Chapter 4 - Taxing employment income from unconditional employee share schemes
4.1 As described in Chapter 2, tax neutrality requires that the benefits provided to employees under employee share schemes are taxed consistently with other forms of remuneration.
4.2 As previously noted, employee share schemes may be divided into three general categories:
- Unconditional employee share schemes – which provide shares or options free from further conditions.
- Conditional employee share schemes – where the shares or options received are subject to future employment conditions.
- Option-like arrangements – which are in the form of a share purchase, but have terms and conditions (often based on the price of the shares) and other features that make the arrangement similar in economic effect to an option. Option-like arrangements often have employment conditions in addition to the price conditions.
4.3 This chapter discusses the current taxation of unconditional employee share schemes. In general, under current rules, unconditional employee share schemes are taxed in a manner which is consistent with the policy framework in Chapter 2. It provides context for the discussion in Chapter 5 of conditional employee share schemes and option-like arrangements.
4.4 Broadly, unconditional employee share schemes fall into two categories:
- share purchase plans, where an employee purchases (or is given) shares; and
- share option plans, which are in effect deferred share purchase plans.
Share purchase plans
4.5 Employees participating in a share purchase plan are taxed when they acquire the shares. The taxable income is the difference between the value of the shares at that time and the price they pay for them. If employees pay full market value for the shares, then no taxable income arises. At the other extreme, if employees are given shares for no consideration, then the full market value of the shares is taxable income.
4.6 We consider that this treatment is appropriate when shares are received without further conditions. Income is earned at the time the shares are acquired in much the same way as income would have been earned if paid as salary and wages and the proceeds used to acquire shares of the company.
4.7 The concerns of start-up companies with the taxation of share purchase plans are discussed in Chapter 6.
Share option plans
4.8 With a share option plan, employees are given a right to purchase shares at some future date for a set price (the strike price). An employee will exercise the option if the shares’ price at the future date exceeds the strike price – the option effectively allows them to acquire the shares at a discount. If the strike price exceeds the shares’ price the employee will not exercise their option.
4.9 When an employee receives an option, employment income equal to the value of the option is received and that income should be subject to tax.
4.10 Under current rules, no tax is paid when the option is issued. An employee participating in a share option plan is taxed only if and when the option is exercised. The difference between the market value of the shares at exercise and the value at the strike price is taxable income. This approach is tax at exercise.
4.11 In principle, an employee participating in a share option plan could be taxed when the options are provided to them. No further tax would be paid when the option is exercised. This approach is tax at issue.
4.12 Concerns have been expressed that tax at exercise taxes the potential share price increase when compared with tax at issue; that is, tax at exercise taxes capital gains. These concerns are misplaced. The two tax treatments are equivalent. They lead to the same distribution of after-tax outcomes for the employee for all share price outcomes. Accordingly, the current tax treatment of employee share options is consistent with New Zealand’s general capital gains tax policy.
4.13 This result is counter-intuitive. Certainly more tax is paid when prices increase. But the bottom line is that the after-tax outcomes of the employee are the same under the two approaches.
4.14 This result is illustrated with Example 3, with shares that can increase or decrease in value by 50 percent in a year’s time with equal probability.
4.15 The essential difference between the two approaches is the after-tax amount available to be held as options by the employee, when equivalent compensation packages are compared. With tax at issue, tax must be paid on the employment income. Only the after-tax amount of income is available to be held in options. Under tax at exercise, no tax is paid when the option is provided, so the entire before-tax amount of income can be held in options.
4.16 Under the assumptions, shares worth $100 currently would be worth either $150 or $50 in a year’s time. An option on the shares with a strike price equal to the current price is worth $25; that is, the 50 percent probability of receiving $50 = $150 - $100. Thus when the share price increases by 50 percent, the option doubles in value from $25 to $50. If the share price falls, the option is worth nothing.
4.17 Assume that the company wishes to provide compensation in the form of options that would be equivalent to pre-tax cash wages of $25. With cash wages, the employee would pay $8.25 in tax, and receive an after-tax benefit of $16.75.
4.18 Under tax at issue, an equivalent option scheme would result in tax being paid of $8.25 and an after-tax amount of $16.75 held as an option on the shares of the company. Under the price assumptions, the option yields a benefit of $33.50 (twice $16.75) when the share price increases. No further tax is paid when the option is exercised. If share prices fall, the option is not exercised.
4.19 With tax at exercise, no tax is paid when the option is provided, so the entire $25 can be held as an option. The option yields a before-tax profit at exercise of $50 (twice $25) when share prices increase, with tax payable of $16.50 (= .33 x $50). The net after-tax benefit is $33.50 (= $50 - $16.50). If share prices fall, the option is not exercised.
Example 3: Taxation of unconditional options
|Period 1||Period 2||Price outcome|
|Price of shares||$100||$150||High price|
|Tax at issue|
|Pre-tax benefit||$25||$33.50||High price|
|Tax paid||$8.25||$0||High price|
|After-tax value of benefit / Option held||$16.75||$33.50||High price|
|Tax at exercise|
|Pre-tax benefit||$25||$50||High price|
|Tax paid||0||$16.50||High price|
|After-tax value of benefit / Option held||$25||$33.50||High price|
4.20 The example demonstrates that tax at issue and tax at exercise result in the same pattern of after-tax cashflows. The basic point is that it makes no difference if a tax rate of 33% is applied when the option is provided or if the 33% rate is applied when the proceeds are received. Either way tax reduces the employee’s final holdings of shares by 33%.
4.21 Because the employee’s after-tax benefit from the arrangement is the same regardless of whether tax is imposed at issue or at exercise, they should be indifferent between the two taxing points.
4.22 This is notwithstanding that more tax, $16.50, is paid in high price situations under tax at exercise than under tax at issue (tax of $8.25). Reducing the shares held by $8.25 in the first period with tax at issue has the same effect on the employee’s final holdings as taxing the full amount of the proceeds under tax at exercise.
4.23 The equivalence of tax at issue and tax at exercise reflects the standard public finance result that taxing income as it is earned and investing the after-tax amount free from further tax is equivalent to investing the before-tax income and taxing the entire proceeds when they are realised in the future.
Maintaining the current approach
4.24 The current taxation of employment income from unconditional employment share schemes is consistent with the framework and no changes are proposed.
We are interested to hear from readers:
- whether they agree that the current tax treatment of unconditional employee share schemes (including employee share options) is appropriate and does not require reform;
- if you disagree with any of the above, why and what your preferred approach would be;
- whether there are any technical or remedial issues with respect to the employee share scheme rules that could be addressed as part of any legislative reform.
 On average, over high and low price outcomes, the government collects the same amount of tax whether tax is imposed at issue or on exercise. However, the government accepts a more risky revenue stream if it taxes on exercise since it only receives tax in high price worlds.