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Inland Revenue

Tax Policy

Appendix 1 - Examples of complex employee share schemes

As noted in Chapter 5, problems arise with the application of the current tax rules to complex arrangements such as conditional employee share schemes and option-like arrangements. These include:

  • discrepancy between the timing and valuation of employment income generally (for example, salary and wages or cash bonuses) compared with the timing and valuation of employment income from conditional employee share schemes;
  • under-taxation of option-like arrangements;
  • anomalous taxation of certain schemes that involve price support by way of debt forgiveness or a taxable payment; and
  • difficulty in valuing shares with rights which can change, and the inconsistency between the taxation of such shares and the taxation of options.

This appendix provides examples of:

  • Conditional employee share schemes – where the shares received are subject to future employment conditions. They may be similar in form to unconditional employee share schemes, are economically similar to conditional cash bonuses and should be taxed in the same manner. That is, they are contingent payments that depend upon future employment services and should be taxed when the value, in the form of shares, is received free from further employment conditions.
  • Option-like arrangements – have terms and conditions and arrangements that may bring forward the taxing point of the share acquisition to a time prior to the earning of the associated employment income and the satisfaction of conditions. If so, they are taxed inconsistently with options, cash bonuses and unconditional employee share schemes, with employment income essentially converted into tax-free capital gains.
  • Shares with contingent rights – are shares (usually of a special class) with terms and conditions that make them very difficult to value, that only become ordinary shares if certain events occur (such as listing or sale of company). They are similar to options and cash bonuses as they only have value if future events unfold and should be treated in a similar manner.
  • Interest-free share purchase loans repayable out of bonuses – are loans to employees made to acquire shares that are not repayable until some future date, effectively deferring tax on the discount on the acquisition of a share.

Simple examples of option-like arrangements and conditional ESS were explored in Chapter 5. The following provides more complex examples of such arrangements to illustrate the problems they raise.

Conditional ESS

The tax treatment of schemes where shares are acquired subject to a risk of forfeiture if the employee does not remain in employment for a specified time appears inconsistent with the tax neutrality framework discussed in Chapter 2. In this case, there is no condition dependent upon the future price of the share.

An example of this kind of share scheme is:

  • an employee purchases shares in their employer for market value, funded by an interest-free loan provided by the employer;
  • the shares are held by a trustee on behalf of the employee, and vest in the employee provided they remain employed for a period;
  • on vesting, a bonus is paid to repay the interest-free loan;
  • if the employment condition is not met, the employee surrenders their right in the shares in repayment of the loan.

This arrangement results in employees being taxed only if and when the employment condition is satisfied, but on the value of shares when they enter into the share scheme.

The arrangement is a contingent bonus dependent on continued service that is paid in shares. However, unlike an equivalent contingent bonus paid in cash, the employee is taxed on the initial value of the shares, not the value of shares when the bonus is paid. Accordingly, it is likely to result in under-taxation (compared with other equivalent forms of remuneration) if a company’s shares are expected to increase in value (which would be the case if, say, the company does not pay dividends). The employee is (in essence) taxed when they become unconditionally entitled to the shares, but on the initial value of the shares rather than their value when they are received free of conditions. The tax system makes the loan and bonus to purchase the shares artificially attractive compared with an equivalent cash bonus without shares.

Example 1: Share issued for value subject to service-related forfeiture, funded by loan with contingent bonus

Say a company is considering offering some form of share-based remuneration to employees to encourage them to stay with the company and to incentivise performance. The shares are currently worth $100.

The first option being considered is to give the employees, in a year’s time, cash equal to the value of a share in the company at that time, if they are still employed by the company.

The second option is the same as the first, but to give the employees a share in a year’s time instead of cash.

The third option is for an employee to purchase immediately a share for $100 funded by an interest-free loan from the employer. The share is held in a trust until the employee has stayed with the company for 1 year. After this, the share vests and the employee is paid a bonus to repay the loan. If an employee leaves before 1 year is up, the share is returned to the employer and the loan is extinguished.

Under the first and second options (transfer of cash or shares in a year’s time), if an employee remains with the employer for a year, the employee will be taxed in year 2 on the value of the share in year 2. Under the third option, if the employee remains with the company for a year, the employee will be taxed in year 2 on the value of the share in year 1 (the bonus to repay the interest-free loan is taxable, and the balance of that loan will be equivalent to the initial value of the shares).

There is clearly an inconsistent approach to taxing these equivalent remuneration methods, with the third option being preferable if the shares are expected to increase in value.

Of course, it may be the case that, at the time the employment condition is met, the shares are worth less than they were when the employee share scheme was entered into. In this case, the result of the scheme will be more assessable income to the employee than in the case of a simple bonus paid in cash or shares.

However, so long as the employer does not pay dividends, the value of the shares will be expected to increase over time, and the employee share scheme considered above will therefore be expected to produce a lower tax burden than its more simple but pre-tax equivalent alternatives. Furthermore, this kind of employee share scheme raises another fundamental question, as to when employment income is earned.

Example 2: Share gifted subject to service-related forfeiture

Suppose the same facts as the third alternative in Example 1, except that the employer decides to gift the shares to a trustee on behalf of the employee at the outset, with the shares vesting in the employee only if the employee is still with the company in one year. That is, there is no loan or bonus.

The economic benefit of this scheme is identical to the scheme in Example 1. However, in this case the employee will be taxable on $100 in year 1, and this income will be reversed in either year 1 (or year 2) if the employment condition is not met.

The taxation of Example 2 is clearly not consistent with the general approach to taxing income from services, which is that the income is derived once the services for which it is provided are performed. In Example 2, these services are performed only once the year is up. The income should therefore be taxed at that time. If the income is provided in shares (or any other non-cash form) it should be determined by valuing the shares at that time.

The only difference between Example 2 and the third alternative in Example 1 is the time of derivation of the income. The employee share scheme in Example 1 defers the income to year 2, when the employment condition is met. However, the amount of income is the same as Example 2.

Option-like arrangements

Some employment income can avoid taxation by being converted to capital gains where there is downside price protection on the shares. For example:

  • if the retention of the shares by the employee is correlated with share price (perhaps with the purchase of the shares funded by a non-recourse loan or if the employee has the right to put the shares back to the employer for the price the employee paid for them); or
  • the shares are retained regardless of their value, but the employee is protected from any fall in their value by loan forgiveness or a payment from the employer.

Share acquired subject to forfeiture purchased with loan from employer

There are a number of employee share schemes which result in non-taxation of employment income. In general, the issue raised is defining the borderline between taxable employment income and tax-free capital gains. Essentially, the schemes involve an upfront purchase of the shares, so that any future gains on the shares will be treated as a capital gain. The result in some employment arrangements is that no tax is payable. However the terms and conditions of the arrangements can mean that they are economically equivalent to a bonus or a share option with employment conditions that would give rise to tax on employment income.

In these schemes, the employee does not need to fund the purchase of the share, as the employer provides the funding through an interest-free loan (as in Example 3 below). The terms of the scheme ensure that the employee will not be out of pocket if the share declines in value. The commercial outcome is equivalent to a bonus or an employee option, in that the employee will only retain the share if it increases in value.

However, under current law, there may be no taxable income to the employee.[28] The benefit derived from the increase in the value of the share is treated as a capital gain. This is inconsistent with the taxation of similar remuneration (such as an employee option or a contingent cash bonus). As the price increase is what gives value to the arrangement and is integral to the employment contract, it is appropriately taxed as employment income. This is demonstrated in Example 3.[29]

Example 3: Share issued for value funded by loan from employer

As in the examples in the body of the paper, the company’s shares are currently worth $100 each and will be worth $150 or $50 with equal probability in a year’s time.

Assume that the employee purchases the shares for $100 in year 1, but this purchase is funded by an interest-free loan from the company.[30] This is treated as a share purchase. Because the employee pays market value for the shares, there is no taxable income. If the shares increase in value, the employee retains the shares and repays the loan, leaving them with a $50 benefit which is treated as a capital gain under current law, and so is tax-free. But if the shares are worth $50, the employee must forfeit the shares in exchange for $100 and use the $100 to repay the loan.

When the shares are worth $150 the employee is effectively paid $50, but is not taxed. Alternatively, the company could offer to pay a cash bonus of $50 if the share value is $150, or could provide the employee with an option with a strike price of $100. These three packages are economically equivalent, but the first package is tax-free, whereas the second and third packages are currently taxed in the same way – if the share is worth $150 in a year’s time, the reward to the employee of $50 is taxed as employment income at that time.

This is illustrated as follows:

Remuneration type Benefit if shares worth $50 Benefit if shares worth $150
Share option $0 ($0 after-tax) $50 ($33.50 after-tax)[31]
Contingent bonus $0 ($0 after-tax) $50 ($33.50 after-tax)[32]
Employee share scheme with forfeiture $0 ($0 after-tax) $50 ($50 after-tax)

Retention of share with downside protection on loan repayment

A possible variation on Example 3, is an employee share scheme which omits the requirement to transfer the share in satisfaction of the loan if it falls in value, and instead allows the employee to retain the share. Downside protection in this case could be provided by limiting the employer’s right to repayment of the loan to the value of the share at the time of repayment.

Example 4: Share issued for value funded by loan from employer, with repayment obligation limited to the value of the share

The facts are the same as in Example 3 except that the employee has no right or obligation to sell the share, but their liability to repay the loan is limited to the value of the share at the time repayment is due. On a pre-tax basis, this arrangement is economically equivalent to Example 3. If the shares go up in value to $150, the employee has a $50 benefit. If the shares go down in value, there is no benefit (the employee has in effect paid $50 for a share worth $50).

However, the current tax treatment differs from Example 3. As in the previous example, because the employee pays market value for the share, there is no taxable income upfront. If the share increases in value, the employee retains the share and repays the full $100 loan, leaving them with a $50 benefit tax-free. However, if the shares are worth $50, the employee keeps the share and is only required to repay $50 of the loan. This results in $50 of income to the employee under the base price adjustment (so called, “debt forgiveness income”). There may well be no corresponding deduction to the employer.

The alternative pre-tax equivalent transactions, and their tax treatment, are as described in Example 3.

This is illustrated as follows:

Remuneration type Benefit if shares worth $50 Benefit if shares worth $150
Share option $0 ($0 after-tax) $50 ($33.50 after-tax)
Contingent bonus $0 ($0 after-tax) $50 ($33.50 after-tax)
Example 3 – share scheme with forfeiture $0 ($0 after-tax) $50 ($50 after-tax)
Example 4 - share scheme with partial debt remission $0 (-$16.50 after-tax) $50 ($50 after-tax)

In this case, there is no difference from Example 3 in pre-tax economic outcome. However, taxation outcomes would be different under current law. When the share price rises, the employee would get a $50 benefit without paying tax. When the share price falls, there would be an inclusion in taxable income equal to the amount of the loan that is forgiven or otherwise offset (in the example, $50). The unrealised loss of $50 on the shares would not be recognised. Accordingly, if the price falls, tax would be paid, while no tax would be due when the price rises.

In Example 4, the correct amount of tax is paid, but in the wrong circumstance. That is to say, if the shares decline in value, the employee has no economic return, but has $50 of debt remission income. If the shares go up in value, there is no taxable income, even though the employee is better off. This reflects the fact that under current law while the debt is effectively on revenue account for the employee, the shares are on capital account.

This would appear to be inappropriate. The arrangement is equivalent to a call option or a conditional cash bonus and should be taxed in an equivalent manner as a matter of principle.

Merely taxing the downside protection could also result in significant under-taxation with different economic assumptions involving the time value of money. Consider a different situation. Share prices in period 2 can be either $100 or $120 with equal probability, and the discount rate is 10%. In that case the arrangement would have expected income of $10 (= 50% x [120 – 100]) that should be subject to tax. But in this case, there would be no debt forgiveness income. In the low price world the share is worth $100 which is sufficient to pay off the loan. The arrangement would be under-taxed. Focussing on the debt forgiveness income ignores the substance of the transaction and concentrates too much on its form.

Employee share schemes with bonus

Example 5 adds a bonus to Example 3 to provide a more significant benefit to the employee. The underlying issues are the same as in the previous examples. Some of the benefit received by the employee from the arrangement escapes taxation.

Example 5: Share issued for value subject to price-related forfeiture, with non-recourse loan and contingent bonus

Suppose the company in Example 1 instead wishes to provide the employee with the entire value of a share, rather than just the $50 increase, if the share value in one year is $150. The company could pay a cash bonus in one year of $150 if the share value is $150, or could provide the employees with the share in one year’s time only if the share price is $150. These packages are economically equivalent, and are currently taxed in the same way. If the share is worth $150 in a year’s time, the reward of $150 is taxed at that time. If it is worth less, there is no income.

However, the company could also use an employee share scheme with an immediate issue of shares subject to a risk of forfeiture if the price drops, funded by an interest-free loan, repayment of which is funded by either the return of the shares or a contingent bonus of $100. The employee purchases shares at the outset for $100 funded by the loan from the employer. Because the employee pays market value for the shares, there is no taxable income. If the shares increase in value, the employee retains the shares, receives the bonus and repays the loan. The employee then has a share worth $150 but only $100[33] of taxable income. If the shares are worth $50, the employee has the right to repay the loan by returning the shares (and receive no bonus).

The table below compares the outcomes under the three scenarios discussed in this example.

Remuneration type Benefit if shares worth $50 Benefit if shares worth $150
Contingent bonus $0 ($0 after-tax) $150 ($100 after-tax)[34]
Contingent gift of share $0 ($0 after-tax) $150 ($100 after-tax)
Employee share scheme with loan and contingent bonus $0 ($0 after-tax) $150 ($117 after-tax)

Shares with contingent rights

A different problem is presented by the current tax treatment of share schemes that use shares with contingent rights. An example is “flowering” shares, when employees are given shares with initially very limited rights (usually of special class with no voting or dividend rights). On specified future and uncertain events occurring (such as the company being sold to a third party for a certain value, or listed), the shares convert into ordinary shares.

Under current law, the shares are taxable at the time of issue. As with share option plans, taxation at the time of issue will give an appropriate outcome provided the price of the share is set appropriately (based on the chance the company will be sold or listed, and the value of the ordinary shares were that to occur). However, this valuation exercise is extremely difficult. The probability of the company being sold, and the value of the shares at sale, is impossible to estimate with any level of accuracy.

Due to these valuation difficulties, it is hard to determine whether such shares are being appropriately taxed at present. It is also clear that as a black letter law matter, such shares provide a similar outcome to options without giving rise to tax when the “option” is “exercised” (that is, the conversion occurs).

Another way of viewing schemes that provide shares with contingent rights is as a contingent cash bonus. A flowering share plan of the type described above is very similar to a bonus (paid in shares) triggered on the sale of the company to a third party. The initial provision of the shares with limited rights is really a promise to deliver the much more valuable ordinary shares upon the sale of the company; in the same way that an employer would promise at the outset to pay a cash bonus to employees if the company was successfully sold.

A contingent bonus would be taxed when (and if) it is paid – not when the prospect of the bonus is offered. This suggests it would be sensible to align the tax treatment of employee share schemes that provide flowering shares with contingent bonuses.

Loans repayable out of bonuses

The use of loans and bonuses by some employee share schemes creates the possibility of an inappropriate deferral of income in the absence of a contingency.

Example 6: Deferral of loan repayment and bonus

In this example, the employee purchases shares for their market value of $100 funded by an interest-free loan from the employer. The loan is repayable in the future, but the employer will provide a bonus to fund the repayment. Because the employee pays market value for the shares, there is no taxable income at that time and because the loan is taken to purchase shares, no FBT is payable on the interest-free loan.

The cashflow under this arrangement is similar to the cashflow for an employee share purchase at a full discount, in that the employee is not out of pocket for the purchase of the shares. Ordinarily a share purchase at full discount would give rise to tax on $100 in period 1.

Subject to anti-avoidance law, this structure might defer the income from the scheme until the bonus is paid to enable repayment of the loan. This could be deferred until the shares are sold or the employee leaves the company. However, the employee has the shares free of any further substantive conditions in period 1.

One option to address this would be a specific anti-avoidance rule to target this type of deferral. For example, a loan which is always repaid out of a bonus could sensibly be disregarded for tax purposes.


[28] If the share declines in value, whether or not there is debt forgiveness income depends on how the scheme is drafted and structured. This example assumes there is no debt forgiveness income, but that is not critical to the conclusion. A case where debt forgiveness income arises is discussed below.

[29] The analysis of the tax consequences of all the examples assumes that section BG 1 does not apply.

[30] The interest-free loan will be exempt from FBT provided it meets certain criteria. The reason for the FBT exemption for employee share loans is discussed in Appendix 2.

[31] Assuming a 33% tax rate.

[32] Assuming a 33% tax rate.

[33] Many share schemes using loan and bonus arrangements gross-up the bonuses for tax to ensure employees do not have to fund any of the loan repayments themselves. However, because the purpose of this example is to compare equivalent pre-tax benefits, the example assumes no gross-up. This means on an after-tax basis, the repayment of the $100 loan is funded by the $67 after-PAYE bonus plus $33 of the employee’s own money.

[34] Assuming a 33% tax rate.