Chapter 3 - Deferral regime for start-up companies
3.1 In the May 2016 issues paper, we asked for submissions on the desirability of a regime which would allow employees in start-up companies to elect to defer the recognition of ESS income until there was a “liquidity event” to fund the tax on the income (for example, when the shares are sold or listed or the assets of the company are sold and the proceeds are distributed when the company is wound up). The employee would be taxed on the value of the shares at this time, less any amount the employee paid for them (and the employer would be entitled to a corresponding deduction at that time).
3.2 This would address both the valuation and liquidity issues. For example, at the time the shares are listed, there is an established market value and the employee can sell some shares to get the cash with which to satisfy the tax liability.
3.3 Deferral of taxation yields an after-tax outcome for the employee which is equivalent to upfront taxation. The taxation of the changing value of the share can be shown to be equivalent to upfront taxation, without the attendant problems of valuation and cashflow. The intuition is that scaling down the amount invested at the outset of the arrangement through taxation is equivalent to scaling down the benefits by the same percentage through taxation at a later time (that is, when there is a sale or listing of the shares).
Example 1: Simple comparison of tax at issue and deferred tax
An employee receives $100 of wages, pays tax (or not if tax is deferred), and invests the after-tax proceeds in shares of the company. Suppose the share value increases by a factor of ten between the investment date and the date when the employee sells them.
Tax at issue
Tax of $33 is paid upfront, leaving an after-tax amount of $67 to be invested in shares of the company.
The shares go up 10 times to $670.
No tax is paid upfront and $100 is invested in the shares of the company.
The shares go up 10 times to $1,000, and tax of $330 is paid when the shares are sold, leaving the same net position of $670.
Tax at issue and deferred tax at sale are equivalent.
Reducing the amount invested by 33% upfront is equivalent to reducing the proceeds by 33% at the end.
The small amount of tax of $33 upfront leaves the employee in the same net position as the large amount of tax of $330 at the end.
3.4 Under a deferral regime, from the moment that a liquidity event has occurred and the employee’s taxable income is calculated, the employee would hold the shares on the same basis as any other shareholder – that is, based on their specific circumstances they may hold the shares on capital account. For example, if an employee continues to hold the shares after an IPO, and did not acquire the shares for the purpose of disposal, then only the increase in value arising between the time the shares or options were granted and when the shares are listed would be taxed. If the shares continued to increase in value after the IPO, those gains would in most cases be tax-free capital gains.
Example 2: Deferral of tax on exercising options
An employee has options to acquire 10,000 shares in the company for $1 per share. The option can be exercised once the employee has been working for three years, and the option does not expire for a further two years.
The employee exercises their options for $10,000 five years after they are granted. As there is no secondary market for the shares it is difficult to establish their market value. An election has been made to defer the tax on shares issued under the ESS.
At the end of year six the company is listed with a share price of $5 per share. This ends the deferral period and the employee is taxed on income of $40,000 ($50,000 of shares less the $10,000 purchase price).
The employee sells 500 shares a year later for $7 per share. In most cases there will be no tax to pay, as the shares are held as a capital asset.
3.5 Start-up companies generally generate unusable tax losses in their early years of operation, only to forfeit these losses when third party investors buy a stake in the company (because they lose shareholder continuity at that point). It is also after this point in time when companies are likely to be generating a net profit and would like to be able to use the earlier carried forward losses to reduce their current year tax bill.
3.6 Therefore, allowing employers a tax deduction for ESS benefits at an early stage in the company’s life cycle may not be particularly beneficial for start-up companies who often expect to forfeit their tax losses at some stage.
3.7 The ability to defer the taxing point for ESS benefits and the associated tax deduction to a time when they are more likely to be able to use the deduction is likely to be attractive for start-up companies. On the basis that tax deferral applies to deductions as well as income, a deferral scheme may be useful to employers directly.
3.8 There are at least two other possible approaches that could be taken to deal with the issues faced by start-up companies.
Non-deductible and non-assessable approach
3.9 One approach would be to exempt the income and deny a deduction. This is the approach taken for widely offered share schemes. It is concessional compared with the tax treatment of other forms of remuneration in two respects. First, insofar as the employee’s marginal rate is higher than the corporate rate and second, where the employer is in tax loss. As to the first of these, while at 5% the current margin is not particularly high, it is possible that may change in the future. Accordingly, we do not propose to extend this treatment beyond the ambit of the widely offered schemes. As to the second, because the ESS benefits may be relatively significant, it does not seem appropriate to treat them as non-assessable to the employee, even if deductions were denied to the employer. Officials believe the deferral proposal is a preferable solution to the issues faced by loss companies.
Cashing out losses
3.10 A second approach would be to cash out the ESS deduction in the case of a loss making company. This would eliminate the rate differential issue, assuming the cash out is at a 28% rate. It would provide the company with most of the money required to pay PAYE or a cash gross-up paid to the employee. Again, however, it would be a significant departure from our current taxation of employment remuneration. Currently, losses are able to be cashed out only where the R&D loss tax credit regime applies. We propose to ensure this applies to ESS benefits like other forms of remuneration. It does not seem appropriate from a policy perspective to allow a cash out to apply to a certain form of remuneration and not to other expenses.
- Do submitters think a deferral regime would be attractive to employers?
- Is there any alternative arrangement that would be attractive to companies and would not result in under-taxation?