Clough v Commissioner of Taxation: A Lesson in Poor Execution?
Tax Alert - December 2021
By Matthew Scoltock & Edwin Zhang
On 12 November 2021, the Full Federal Court of Australia handed down its judgment in Clough v Commissioner of Taxation  FCAFC 197, finding in favour of the Commissioner of Taxation and largely affirming the courts’ view as to the deductibility in Australia of a payment made by a company to cancel employee options and other employee equity rights in order to facilitate a liquidity event (in the taxpayer’s case, a takeover and delisting)
The taxpayer, Clough Limited (“Clough”) had in place an employee share option plan (“Option Plan”) and a separate equity-based employee incentive scheme (“Incentive Scheme”). Under the Option Plan, Clough offered options to employees pursuant to which the employees were entitled, upon exercise, to subscribe for shares in Clough at a specified strike price. Under the Incentive Scheme, employees were offered “performance rights” which, after three years, entitled the employees to either (a) acquire shares in Clough, or (b) receive in cash an amount equal to the market price of the shares that they would otherwise have been entitled to acquire. The Option Plan and Incentive Scheme were designed to secure key personnel and incentivise their performance as employees of Clough. While the Option Plan and the Incentive Scheme had different vesting criteria, both allowed for accelerated vesting upon a “Change of Control Event.”
On 28 August 2013, Clough and its c. 60% shareholder, the Murray & Roberts Group, entered into a scheme implementation agreement under which the Murray & Roberts Group was to acquire the remaining c. 40% shareholding in Clough pursuant to a scheme of arrangement; and Clough was to be delisted from the Australian Stock Exchange (“ASX”). Clough’s entry into a scheme of arrangement constituted a “Change of Control Event” with respect to the Option Plan and the Incentive Scheme. Pursuant to the scheme implementation agreement, Clough made an offer to cancel both the options and the performance rights, outside the terms of the Option Plan and Incentive Scheme, and despite the terms of the Incentive Scheme allowing for performance rights to be cashed-settled without actually being cancelled.
The scheme of arrangement was implemented on 11 December 2013. On the same day, a subsidiary company of Clough paid c. A$15M to certain employees to cancel their options and performance rights in accordance with the cancellation offer. Clough was delisted from the ASX the next day. A deemed assessment was subsequently made in respect of the 2014 income year, on the basis that the c. A$15M payment was not allowed as a deduction. Clough’s objection to the deemed assessment was disallowed.
On appeal from the lower court – which found in favour of the Commissioner of Taxation earlier in 2021 – the Full Federal Court held that the payment was not allowed as an immediate deduction under Australia’s general permission. In doing so, the Court stated that:
“… in a practical business sense, the payments are better characterised as payments made pursuant to an agreement to secure a change in control rather than as meeting employee entitlements on a change of control. The payments were made to effect a reorganisation of the capital structure of Clough, through a takeover by [the] Murray & Roberts [Group] and the delisting of Clough from the ASX. The bringing to an end of the various rights of the employees under the employee schemes was necessary to secure the reorganisation of the company’s capital structure for the enduring advantage of the business.”
The Court, agreeing with the decision of the lower court, concluded that the payment failed to meet the “positive limbs” of the general permission on the basis that it was not “incurred in gaining or producing… assessable income.” The need or occasion for the payment lay in the takeover, despite the fact that the payment would not have been made but for the existence of the options and participation rights in the first place.
The Court went further to note that even if the payment had satisfied the positive limbs of the general permission, it would not have been allowed as a deduction as it was also of a capital nature.
However, as Australia has a general rule allowing “black-hole” expenditure to be deducted on a straight-line basis over a five-year period, Clough’s appeal was allowed in part, and the deemed assessment to entirely deny a deduction for the 2014 income year was found to be commensurately excessive.
The Court also made the important observation that its finding as to the deductibility of the payment was not to be denied by the fact that a payment to cash-settle the performance rights – pursuant to the terms of the Incentive Scheme – may have been allowed as a deduction. Citing academic text and well-established case law authority, the Court noted that a payment is not allowed as a deduction simply because it is made to relieve a taxpayer of a future payment that may itself be deductible.
There are a number of compelling reasons why the Full Federal Court’s analysis may not be applicable in New Zealand, given that Clough related to Australia’s general permission and capital limitation rather than a specific statutory regime governing the deductibility of expenditure incurred in relation to employee options and other employee equity rights.
In New Zealand, an employer’s allowable deduction for actual or deemed expenditure in relation to an “employee share scheme” is codified by section DV 27 of the Income Tax Act 2007. Section DV 27 was deliberately drafted to supplement New Zealand’s general permission by deeming the employer to incur expenditure in an amount equal to the employee’s income. While subject to the capital limitation (to ensure that expenditure is not allowed as a deduction if it relates to an employee share scheme with clearly capital features), the fundamental intent of section DV 27 is to ensure that remuneration in the form of an employee share scheme is subject to income tax in the same way as a cash bonus and the deductions follow suit.
The deductibility of a payment to cancel “shares or related rights” under an employee share scheme is specifically within the ambit of section DV 27. It may therefore be appropriate that if the employee share scheme is “vanilla” – without any features of a capital nature – a cancellation payment ought to be allowed as a deduction under section DV 27, just as a deduction would be allowed if a cash bonus had instead been paid. Within the unique framework established by section DV 27, where the terms of the underlying options/equity rights do not have capital features, the right policy outcome is surely to allow a deduction for the employer.
As New Zealand’s legislation does not allow a general deduction for black-hole expenditure, the application of Clough has the potential to be highly detrimental (by contrast, in Australia, the issue is likely to be one of timing only). It is therefore particularly important that companies think very carefully about the terms of employee share schemes at the outset; as well as the appropriate mechanisms (and income tax outcomes) before cancelling options/equity rights. Notwithstanding the very different statutory regime in New Zealand, it does seem clear that cancelling the options and performance rights – rather than allowing them to vest, be exercised, and for the employees to then participate in the takeover – was an important factor in Clough’s sub-optimal result.
Accelerated vesting upon a liquidity event is very common in the New Zealand market. It is important that the design of any accelerated vesting is considered through a tax “lens” to ensure that it provides commercial flexibility without compromising tax deductibility. If you would like to discuss Clough in more detail, or if you would like to understand what it might mean for your employee share scheme, please reach out to your usual Deloitte tax advisor.
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