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Making ESOPS hard
In certain respects the new Division 83A represents an advance on the now superseded Division 13A as a means of spreading employee share ownership more widely among rank-and-file employees. But in other ways, Division 83A preserves - and even extends - the old obstacle course in the way of broader employee share ownership.
The more things change …
Two great weaknesses of the old regime were:
Problem 1: Employees restricted to choosing either an Exempt or a Deferred plan in the same tax year.
This had the effect of locking ordinary employees into the Exempt plan and of thereby limiting employee ownership to minimal levels, particularly where shares were issued free. This way of confining ordinary employees to the Exempt plan tended to defeat the key objective of employee ownership: to promote deep levels ownership in the employer’s company.
Problem 2: Weak tax integrity.
The ATO had no administratively effective way of checking tax obligations of employees occasioned by their participation in share plans.
Both problems were addressed and resolved by the new Division 83A.
Reform 1: Abolition of up-front election.
First, the new legislation abolished a perplexing requirement (under the old s 139E) to make a decision about whether or not to pay tax upfront – a decision that determined whether a rank-and-file employee could benefit from the tax-exempt concession. If, thanks to this mechanism, an employee chose to participate in a tax-exempt plan, he was closed out of participating in a tax-deferred plan. Now, under Division 83A, an employee benefits from the available tax concessions simply by participating in a share plan. Hence an employee can participate in the same tax year in:
- a tax-exempt plan;
- a tax-deferred share plan; and
- an option plan.
This is a major reform long advocated by the Employee Ownership Group
Reform 2: Introduction of TFN-based reporting system
Secondly, the new legislation introduced a TFN-based reporting system to ensure that all tax obligations arising from participation in any employee share plan are fully reported. This measure is also one that the EOG has promoted for many years. Unfortunately, the Government spoiled the simplicity and efficiency of the measure by linking it to an over-the-top reporting system – one that is onerous on business and does not provide the ATO with better or more timely intelligence about the tax obligations of employees.
… the more they remain the same
Notwithstanding these valuable reforms, several deficiencies of the previous system endure in the current one and new problems have been created.
An illogical, unjust and heavy-handed way of taxing share plans.
Division 83A provisions continue the old Division 13A tax treatment of Exempt and Deferred plans. When shares acquired under an Exempt plan are sold, any increase in value is taxed at the CGT rate. However, when shares acquired under a Deferred Plan are sold, they are subject to income tax applied to the full value of the shares on the date of sale. This is illogical and oppressive. There is no ground for treating Exempt shares in the normal manner and Deferred shares in an abnormal - and unfavourable - manner except, perhaps, to penalise the wider spread of employee share ownership.
Onerous and costly prospectus requirements.
These are burdensome for unlisted companies and for small companies that wish to offer shares widely. These requirements represent the major obstacle to the spread of ESOPs.
Restricting ESOPs to ordinary shares in the employer’s company.
This means that companies that cannot issue an ordinary share - for example, a wholly owned domestic subsidiary of a foreign company, or a small company in which control is vital to the owners - can do nothing to help their employees become part-owners of the business.
A limit on employees acquiring, though an ESOP, more than 5 per cent of the voting shares in their employer’s company (the 5 per cent Rule).
This limit does not match what is required, especially by small, entrepreneurial businesses, in order to attract and to hold key employees. The limit also means that small companies often would be unable to implement “succession planning” arrangements where the retiring employer uses an ESOP to sell the company to his employees.
New obstacles
Options can be taxed before employees can realise any value from them
A basic condition that share or option plans must meet in order to secure tax-deferred is that the shares or options must be subject to a “real risk of forfeiture”. When this “real risk of forfeiture” is lifted, then the shares or options are subject to tax. For options, this presents a serious problem. The normal international practice is to tax them upon disposal. Taxing options upon the lifting of any forfeiture conditions means that an employee can be taxed on “income” attributed to him that he might never receive. This is contrary to basic principles of tax logic and equity.
The maximum tax-deferral period has been scaled back from 10 to 7 years.
To limit tax-deferral to a set number of years is contrary to the notion of spreading employee share ownership. Limiting deferral to an arbitrarily chosen point in time will have the effect of obliging employees to sell shares when that period of time has expired. The aim of employee ownership is to promote the ownership of shares among employees that are held for the long term. The term of the holding is important. The longer shares are held, the greater the alignment between the interests of employees and the interests of the company in which they work. This alignment should not be arbitrarily terminated by Government fiat.