employee becomes eligible to participate must not exceed three years (or the equivalent of three years full-time service) (proposed section CW 26C(3)(e)).
• If the employee is required to pay any amount for the shares, then the employer must provide a loan for that amount or allow the employee to pay for the shares in instalments (proposed section CW 26C(4)(a)).
• Loans to employees for the purchase of shares must be free of all interest and other charges (proposed section CW 26C(4)(b)).
• Employees will repay loans by regular equal instalments at intervals of not more than one month over a period between three and five years from the date of the loan (proposed section CW 26C(4)(c)).
• Generally speaking, the shares have to be held for three years (either by the employee or by a trustee of a trust on behalf of the employee) – this is to ensure that the scheme is really a share purchase scheme, and not a mechanism for providing cash remuneration. If the employee has paid full market value for the shares, then they only have to hold them until they have fully repaid the loan – at this point they are like any other shareholder and should not have extra restrictions placed on them (proposed section CW 26C(7)).
• The employee can choose to withdraw from the scheme by giving the employer 1 month’s notice and have their shares purchased back for the lesser of market value and cost (proposed section 26C(5)).
• If participation in the scheme is causing serious hardship for the employee, the terms of payment can be varied or employees can be allowed to withdraw from the scheme and receive the market value of their shares (proposed section CW 26C(6)).
• If the employee leaves employment before the three years is up, then:
  • if they leave because of death, accident, sickness, redundancy or retirement at normal retiring age they can keep the shares (subject to repayment of the loan) or have the shares bought back for the lesser of market value and cost; and
  • if they leave for any other reason, the shares are bought back at the lesser of cost and market value. (see proposed section CW 26C(6) and (9)).
• The exempt scheme is not required to be approved by the Commissioner of Inland Revenue, however, the Commissioner must be notified of the scheme’s existence and the employer must advise the Commissioner when grants are made under the scheme (see clause 248 which contains proposed section 63B of the Tax Administration Act 1994 and clause 31 which repeals section DC 12 – DC 15).
• There is no requirement for a scheme to have a trust – many schemes have trusts as a matter of convenience. Removing this requirement provides greater flexibility (especially for small employers who may not want the administrative expense of operating a trust for a fairly small scheme).

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TECHNICAL, CONSEQUENTIAL AND TRANSITIONAL MATTERS

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(Clauses 12, 14, 28, 60, 70, 74 and 187(26))

Summary of proposed amendments

A number of transitional and consequential provisions are needed to support the core amendments. These provisions:

• specify a cost base for shares acquired under an employee share scheme (proposed section CE 2(4));
• provide for the treatment of employee share scheme shares subject to the foreign investment fund (FIF) rules (amended section EX 38);
• specify the treatment of employee share scheme trusts (proposed section CE 6 and repeal of existing section HC 27(3B));
• introduce a specific anti-avoidance rule to counteract tax avoidance transactions with respect to employee share schemes (proposed section GB 49B);
• make a minor amendment to the penalties applying to employers who do not take reasonable care in reporting employee share scheme benefits (proposed amendments to the definition of “tax shortfall” in section 3(1) of the Tax Administration Act 1994);
• provide transitional rules for existing schemes to ensure taxpayers have sufficient time to amend schemes (if necessary) to take account of the new law following enactment of the Bill (proposed new section CZ 1); and
• replaces the former terminology – share purchase agreement – with the new term – employee share scheme – throughout the Income Tax Act 2007 and Tax Administration Act 1994.

Application date

There are various application dates for each of the amendments, as specified below.

Detailed analysis

Cost base

It is proposed that income from an employee share scheme benefit, be added to the cost of the shares for tax purposes (clause 12, proposed new section CE 2(4)). Similarly a deduction reduces the cost base.

This provision applies from the date six months after the date of enactment.

FIF regime

The Bill effectively excludes from the FIF regime employee share scheme shares which are treated as owned by the employee for tax purposes but for which the share scheme taxing date has not arisen. Before that time, it is appropriate to tax the dividends on the shares, but not appropriate to tax any change in value, since that will be taxed when the shares give rise to income under section CE 2. See clause 60, proposed amendments to section EX 38.

This provision applies from the date six months after the date of enactment.

Trusts

As referred to above, an employee share scheme trustee will be treated as the nominee of the employer and (if different) the share issuing company (see clause 14, proposed section CE 6). This means that the activities of the trustee on behalf of those companies will be treated as undertaken directly by the companies themselves. They will therefore have no effect on the trustee’s taxable income.

Section HC 27(3B), which deals with the situation where an employer has claimed a deduction for a settlement on an employee share scheme trustee, is proposed to be repealed, as such settlements will no longer be deductible. See clause 74.

These provisions apply from the date six months after the date of enactment.

Specific anti-avoidance provision

Clause 70 of the Bill contains a specific anti-avoidance provision, in proposed section GB 49B. This allows the Commissioner to counteract any tax advantage gained from an arrangement which attempts to circumvent the intent and application of the share scheme taxing date, by seeking to have shares taxed either earlier or later than is consistent with that intent.

This provision applies from the date six months after the date of enactment.

Penalties

Clause 187(26) of the Bill amends the definition of a “tax shortfall”, so that an employer who is required to report the amount of an employee’s share scheme income in a tax return, and who fails to take reasonable care in determining the amount of that income, is liable for the same shortfall penalty whether or not the employer has elected to pay PAYE on the benefit. There is no basis for differentiating in this respect between employers who do and those who do not withhold PAYE.

This provision applies from the date of enactment.

Transitional rules

Employee share schemes are often long-term arrangements, lasting three or more years. Additionally, new share schemes are set up fairly regularly by companies and it is important for companies and employee participants to have clarity around the tax laws when they enter into these arrangements.
Accordingly, it is important to provide sufficient transitional measures for existing and contemplated employee share schemes. It is not desirable to put employers and employees in a position where employees are being granted employee share scheme benefits without certainty as to their tax treatment. However, it would also not be appropriate for employers and employees to be able to unduly extend the application of the existing rules by artificially qualifying for grandparenting grants of employee share scheme benefits which are not, in substance, intended to be conferred until a much later time.

To balance these competing objectives, a 6 month period after enactment is proposed when benefits can continue to be taxed under the old law in specific circumstances. Clause 28 proposes section CZ 1 which provides that the new employee share scheme rules do not apply to shares granted or acquired before the publication of the officials’ issues paper on 12 May 2016. The new rules would also not apply to a particular share if:

(i) that share was granted or acquired before the date that is six months after the date of enactment;

(ii) the shares were not granted with a purpose of avoiding the application of the new law; and

(iii) the share scheme taxing date under the new law is before 1 April 2022.

If shares benefits are taxed under both the existing and proposed new rules, the new rules provide the employee with a credit for income recognised under the old rules.

This transitional provision applies from the date six months after the date of enactment.

5 Which includes any person receiving a PAYE income payment (for example, certain directors).

6 Annual “total shareholder return” is a combination of dividends paid and appreciation in share price during a year.