Chapter 3 - Possible solutions
3.1 There are two key considerations in designing a solution to the identified problem of taxing employee share scheme benefits:
- What is the appropriate source taxation system – PAYE, FBT or a new, specific employee share scheme withholding tax?
- Should taxation at source be compulsory for all employee share schemes or be available at the option of the employer or employee, or by agreement between them? If it is compulsory, should employers be able to choose which system they use?
Source taxation system
3.2 Officials see there being three options for taxation at source – PAYE, FBT or a new employee share scheme withholding tax. In our view, it is preferable to use one of the existing employment income systems to tax employee share scheme benefits, rather than introducing a new withholding regime for employee share schemes. These systems are already well-developed and employers are familiar with operating them. There is little justification for considering the development of a new system.
3.3 To date, officials have received different views about whether PAYE or FBT would be the preferred system to deal with employee share scheme benefits.
3.4 One advantage of using the PAYE system is that all employers operate a PAYE system, whereas not all employers have to operate an FBT system. PAYE returns are filed monthly or twice monthly, compared with FBT returns which are quarterly (at most). Therefore, the employee share scheme benefit is likely to be taxed in a more timely manner if PAYE is used.
3.5 For existing employee share schemes, using the PAYE system would also mean that the economic incidence of tax remains with the employee consistent with the current treatment. In contrast, for existing schemes, using the FBT system could prima facie increase the cost to the employer of providing a set level of employee share scheme benefits. As discussed in Chapter 4, transitional measures could be introduced to ensure the change in the tax collection mechanism does not adversely affect current schemes. For new schemes, the economic incidence of tax can be contractually determined between the parties under either the PAYE or FBT systems, so officials do not see this as a factor influencing the choice of one system over the other.
3.6 Using the PAYE system would involve the employer recording the amount of the employee share scheme benefit as an “extra pay” in the Employer Monthly Schedule (EMS) IR 348 in the period in which the shares are acquired and paying a corresponding amount of PAYE.
3.7 The disadvantage of using the PAYE system is that it is designed to deal with cash payments. As there is no cash to be withheld in the case of a benefit under an employee share scheme, to make PAYE work, the employer would have to either recover the cost of the tax from the employee (potentially by deducting it from after-tax salary), or sell a portion of shares on the employee’s behalf to fund the tax (this is only an option when the shares are relatively liquid – for example, when they are traded on an exchange). The alternative is for the employee share scheme contract to provide a cash gross-up to accompany the employee share scheme benefit to fund the PAYE.
3.8 The problem of funding tax payments is the same dilemma currently faced by employees when they have to account for tax themselves on non-monetary benefits under an employee share scheme (which may involve selling some of the shares to fund the tax payment). Officials expect that the contractual arrangements associated with employee share schemes should be sophisticated enough to deal with this problem between the parties to the employee share scheme.
3.9 Officials also note that employer-provided accommodation is already dealt with through the PAYE system. Therefore, the PAYE system has already been used to account for tax on a non-monetary benefit. However, given employee share scheme benefits tend to vest in large lump-sums, there is a greater likelihood of there being a cash shortfall in a given pay period than in the case of employer-provided accommodation. If there is insufficient cash in the other PAYE income payments to meet the PAYE obligation in respect of the employee share scheme benefit in the period of vesting, the employee must reimburse the employer for the PAYE (if the employer has paid it), or if the employer has not paid the PAYE, the employee must pay the PAYE to Inland Revenue. This reproduces the problem with the current system – the employee has to account for the tax on their employee share scheme benefit. Accordingly, employers would need to carefully consider how to manage this issue. Officials are interested in readers’ views on this problem with using the PAYE system.
3.10 The advantage of using the FBT system is that it is designed specifically to deal with non-monetary remuneration. The gross-up is therefore effectively built into the rules (via the rate structure and the cost of FBT falling on the employer). There is a parallel between the tax treatment of shares provided by an employer to an employee for no consideration or below market value consideration, and the provision of goods or services by an employer to an employee for below market consideration. The latter category of employment remuneration is currently dealt with under the FBT rules, which suggests that it may be an appropriate system to deal with this type of benefit.
3.11 Example 3 illustrates the tax effect of PAYE and FBT when applied to an employee share scheme benefit.
ZCo has decided that it wants to provide (after-tax) $10,000 worth of shares to a key employee – Scott. Scott is subject to the highest marginal tax rate.
If ZCo accounted for tax on the shares through the PAYE system, they would need to provide Scott with $10,000 of shares and a $4,925 cash bonus (a cash gross-up). This means that Scott’s gross income is $14,925. After deduction of PAYE at 33%, Scott is left with $10,000 worth of shares.
If ZCo accounted for tax on the shares under the FBT system, it would return a fringe benefit of $10,000 and be liable for FBT of $4,925 ($10,000 x 49.25%). Scott would receive an after-tax benefit of $10,000 worth of shares.
Ultimately the tax collected is the same regardless of the system used.
3.12 We are interested to hear readers’ preferred source taxation system – PAYE or FBT.
Should source taxation be compulsory or elective?
3.13 There are benefits to making some form of source taxation compulsory for all employee share schemes, as previously discussed. Additionally, having one source taxation system (FBT or PAYE) for all employee share schemes reduces legislative complexity and administrative costs associated with processing and monitoring elections.
3.14 However, officials are aware that a large number of employee share schemes currently exist and employers (and employees) will have different views on their preferred tax collection approach.
3.15 Officials appreciate that existing employee share schemes’ contractual arrangements may have been negotiated on the basis that the employee will account for tax. As discussed in Chapter 4, appropriate transitional rules can deal with existing schemes.
3.16 Officials also appreciate there may be other reasons employers prefer the tax obligations associated with employee share schemes to lie with their employees (especially in the case of executive-level schemes). However, other employment income is subject to collection of tax at source, so there does not seem to be a compelling case to treat employee share scheme benefits differently (except in the case of certain option schemes, as previously discussed).
3.17 Even if employers were able to elect to continue with the current filing and tax payment arrangements (that is, the employee is required to return the employee share scheme benefit and pay the resulting tax), this does not provide sufficient information to Inland Revenue and is therefore undesirable from a compliance perspective. Accordingly, officials propose that any election by employers to retain the current arrangement would need to be accompanied by an obligation to provide a schedule detailing the names and IRD numbers of participating employees and the value of the employee share scheme benefits provided to each employee.
Officials seek feedback on:
- whether all employee share schemes should be subject to source taxation or whether employers should be able to elect for employees to continue to be responsible for returning and paying tax on employee share scheme benefits, with the only obligation of the employer being to provide Inland Revenue with a schedule of employee share scheme benefits granted to employees;
- whether employers should be able to choose between using the FBT or PAYE system to account for tax;
- if source taxation were to be made compulsory, whether:
- employers should be entitled to elect to grandparent the tax treatment of existing employee share schemes; and/or
- source taxation should be phased in over an appropriate period of time to accommodate changes to existing schemes and systems to provide for this.
6 In the case of options sold to non-associates (or options exercised without the employer’s knowledge) the employee would still need to account for the tax on the sale proceeds in an IR 3 because the employer may not have any knowledge of the sale of the option. Officials expect this situation to be fairly rare.
7 If the ESS benefit vested in a particular pay period was large, there may not be sufficient cash from other salary and wages to fully satisfy the PAYE obligation. Therefore there may be a need to offer an income spreading option if PAYE was adopted.
9 If source taxation were to be elective, officials would prefer that the election be at the employer’s discretion, rather than the employee’s. This is to minimise the number of employees with different tax treatments within the same employee share scheme (which would increase compliance and administrative costs).