Capital gains tax on shares? Inland Revenue proposes changes to Employee Share Schemes
Tax Alert - June 2016
By Greg Haddon and Liz Nelson
Late last year Inland Revenue raised some alarm when it issued a Revenue Alert indicating that it had concerns over various employee share schemes, going so far as suggesting they may constitute tax avoidance. They have now released an Officials’ issues paper to seek feedback on proposals to significantly change the rules relating to the taxation of employee share schemes.
In summary, the paper includes the following proposals:
- Unconditional employee share schemes (shares and options offered to employees free of any further conditions) should be taxed at the time the employee acquires the shares or exercises the option to acquire shares (i.e. no change).
- Conditional employee share schemes (shares or options offered to the employee where retention of the shares is subject to future conditions) should be considered a reward for future work and therefore taxation should not occur until the conditions have been satisfied. This means any movement in share price up until the conditions are satisfied will be subject to tax.
- Option-like arrangements (being arrangements where shares are acquired at market value and then held on trust for a period before they vest with the employee, including interest-free non-recourse loans and mechanisms to return the shares if conditions are not met) should be similar to conditional employee share schemes, and taxed at the point that the conditions have been satisfied. This is in direct contrast to a product ruling issued by Inland Revenue last year on a commonly used form of share scheme.
- Employers should be allowed a deduction for a deemed cost of the shares provided under an employee share scheme at the same point as the income is taxed in the hands of the employee based on the amount that is taxable for the employee.
- The concessionary regime for widely offered share schemes should either be repealed or modernised (with a preference for the former) on the basis that the rules are antiquated and unfair.
- The paper also considers whether a concession should be offered to start-up companies that would potentially defer taxation of employee share schemes until the shares are sold or listed (based on the value at that time).
The premise of the paper is that a benefit under an employee share scheme should be subject to tax in the same manner as an employment benefit paid in cash. As a cash bonus is not taxable until the cash is received, shares should be taxable when they are granted unconditionally. In the Officials’ opinion, options should be taxable on exercise. Where there is the potential for forfeiture, Officials view the arrangement as more akin to an option, so such arrangements should be taxed like an option.
In our view, what the paper fails to recognise is that the value of the benefit received by the employee (as employment income) is the value of the instrument granted, whether it is a share or an option. Any change in the value of the instrument should be considered a capital gain or loss. Neither the employee nor the employer has control over the value of the instrument, as this is a function of capital markets, and the value of a share at vesting is not interchangeable with cash remuneration.
Australia and the U.S. recognise the capital gain element. We understand that Australia will only tax the employee share scheme as employment income where there is a discount on the option or share offered. Where there is no discount, there is no employment income to tax, and any future movement in the value of the share or option is only subject to capital gains tax. Similarly, in the U.S. employees can elect to be taxed upfront on option-like arrangements, and where there is no discount there should be no tax.
The paper uses the difficulty of valuing options as a reason not to tax them upfront and seeks to rationalise this position on the basis that the after-tax outcomes for the employee are equivalent regardless of whether tax is imposed at issue or exercise. However there is no such valuation difficulty in Australia and in our view the after-tax equivalence examples are over simplified. The Australian Taxation Office (ATO) publishes specific tables that give a safe harbour for the valuation of an option. The taxpayer can either use these tables or seek their own valuation. In addition, a share scheme such as the arrangement that was the subject of last year’s product ruling is respected as an upfront acquisition of shares in Australia. This leaves New Zealand employees at a significant disadvantage relative to their Australian counterparts and creates complexity within Australasian businesses that offer employee share schemes in both countries.
Officials are also considering offering a “concession” to start-up companies, enabling employees to defer taxation until the shares are sold or listed. Employee share schemes are a popular tool in start-up companies due to the shortage of cash to attract talent and the culture that it creates when employees have skin in the game. This proposal would tax any upward movement in the value of shares until they are ultimately sold or listed in an open market. Again, in our view this is taxing what should be a capital gain on the movement in share price. An argument might exist for imposing a time value of money cost, however taxing the capital gain is neither appropriate nor is it a concession.
Turning to Australia again, there are specific rules for valuing options for start-up companies. Any gain on the shares once they are sold should only be subject to capital gains tax, and potentially gets the benefit of a 50% discount on capital gains tax.
The consideration of start-up companies also fails to look at the wider taxation issues they face, for example, shareholder continuity and tax losses. The benefit of a tax deduction for employee share scheme benefits will be severely limited if a start-up company cannot make use of the tax losses it has available, and is likely to forfeit those tax losses in the event of a significant shareholding change or share listing.
In summary, we are concerned that the proposals will result in the over taxation of employees in New Zealand, in exchange for what should only be a small increase in revenue for the Government (assuming companies are ultimately able to utilise their deduction). Effectively, the revenue generated by the proposals should be limited to the tax rate differential between companies and employees (as employers will be able to take a deduction for the employee share scheme benefits); however the cost must be borne by employees. This does little to align the interests of businesses and employees.
In our view the proposals will materially impact the ability of companies to use employee share schemes to attract and retain talent. It is likely to be difficult to construct a scheme that delivers the commercial benefits that a number of the existing schemes provide in a form that is manageable from both a company and employee perspective. This cannot be good for New Zealand.
The closing date for submissions is 22 June 2016. If you would like to make a submission, please contact your usual Deloitte tax advisor.