Chapter 5 - Proposed taxation of conditional employee share schemes and option-like arrangements
5.1 This chapter discusses the problems associated with conditional employee share schemes before addressing option-like arrangements. For conditional employee share schemes, the timing of taxation may differ from other forms of employment income. In some cases, the expected level of taxation may also be different. For option-like arrangements, employment income may be derived that would be taxable if it were in the form of an equivalent option or a conditional bonus. However under the current treatment of the arrangement, this employment income may escape taxation altogether. Further examples of conditional employee share schemes and option-like arrangements are contained in Appendix 1.
5.2 The chapter puts forward a proposal to address the timing and under-taxation problems. The proposal does not affect the taxation of the income of employees arising from unconditional employee share schemes.
Taxing conditional employee share schemes
5.3 Unconditional employee share schemes are granted without a stipulation that the employee continues in employment with the company. As the receipt of the shares does not depend upon performing any services in the future, they can be seen as a reward for past employment services, and their tax treatment reflects this.
5.4 However, a conditional employee share scheme shares many characteristics with conditional cash bonuses or other forms of remuneration. In particular, the services that the contract rewards have not yet been performed and the associated employment income not yet earned. It effectively provides a reward for future work.
5.5 Under current law, a conditional employee share scheme may, at times, be disadvantaged compared with a conditional cash bonus. Currently, a conditional employee share scheme has a different taxing point to a conditional bonus providing an equivalent employment benefit. Consider a share, worth $100, acquired in Period 1 for no consideration, subject to forfeiture if the employee is not employed at the end of Period 2. Currently, $100 would be taxed in Period 1. If the employee leaves before the end of Period 2 (thus forfeiting the share), this income would be reversed for tax purposes, but the employee would have been out of pocket for the tax over the period.
5.6 In effect the tax would be payable before the services were rendered and before any remuneration was earned. An equivalent cash bonus and its tax would only be payable in Period 2.
5.7 On the other hand, Example 1 in Appendix 1 outlines situations where the expected value of tax could be reduced by using a conditional employee share scheme in combination with an interest-free loan and a bonus.
5.8 Current law already deals satisfactorily with share options where the right to exercise is conditional on remaining in employment (the employee share scheme benefit is taxed on exercise).
Taxing income from option-like arrangements
5.9 Option-like arrangements have more complicated features than other conditional employee share schemes. Features can include interest-free non-recourse loans and various mechanisms to return the shares if conditions are not met. More examples of option-like arrangements are contained in Appendix 1.
5.10 Under an option-like arrangement:
- an employee purchases shares in the company, but retains the shares only if certain share price-related conditions are met;[14]
- because of the price conditions, the arrangement has a positive expected value at the time of issue;
- if the conditions are not met, the shares are forfeited, but there is no loss to the employee;
- as the arrangement is remuneration for employment services, the value is employment income and should be taxed;
- however, the effect of the arrangement is to bring forward the taxing point to a time prior to the satisfaction of the conditions;
- under current law, the arrangement is viewed as a purchase of shares for full consideration;
- accordingly, no income is subject to tax at issue;
- any income arising from price movements of the shares between the time that they are purchased and the satisfaction of the condition is tax-free; and,
- as a consequence, taxable employment income is converted into tax-free capital gains.
5.11 The cashflows of this type of arrangement can be equivalent to the cashflows of an option that would give rise to tax. Or, they can be the same as a conditional cash bonus where the amount of the bonus depends on the price of the shares (sometimes referred to as a phantom share scheme).
5.12 Given the income arises from a benefit which is conditional on future services, it is appropriate that it be taxed at the same time as other equivalent forms of employment income.
5.13 Consider Examples 4 and 5 which compare the taxation results of an option and an option-like arrangement under current law. In the examples, the option-like arrangement results in no tax. This is despite the fact that $25 of income has been provided to the employee by the employee share scheme. By contrast, the equivalent option yields $25 of expected taxable income. The examples are based on the price situation used in Example 3.
Example 4: Taxation of option
The share prices movements are the same as in Example 3. In this case, the employee is given a share option that is exercisable with a strike price of $100 if they continue in employment for one year. The expected value of the benefit is $25 (that is, a 50 percent chance of getting $50).[15]
| Period 1 | Period 2 | Probability | |
|---|---|---|---|
| Share price | 100 | 150 | 50% |
| 50 | 50% | ||
| Employee cashflow | 0* | 50** | 50% |
| 0 | 50% | ||
| Taxed income | 0 | 25 |
* the employee receives a benefit of an option worth $25, but no cashable benefit
** $50 is the difference between the strike price of $100 and the share value of $150 in the high-price state of the world. In the low-price state of the world, the share value of $50 is less than the strike price and the option is not exercised by the employee.
Example 5: Taxation of option-like arrangement
The facts are the same as in Example 4, except that, instead of issuing an option, the employer issues shares to the employee for $100, funded by an interest-free loan. There is zero net cashflow for the employee in period 1, which is the same as the option in Example 4.
If the price is $150 in period 2, the employee keeps the shares and repays the loan. Net income and benefit are $50, the same as the option in Example 4.
But the benefit in this example is treated as a capital gain and no tax is payable under current rules.
If the share price falls to $50, the employee hands back the share in satisfaction of the loan, with no taxable income or loss if the documents are appropriately drafted.
| Period 1 | Period 2 | Probability | |
|---|---|---|---|
| Share price | 100 | 150 | 50% |
| 50 | 50% | ||
| Employee cashflow | 0* | 50** | 50% |
| 0 | 50% | ||
| Taxed income | 0 | 0 |
* $100 loan advanced minus $100 purchase price.
** $150 share minus $100 loan repayment.
5.14 As noted above, some concerns have been expressed that tax at exercise taxes the potential share price upside more than tax at issue. Under tax at issue, the same $25 of income would be subject to tax, in contrast to the option-like arrangement which results in no tax. As discussed in detail in the chapter on unconditional employee share schemes, tax at issue and exercise are equivalent, and in any event are not relevant to the conclusion that option-like arrangements can lead to under-taxation under current rules.
Summary of problems
5.15 The current tax treatment of conditional employee share schemes and option-like arrangements is not appropriate when tested against the framework described in Chapter 2. Specifically, inconsistency between the taxation of conditional employee share schemes, option-like arrangements and other forms of employee remuneration can arise if:
- shares are subject to forfeiture if the employee does not continue to provide services for a certain time;
- there is downside price protection on the shares; or
- shares have contingent rights that make them hard to value on issue.
5.16 In all cases, income can be considered to be earned when the conditions are satisfied (or the downside protection ceases) and value is received. However, under current rules, taxation may occur at a prior point. For option-like arrangements and shares with contingent rights, early taxation may result in some employment income not being taxed.
5.17 The current rules are also a source of considerable complexity and uncertainty as economically equivalent transactions can have a significantly different tax treatment depending upon arbitrary and obscure technical differences. The current rules lack clear legislative guidance on which to base consistent determination of treatment.
Proposal to clarify taxation of conditional employee share schemes and option-like arrangements
5.18 The objective of the proposal is to clarify the tax rules applying to employee share schemes to:
- ensure that the amount of taxable income reflects the employment income arising from the arrangement;
- ensure consistency with the taxation of other equivalent forms of employment income;
- eliminate uncertainty of application; and
- ensure employers can use employee shares schemes where they are economically efficient.
5.19 The proposal directly addresses the problem of the taxing point occurring before the income is actually earned. It defers the time of taxation until all of the substantial conditions have been fulfilled. We refer to the proposal as a “substantial conditions” approach. It would clarify the taxation of complex schemes, and would generally align the taxation of employee share scheme benefits with the taxation of equivalent benefits provided in cash.
5.20 By clarifying the taxation of complex arrangements, it will eliminate uncertainty and simplify compliance and administration.
Technical issues
5.21 Deferral of income recognition would apply generally when the employee does not have all the risks and rewards associated with share ownership.[16] For example:
- when there is a real risk of forfeiture of the shares;
- where the employee has a right to transfer the shares back to the company (often in satisfaction of a loan used to acquire the shares);
- where the employee is protected against loss due to a decline in the share price, for example, by way of a non-recourse loan or other payment;
- when employment-related conditions have not been satisfied; and
- when contingent rights associated with the shares have not been exercised or extinguished.
5.22 Not all conditions would be considered to be substantial. For example, a sale restriction alone should not be considered to be a substantial condition that gives rise to deferral of tax, nor should it be taken into account in valuing employee share scheme benefits.[17] This is because sale restrictions are very difficult to value, and if they were taken into account to reduce the assessable income under an employee share scheme, when the sale restriction was removed, the remaining value of the shares would need to be taxed at that point. This approach seems overly complex and compliance cost-heavy.
5.23 If the substantial conditions approach is adopted, a number of technical details would need to be worked through during the legislative process. In particular, deferring the taxing point for shares may also require legislation to deal with other possible events that might occur before a condition is fulfilled, but that should nevertheless trigger recognition of employment income. Such events include:
- termination of employment where shares or options are retained (often they will not be);
- migration by the employee;
- expiry of a certain number of years; or
- the condition becoming insubstantial.
5.24 It is important that the new rules cannot be circumvented, either by avoiding an employment relationship, or having shares or options issued directly to an associated person of an employee, rather than the employee themselves. For example, suppose a person provides personal services to an employer through a personal services company and the company receives shares as part of the remuneration for those services. Prima facie, because the company is not an employee, the taxation of those shares will not be determined by the proposed rules. Some form of anti-avoidance provision would be appropriate to ensure that the new rules do apply in such a situation, perhaps adopting a similar approach to the existing personal services attribution rules.
5.25 There will be other technical or remedial issues that should be dealt with if and when the legislation is amended. These issues could include:
- the anomalous treatment of convertible notes under the employee share scheme rules;
- clarifying the cost base of the shares for the employee;
- any cross-border issues peculiar to employee share schemes; and
- any uncertainties that exist in the way employee share scheme trusts are currently taxed.
Submission points
We are interested to hear from readers:
- whether they agree that the current tax treatment of conditional employee share schemes and option-like arrangements is at odds with the neutral framework outlined in Chapter 2; and
- whether they agree with the “substantial conditions” approach to taxing employee share scheme benefits.
If you disagree with any of the above, please outline why and what your preferred approach would be.
[14] There are also typically employment conditions.
[15] If the share pays a dividend during the year after it is given, the employee receiving the employee share scheme benefit will also receive the dividend. However, the employee will in that case be taxed on the dividend, so this difference in outcomes is appropriately taxed.
[16] If an employee simply acquires ordinary shares in their employer using a loan (interest-free or otherwise) from the employer and there are no other arrangements relating to the shares, for example, substantial contingencies attached to the shares, or downside protection, then the shares will be treated as acquired by the employee at the outset of the arrangement. This treatment is consistent with the position of other equity investors in the company who have borrowed (at full recourse) to purchase shares.
[17] Contrary to the current rules in section CE 3 of the Income Tax Act 2007.