Incentivising employees
Sally Preston
Are you looking to incentivise your key employee with the issue of shares or an interest in your company? You may have heard about employee share schemes, but did you know there are different types of schemes, plus alternatives you may want to consider?
Some options to consider are:
Employee share/option schemes – these include employee share plan; employee share option plan
Vendor financing the issue of shares – this is where the company issues shares at the market value but provides the employee a loan to buy them
Partly paid shares – where the share is not paid up in full and can be paid up in full over time
Phantom share arrangements – where shares are not issued but some form of percentage of profit is given as a bonus and then perhaps some payment on the sale of business.
At a high level we explain the options below.
Employee share/options schemes
If you know much about how benefits provided to employees are taxed – generally under the fringe benefits tax rules – then you’d be right to assume the ATO would not let shares issued for a discount go untaxed.
If we say for now that in general an employee is taxed on any discount on the share issue they receive. That’s right – the employee. So as an employer, this doesn’t impact you, but your employee may be hit with a tax bill for you issuing them shares!
That’s the general premise. However, there are some concessions and structuring opportunities to consider. As a high level summary, these include:
There may be a concession where the company qualifies as a “start up” and where employees are issued:
shares at only a 15% discount to market value; or
where they are given an option to buy shares and the exercise price in the agreement is the current share price or higher.
So practically what does this do? Well, it means that if an employee sees value in the company then they may purchase shares at a discount without having any tax. Likewise, a company can grant an option to purchase shares at the current price which means if the share value goes up, then an employee may bag a bargain and not have to pay any tax.
To qualify as a start-up the company cannot be listed on the stock exchange, plus all companies in the corporate group must have been incorporated less than 10 years ago, and the aggregated turnover must be less than $50m.
Where the scheme does require the employee to pay tax on the discount, they may be eligible to reduce the discount amount included in their income tax return by $1,000 if certain criteria are met.
For this to apply, there is an employee income test plus the scheme needs to meet certain requirements. One of these is that the scheme must be offered on a non-discriminatory basis to at least 75% of your Australian permanent resident employees with at least 3 years of service.
A third type of concession to consider is structuring the scheme so that any potential tax payable by the employee is deferred to a later date. It means that the employee will be taxed on the benefit received (the discount) in the year that the deferred taxing point occurs.
There are several ways this can be achieved and generally, this is all in the drafting of the rules of the scheme.
The rules can be drafted so that the employees have a risk of forfeiting the shares or options and/or are restricted in disposing of the shares or options. Once there is no risk of this, the taxing point for the employee may be triggered. There are also rules around the amount of time the employee needs to hold the shares and so on.
Financing shares through giving a loan
If, as the employer, instead wants to just make a loan to an employee to acquire the shares at market value and the loan is interest free, then, it is worth also being aware that the loan may be subject to fringe benefits tax depending on how the arrangement is structured, or if this is the second loan offered to the employee it may be treated as a deemed dividend.
If for example, the loan was for no more than 7 years, plus the ATO required repayments and were made, and interest was charged on the loan at the ATO rates, then there may be no implications of this. In this case, it would be worthwhile for the employee to shop around whether they may get a better deal on interest rates and repayment terms from an external financier.
These are complex rules so should be carefully considered.
Partly paid shares
An alternative is to offer partly paid shares instead. This could work as follows:
The employee is issued shares with a market value at the current value.
Only a small amount is paid to the company on the issue
The remaining amount remains unpaid and is payable when the company makes a call on the shares.
A call may be made for example, when a dividend is paid so that some of the share is paid up when cash is also received.
Some considerations with this:
Will the employee still have full access to dividends?
Does the company constitution allow for partly paid shares?
What happens if the company is sold? The shareholder will need to pay up the unpaid amount but will also have hopefully some good profits on the sale of the shares!
Benefits – shareholder gets in at current market value and collects dividends along the way.
Downside – unpaid portion on shares can be called upon in the event of insolvency/liquidation.
Phantom shares
A Phantom Share Scheme works where you want to pay employees based on any increase in the company’s share price without actually giving them ownership of those shares. It’s a great way to incentivise them without losing equity, but you’ll need to ensure this is clearly set out in writing through a Phantom Share Agreement. Note that the payments received are likely to be treated similar to a bonus would.
Administration and reporting requirements to be aware of
One thing to be aware of is that there may be both employee and ATO reporting requirements depending on what is put in place. These are generally due by 14 July to the employee and 14 August to the ATO – so it is a tight turn around at the end of the financial year.
Don’t let some admin deter you though but do make sure you get upfront advice from both your tax adviser and lawyer prior to issuing new shares in your company. It is super tricky and not something you should do alone!