Business success is often reliant on attracting and retaining talented staff.
The challenge for business owners is to design remuneration packages that motivate staff in a way that aligns their performance with the owners’ business objectives.
The most common way businesses incentivise and reward employees is through the payment of rewards or cash bonuses. Another is to allow employees to take an ownership stake in the business through acquiring equity or shares in the business.
There are a number of different types of employee equity/share schemes (ESS) that can be used to give employees an ownership interest.
The tax treatment of certain ESS is currently under review by the Inland Revenue (IR). The IR’s concern is that the current tax framework results in inconsistent tax treatment of such schemes compared with other means of incentivising employees, such as the payment of bonuses.
IR earlier this year released a public consultation document where it identified the problems with the current treatment of ESS and proposed means to address the problems. It followed this up with another document in September where it has given its thoughts on more refined proposals for the taxation of ESSs.
The IR’s issue is with “conditional ESSs”. These are schemes where the employee may legally own the shares (or have a beneficial interest in them) but does not have all the risks and rewards associated with ownership. An example of this is a scheme where the employee will forfeit the shares if employment-related conditions have not been satisfied (eg. if the employee does not meet performance targets, or leaves the firm before a certain agreed period of tenure).
Under the current tax framework, the taxing point for most conditional ESSs is at the time the employee receives the shares. Often such schemes are structured in a way that the employee purchases the shares at their market value, often through the provision of a favourable loan from the employee. Given the employee pays market value for the shares at the time no income arises and there is therefore no tax liability results.
This tax treatment is generally inconsistent with the taxation of other employee rewards, such as the payment of a cash bonus on the employee meeting certain performance objectives. For example, a cash bonus will be taxed when the objective is fulfilled and the employee receives the bonus.
This can be illustrate by the following example.
An employer would like to encourage a key employee to remain with the firm for a minimum of three years. To do so, the employer is willing to give the employee an ownership stake in the business.
The employer sells shares to an employee in 2016 for $100 which is the market value. The employer provides a $100 interest-free loan to enable the employer to fund the purchase. The employee will be entitled to keep the shares if they remain with employee for three years, at which time they will repay the loan. No taxable benefit arises to the employee as they have paid market value for the shares.
The employee remains with the firm for three years. The firm has done well over the period and the market value of the shares held by the employee has increased from $100 to $150. The employee retains the shares and repays the $100 loan to the employer.
The economic benefit to the employee is $50. This benefit is not subject to tax under the current tax rules.
By contrast, if the employee had instead agreed to provide the employee with a $50 cash bonus after three years, the bonus would be taxable.
The IR wishes to combat this inconsistent treatment by shifting the taxing point for ESS to the time the employee holds the shares free from conditions. The IR propose to tax ESS’s based on the following tests:
- ESS benefits that depend on continued employment will be taxed once that employment has occurred; and
- ESS benefits that are options or subject to contingencies will be taxed once the option is exercised or the contingencies are resolved.
The practical result of this is that the ESS will be subject to tax when the employee has met the specified performance objectives and therefore holds them on the same basis as any other shareholder.
In the example above the employee would be taxed at the end of the three year period. They be taxable on income of $50, being the excess of the market value at the time ($150) over the price they paid for the shares ($100).
The cost to employers for providing ESS is currently not explicitly deductible for tax; this leads to over taxation and discourages employers from offering ESSs. On the other hand, employment remuneration paid in cash is tax deductible. To achieve consistent treatment, the IR is proposing to give the employer a deduction, equal in both timing and amount to the income taxable to the employee.
The IR proposes favourable terms for the transition from the old to the new proposed rules. Under the terms, ESSs may not be subject to the new rules depending on when they were entered into and when the ultimate benefit under the schemes arises.
Employers and employees should be aware of the IR’s proposed changes and the tax consequences. Given the proposals, employers may need to reflect on just how they best incentivise and reward their staff in future.
The comments in this article of a general nature and should not be relied on for specific cases. Taxpayers should seek specific advice.