Chapter 3 - Employer deductions for shares provided under employee share schemes
3.1 Under current law there is no explicit deduction for a company that issues shares to an employee at a discount. This is not appropriate. In principle, employers should be able to claim a deduction for providing employee compensation in the form of shares, just as they can claim a deduction for other types of remuneration. Providing a deduction would ensure that the tax system does not act as an impediment to paying staff in the most sensible manner.
3.2 In the absence of income taxes, it is worthwhile paying an employee $1,000 if that employee will increase company revenue by $1,001. In the presence of taxes, it remains sensible to hire the employee only if the salary is deductible. If it is deductible, the company will be taxed only on its $1 profit – it will be profitable to hire the employee in the same circumstances after tax is imposed as before tax is imposed. If the salary is not deductible, the company will face tax on income of $1,001, despite making only $1 of profit. It would not be profitable to hire the employee.
3.3 Similarly, in the absence of tax it is worthwhile providing an employee with $1,000 of shares if this would incentivise the employee to increase revenue by $1,001. In the presence of tax, it is necessary to allow an employer a deduction for the provision of shares in order to maintain tax neutrality. Without a deduction, the employee would have to increase revenue by at least $1,390 in order for it to be worthwhile (for the company) to provide $1,000 worth of shares.
3.4 Allowing employers a deduction for remuneration in shares is important to ensure tax neutrality. It equalises the tax treatment of employee share scheme benefits with cash remuneration, which is deductible to the employer. If a deduction is available for cash remuneration but not remuneration in shares, the tax system will discourage the use of employee share schemes.
Costs when shares provided
3.5 In general, the costs of issuing a share are not deductible as they do not represent a cost to the company. The value of the shares is supported by the extra cash the company receives as a consequence of selling the shares. However an employee share scheme is a different transaction. The transaction could be viewed as payment of a cash wage to the employee, followed by the purchase of shares of the company. The cost being deducted is not for the issuance of the share, per se, but the implicit cash wage that the share represents.
3.6 In some circumstances, it is possible under current law for an employer to structure employee share schemes so deductions are available. However, this is an unsatisfactory solution. Such employee share scheme structures may be costly and complex and could also be seen as tax avoidance. The amount and timing of the deduction may be different from the amount of income to the employee. For these reasons, not all employers offering employee share schemes may be able to or want to structure them so that the amount treated as income to the employee is also deductible to the employer. This creates a barrier to otherwise beneficial employee share schemes.
3.7 The fact that the issue of shares by a company does not involve an explicit cash cost to the company itself does not affect the above analysis. The deduction reflects the transfer of value to the employee, which arises whether that value is transferred as cash or as shares in the company. In contrast, in the case of shares issued for consideration, there is a dilution cost to the existing shareholders in the company when shares are issued as part of an employee share scheme. Under the corporate tax system, where company expenses are deducted by the company as a separate taxpayer from its owners, this cost must be recognised in the calculation of income by the company rather than the shareholders on whose behalf it is earned.
3.8 Recognition of expenditure arising from the issue of shares and options to employees is now required under International Financial Reporting Standards (IFRS), though on a different basis to that proposed here.
3.9 It is proposed that employers be allowed a cost for the provision of shares under employee share schemes to the extent that they give rise to employment income taxed in the hands of employees in the year.
3.10 Clear availability of this deduction, and its linkage to taxation of the employee, may well assist in reducing concerns about the amount and timing of employee share scheme income to employees, and also in reducing the incentive to find ways to artificially reduce or defer employee share scheme income. It also ensures the deduction is available to the employer without having to structure the employee share scheme to achieve deductibility.
3.11 Consequential amendments would be required to ensure that no other costs with respect to the provision of the shares are deducted by the employer. Other consequential issues would also need to be considered – for example, the effect of employee share schemes on the employer’s available subscribed capital.
We are interested to hear from readers:
- whether the current non-deductibility of employee share scheme benefits is a barrier to offering employee share schemes in practice;
- whether clarifying the basis for a deduction is desirable;
- whether readers agree that the appropriate approach to quantifying and timing the deduction is to match it to the employment income recognised by the employee. If not, why not, and what would be preferable approach?
- whether the approach should be modified where the employer is not the direct provider of the shares, for example, where there is a trust involved, or where the shares are issued by the ultimate parent company of the employer.