Employee Share Schemes – time to revisit loan and bonus arrangements?
Tax Alert - May 2017
By Jayesh Dahya and Varshini Suresh
The Inland Revenue continue to press ahead with reforms to the taxation of employee share schemes with the introduction of the Taxation (Annual Rates for 2017-18, Employment and Investment Income, and Remedial Matters) Bill (the Bill) last month.
The Bill outlines new rules for the taxation of employee share schemes that are broadly consistent with proposals announced last year.
According to Inland Revenue, the changes are intended to remove “the considerable uncertainty” that has existed in how to apply the current rules which have apparently deterred employers from offering schemes to their employees. Whether that is the case is debatable, however what is certain is that the changes will bring to an end to employee share schemes that deliver non-taxable capital gains to their employees.
What this means is that employers operating employee share schemes that have these benefits will need to consider their options in light of the transitional rules and the proposed application dates for the new rules. This article considers benefits under general employee share schemes; refer to our separate article in this issue on “widely held” or exempt employee share schemes.
Scope of the new rules
The new rules apply to benefits received under an “employee share scheme”.
This covers all arrangements involving the provision of shares in a company to past, present or future employees (or their associates). The definitions are cast deliberately wide to cover all types of arrangements such as loans to buy shares, bonuses, put and call options and transfers to employee trusts.
The rules will not apply to:
- Schemes that are eligible for concessions i.e. widely held or exempt schemes – (refer to our separate article on these schemes in this issue of Tax Alert).
- Arrangements where employees pay market value for the shares on the “share scheme taxing date”.
- Arrangements that require employees to put at risk shares they acquired for market value with no protection to the person against a fall in share value.
Calculating the taxable benefit
The taxable benefit is broadly the difference between the market value of the shares at the “share scheme taxing date” less the amount paid for them by the employee. Inland Revenue has just released a statement providing guidance on valuation methods; see our separate article on this issue. Any ‘black out periods’ where employees are restricted from disposing of shares are not to be taken into account.
The “share scheme taxing date” is the date when:
- There is no real risk that the beneficial ownership (i.e. entitlement) will change, or that the shares will be required to be transferred or cancelled;
- The employee is not compensated for a fall in share value; and
- There is no real risk that there will be a change in the terms of the shares affecting their value
There are ten examples to illustrate how the rules are intended to apply in the Commentary to the Bill. Broadly, if the scheme has any conditions or contingencies that need to be satisfied, the taxing point will be the time that the conditions or contingencies are satisfied. Another way of looking at this is that the taxing point is the time that the employee is exposed to the full economic risk associated with share ownership, as illustrated in the examples below.
Inland Revenue Examples
Example: Simple vesting period
A Co transfers shares worth $10,000 to a trustee on trust for an employee. If the employee leaves the company for any reason during the next three years, the shares are forfeited for no consideration. After three years, the shares are transferred to the employee.
The share scheme taxing date is when the three years is up and the employee is still employed.
The risk of loss of the shares for the first three years means there is a real risk that the beneficial ownership of the share will change. None of the exceptions applies.
Example: Loan funded scheme
B Co provides an employee with an interest-free full recourse loan of $10,000 to acquire shares in B Co for market value, on the basis that:
The share scheme taxing date will be the earlier of when the employee leaves employment, or the expiry of the three years.
Until the three years are up, if the employee leaves B Co for whatever reason, they lose their beneficial ownership of the shares for an amount that is not their market value. So the share scheme taxing date will, on the face of it, be the end of that three-year period. If the employee leaves within that period and is therefore required to transfer their rights, the sale price will be taxed, but since the sale price is the same as the amount contributed, there will be no gain or loss. Once the three-year period is up, the employee will either have no income (if they sell the shares back to the trustee for $10,000) or will pay tax on the difference between the value of the shares at that time and their $10,000 price (if they choose to keep the shares).
Where an employer opts to pay a bonus under a loan funded scheme, some further complexities arise which are likely to mean that in the future such arrangements will no longer exist.
In the loan funded Inland Revenue example above, if the employer pays the employee a grossed up bonus of $14,925 (at 33%) to repay the $10,000 loan after three years at a time where the value of the shares are now $15,000, the employee will have taxable income equal to the bonus plus the difference between the value of the shares at the taxing point and the amount paid for them (i.e. the bonus after PAYE). In this case, this would be $14,925 plus $5,000 ($15,000-$10,000).
If however, the shares were only worth $2,000, the employee would have taxable income of $14,925 being the bonus and a tax deduction for $8,000 ($2,000-$10,000) that would be claimed in the tax return.
What this illustrates is that employers will have challenges with operating loan and bonus arrangements in the future. There will be difficulties in administration if we overlay the employer share reporting rules and employees are likely to find it difficult to grasp the concepts when it comes time to file their returns.
Deductions for employers
Currently, the general position is that shares issued to employees are not deductible to the employer (as there is no cost which has been incurred on a new share issue). Employers can obtain deductions by structuring employee share arrangements differently, for example by acquiring shares on market or arranging for the purchase of shares from another group entity.
Under the proposed rules employers will be allowed a deduction for:
- Benefits provided under an employee share scheme that is equal to the amount calculated on the “share scheme taxing date” (i.e. the amount of the benefit that is taxable to the employee(s)).
- Costs associated with the administration and managing the scheme, subject to the usual capital/revenue tests.
While this may be good news to those employers who currently do not get a deduction, deductions are of limited benefit to companies who may be in losses, particularly start-up companies that may lose their losses before they become profitable by introducing new shareholders. Unfortunately the suggestion that taxpayers in loss are able to cash up the benefit of deductions in these cases did not have much appeal with Inland Revenue officials.
The Inland Revenue has recognised that employee share schemes are long term arrangements that may have vesting periods of three years or more. Given this, it has been proposed that the new rules do not apply to:
- Shares granted or acquired before 12 May 2016.
- Shares granted or acquired within six months of enactment of the Bill provided the shares were not granted with the purpose of avoiding the application of the new law and the share scheme taxing date (i.e. the date benefits vest) is before 1 April 2022.
As we are in an election year, it is unlikely the new legislation will be enacted until early 2018. This means most schemes should be able to continue to operate under the existing rules until mid-2018.
Where to now?
It is now time for employers with established schemes to start thinking about how their existing schemes would operate under the new rules and whether they need to be updated for the changes that are coming.
For some employers, it may be beneficial to consider whether to make further issues or grants of shares under existing schemes given the transitional rules and likely application dates. Employers would need to ensure that benefits vest before 1 April 2022 and the further issues or grants of shares are not seen as avoidance.
Over time, it may be that employers will move away from the complex and administratively burdensome arrangements that presently exist to more traditional options or share grant schemes that offer an element of simplicity given the new rules will effectively tax all employees share schemes on the same basis as options.
If you have any questions or comments, please contact your usual Deloitte advisor.
May 2017 Tax Alert contents
Employee Share Schemes – time to revisit loan and bonus arrangements?
Closely held companies – changes to LTC eligibility and tainted capital gains
Start preparing for changes to investment income
Widely held share schemes – proposed changes announced
Determining the “value” of shares received by an employee under a share purchase agreement
The new related party debt remission rules
Tax-free capital gain, or taxable land sale?
A snapshot of recent developments