Australian startups and small businesses will generally be pleased with the proposed changes to the taxation of employee share schemes announced yesterday, but there are still a number of issues to be resolved before companies can start implementing new share and option incentives.
Those involved in the startup sector will be well aware of the problems that the 2009 tax changes caused, especially for early stage companies for whom incentivising their employees with equity is critical, due to limited cash flow.
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The current rules impose income tax on employees ‘up front’, at the time they are granted shares or options, rather than when the options are exercised or when the shares are sold. There are some exceptions which can defer the tax, but many arrangements don’t meet the requirements for tax deferral.
Yesterday’s announcement recognises the problems faced by startups and the fundamental difference in remuneration strategy for many startup employees, who accept a below-market-rate salary in exchange for a share in the potential upside of the business they are helping to grow.
10 key points from yesterday’s announcement
1. For all companies, employees will generally pay tax on options when they are exercised, not when they are granted.
2. For employees of ‘eligible startups’, tax on shares and options issued at a ‘small discount’ can be deferred until sale. The maximum period for deferral will be extended from 7 years to 15 years.
3. Yesterday’s announcement does not confirm what will constitute a ‘small discount’ and this will be a critical part of the details of the new rules.
4. To be an ‘eligible startup’, the company must meet three criteria:
have under $50m turnover.
be in its first 10 years.
5. Startup employees will need to hold their shares or options for at least three years to qualify for tax deferral. The new rules will need to allow for situations where employee equity is returned by later-round investors or an acquisition of the company within the three years.
6. It appears from the announcement that when employees sell tax-deferred shares or options they will be taxed at individual tax rates and will not be eligible for the 50% CGT discount.
7. The new rules won’t come into effect until 1 July 2015. Companies still need to be careful about promising shares or options to an employee. If a company gives an employee, today, the right to get shares or options in the future (even after 1 July 2015) that could trigger a tax liability under the existing rules rather than the new rules.
8. There is no indication about a cap on the amount of equity that a startup employee can hold and still be eligible for tax deferral. If the current cap of 5% is carried over to the new rules, it could cause issues for key early-stage employees and co-founders.
9. The tax valuation methodology for employee options is to be ‘updated’ – but it is not clear whether this will result in more favourable or less favourable tax outcomes.
10. The new rules should include an approved valuation mechanism for early stage startups, to avoid the cost and complexity of formal valuations.
Yesterday’s announcement is good news, but there is still a long way to go. The startup community needs to work with government to make sure the final version of the changes allows Australian startups to retain and incentivise employees without the significant tax and compliance costs they currently face.
Reuben Bramanathan is a senior lawyer at Adroit Lawyers.