Background and proposed changes
The changes proposed by the Federal Budget will materially alter how employee incentive arrangements are structured in private companies. Under the Budget measures, it is proposed that the 50% capital gains tax (CGT) discount will be abolished from 1 July 2027 and replaced with cost base indexation. A minimum 30% tax rate on all capital gains will also be introduced. While the policy is framed as a broader integrity and revenue measure to assist in housing affordability, it will have far-reaching consequences for numerous asset classes, including employee share schemes (ESS).
Whilst less common in listed companies, private companies often structure their employee incentive arrangements to ensure that the economic benefit received by an employee is ultimately taxed on capital account rather than as ordinary income. Under current law, a capital gain realised by an individual who has held an asset for at least 12 months is subject to a 50% discount, reducing the effective rate of tax to 23.5% for a top-marginal-rate taxpayer (inclusive of the Medicare levy), compared with 47% on ordinary income.
The proposed changes materially reduce the benefit of structuring an ESS in this way. The introduction of indexation also introduces a new dynamic, given that both the quantum of the employee’s cost base and the time at which the cost base is paid could ultimately affect the quantum of tax payable.
Structuring issues to consider
Loan-funded shares schemes
Employees who receive equity through loan-funded share schemes will no longer get the benefit of reducing their gain by 50% on a future disposal. Given that loan-funded share schemes have inherent complexity that needs to be managed (including Division 7A issues surrounding subsequent ‘top-up’ grants of shares, the inclusion of shareholders on the register, and managing the implications of bad leavers), without the offsetting benefit of the CGT discount for participants, companies are likely to reassess whether these schemes provide sufficient pay-off for participants.
Deferred tax schemes under Division 83A
Deferred tax schemes that fall squarely within the ESS rules in Division 83A are likely to become more popular. The value of incentives provided under Division 83A schemes has always been taxed as ordinary income (taxed at up to 47%) and, consequently, deferred tax schemes are not impacted by the CGT changes in the Budget. The benefits of such schemes lie in:
- the relative simplicity of such schemes to implement, as they are low cost to design and, given that they are usually structured as option schemes (rather than share schemes), bad leavers and unvested incentives are easily dealt with; and
- the fact that the taxing point for participants can generally be structured to align with a liquidity event, ensuring the employee is never out of pocket for a ‘dry’ tax liability.
Premium priced options and cost base timing
There is now an incentive for employees to acquire their equity interests (and pay full market value to establish their cost base) as early as possible. For companies that are still considering loan-funded schemes, this aligns neatly: loan-funded schemes by their nature require participants to acquire shares at full market value from the outset. However, for companies that use premium priced options as a capital account incentive, only a minimal cost base (if any) will be established from the outset, resulting in the full value of the option being subject to tax at 47% on a future exit, without any benefit from indexation. This means that from 1 July 2027, premium priced options are taxed no differently from an option scheme that operates under Division 83A, but have the inherent disadvantage of a ‘stretch’ strike price that was designed to obtain a CGT benefit that will no longer exist.
Start-up ESS concessions
When they were introduced in 2015, the ESS rules applying to start-up companies were specifically designed to enable participants to be taxed under the CGT regime with the benefit of the CGT discount. Given that start-up schemes are typically designed as option schemes, similar to the issues raised above in relation to premium priced option schemes, the Budget changes effectively result in the value of such incentives being taxed in full at marginal rates (given that no material indexation of the cost base is likely to occur over the duration of the scheme). The Federal Government has specifically called out that further consultation will be undertaken with the early-stage and start-up sector. It remains to be seen whether the distinct policy rationale that applies here (enabling start-ups with minimal funds to attract talent) will be sufficient grounds for a modification to the proposed CGT rules.
Revisiting existing schemes
Any existing schemes which were structured with the promise of the CGT discount benefit for participants may need to be revisited:
- For schemes that were put in place recently: without the CGT discount pay-off, will such schemes sufficiently incentivise staff? If not, should such schemes be cancelled and what are the implications of doing so?
- For schemes that have been in place for some time: is there an opportunity to enable participants to crystallise gains before 1 July 2027?
- For schemes that involve premium priced options that do not have a strong likelihood of ever being ‘in the money’: should these schemes be replaced with deferred option schemes that would at least permit employees to participate by reducing the exercise price to an achievable level?
Loan-funded schemes in established private companies
For established (i.e. profitable) private companies, loan-funded schemes are not necessarily redundant. A loan-funded scheme still provides access to dividends with minimal capital outlay by participants. In addition, even without the 50% discount, a loan-funded scheme in an established private company at least provides participants with an early and meaningful cost base, which will be indexed over time.
Phantom profit schemes
Phantom profit schemes are likely to become more popular than they currently are. Phantom schemes (sometimes called share appreciation rights or synthetic equity) give participants a notional equity interest which mimics the financial benefits of owning shares without actually owning shares. Participants are paid a bonus on the occurrence of a milestone based on the return they would have received had they actually owned the relevant equity. Such schemes are popular elsewhere in the world and are often used in global plans. In Australia, however, the treatment of such payments as ordinary income has meant that they are relatively uncommon. Given that:
- the counter-factual (actual equity ownership) will no longer provide a CGT discount benefit;
- phantom share plans can now be structured in a way to qualify for regulatory relief under Division 1A of the Corporations Act (such that they are not subject to the regulatory obligations that may otherwise apply to ‘derivatives’ under the Corporations Act); and
- phantom plans have considerable structuring flexibility and are not restricted by the 10% ownership limitation that exists under Division 83A deferred tax plans,
it is expected that these plans may now become more common in Australia.
Looking ahead
The proposed CGT changes in the Federal Budget will shift the future structuring of incentive plans, in addition to changing the way that participants are taxed in respect of their existing incentives. Certain structures that have been historically attractive for their capital account treatment (and are widespread in Australian private markets) will need to be reconsidered, ideally before 1 July 2027. For the start-up sector, active engagement with the Federal Government in the consultation process that has been flagged will be important to ensure that the policy rationale behind the start-up concession is preserved.
For further information on how to structure your employee share scheme arrangements in light of the proposed Federal Budget changes, please contact Seema Sandhu.
