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Chapter 2 - Framework for taxation of employee share schemes

2.1 Under employee share schemes, an employer provides its shares, or options to acquire shares, to employees. Income can result when the price charged to employees for the shares or options is less than their market price. Employee share schemes can align the incentives of employees with those of the firm and its non-employee shareholders and can engender greater work effort and employee engagement.

2.2 It is important that, as far as possible, tax rules are not an obstacle to firms using employee share schemes where they are a sensible and economically efficient form of remuneration.

BBLR and tax neutrality

2.3 The framework adopted to achieve this result is one of tax neutrality. This means that the imposition of tax should not affect the form in which employees are paid. Tax neutrality is a core part of New Zealand’s general BBLR approach to taxation.

2.4 Tax-neutral treatment of the employment income in employee share schemes means, as much as possible, we should tax all types of employee remuneration, whether paid in cash or shares, consistently. It also means we should ensure that taxation does not act as an impediment to otherwise sensible remuneration decisions.

2.5 Under the BBLR framework, tax bases are defined as broadly as possible, so no activity or form of payment (such as remuneration in shares) is either advantaged or disadvantaged through the operation of the tax system. This helps reduce economic distortions. It also helps keep tax rates low as a broader base means the Government’s revenue needs can be met with lower tax rates. This, in turn, also helps reduce the distortions generated by the tax system.

2.6 A BBLR tax system also ensures that taxes are fair because, as much as possible, all forms of income are subject to tax. New Zealand’s personal income tax rates are relatively low by OECD standards. This is only possible because the tax base is broad.

2.7 An alternative approach would be to provide tax incentives for employee share schemes.

Should tax incentives be offered for employee share schemes?

2.8 As noted above, employee share schemes are offered to help align incentives of employees with those of the firm and to improve general employee engagement. Given these positive effects, it is sometimes suggested that these schemes should benefit from tax incentives.

2.9 A prima facie case for the Government to provide some form of subsidy, possibly tax incentives, arises if an activity produces positive externalities – that is, benefits arising from an activity (or a transaction) that are not enjoyed by the parties involved, but by a third party. Without some sort of Government incentive, less of the activity/transaction would occur than is ideal from society’s perspective, as the wider benefits are typically ignored by those undertaking the activity/transaction.

2.10 An example of a positive externality is a beautiful home garden. A beautiful garden improves the home of the homeowner but also improves the character of a street for all who live on it. However, this wider benefit typically is not taken into account by homeowners; many homeowners do not create a garden even if society would be better off if they did.

2.11 Externalities can also be negative, in which case a special tax would be applied to the offending activity under the same logic justifying incentives.

2.12 The 2001 Tax Review[3] noted that, as a practical matter, it is difficult for the tax system to identify positive externalities. Moreover, because positive externalities are common, subsidising an activity on externality grounds would invite lobbying to support other activities on the same grounds. The Tax Review noted:

A practical difficulty with the externality theory, however, is that such effects are pervasive, and it is generally impossible to measure either the relevant external effects or the effects of the intervening government measure. Many economists argue that government intervention typically worsens rather than improves national welfare because of infirmities of the political market. These concerns about externality-based interventions are compounded by the fact that the widespread existence of externalities provides a platform for practically any lobbyist’s reform agenda.[4]

2.13 For this reason the 2001 Tax Review suggested a high burden of proof is required before providing tax incentives on externality grounds.

2.14 This high burden of proof is not met for employee share schemes. It is unlikely that employee share schemes generate significant positive externalities. While these schemes can provide benefits (higher productivity, better engagement), these benefits are likely to be fully captured by the parties to the transaction (the employer and the employee). Higher productivity will increase profits for the employer, and likely increase remuneration for employees. An employee share scheme is unlikely to generate a greater positive externality than a simple cash bonus dependent on share price performance.[5]

2.15 If employee share schemes do not generate significant positive externalities compared with cash remuneration, then providing tax incentives for them would reduce New Zealand’s welfare. Incentives would lead to employee share schemes being excessively used when this would not be attractive under a more neutral tax regime. They would reward firms that are able to provide remuneration by means of employee share schemes ahead of other firms. They would also be unfair, as employees of such firms would more easily be able to earn income by way of employee share scheme benefits and therefore bear a lower tax burden than employees of other firms earning equivalent cash remuneration. Moreover, it is difficult to target tax incentives, so that the benefits would likely spill over to arrangements that do not satisfy the intent underlying the granting of the incentives.

2.16 For these reasons we consider that tax neutrality is the best framework for deciding how to tax employee share schemes, as providing tax incentives for these schemes would be detrimental to New Zealand’s national welfare.

Taxing employment income consistently

2.17 Salary and wages are taxed on a cash basis – that is, an employee derives the income, and is therefore liable for tax, when it is paid to them.[6] This is also true of other forms of employee remuneration paid in money, such as cash bonuses. If an employee is promised a $10,000 bonus if they remain employed for three years, no tax is payable until they receive the bonus. If they fulfil the condition and are paid the bonus, the full $10,000 will be taxable in the year it is paid. No tax is payable before the condition is fulfilled and bonus paid.

2.18 There are other ways of rewarding employees, for example through employee share schemes. Tax neutrality requires income arising from share schemes to be taxed similarly to income arising from payments of cash. This ensures that tax does not affect how employees are best rewarded – they will be rewarded in the way that makes the most commercial and economic sense.

Example 1

Jim has a tax rate of 33%. If his employer offers him a $1,000 bonus if he is still working for the employer in a year’s time, he will receive a net $670 in one year and $330 tax will be withheld.

If instead his employer decides to pay Jim the same bonus in shares, the tax-neutral outcome[7] (assuming the shares are not subject to PAYE) would be for the employer to provide $1,000 of shares, and for Jim to pay $330 tax (this assumes there is no cash gross-up provided by the employer with the shares).

In both cases Jim receives $1,000 of before-tax income and has paid $330 of tax. Tax will not be a factor in how Jim wants to be paid.

2.19 Consistent treatment of employment income is not simply a matter of ensuring that employee share scheme benefits are treated as taxable income. It is also important that the timing and amount of the income is determined consistently with the timing and amount of other forms of remuneration, most obviously cash.

Example 2

Suppose that in the previous example, instead of offering Jim a $1,000 bonus in one year, Jim’s employer promises him 1,000 shares if he is still with the company in one year. At the start of the year, when the offer is made, the value of the shares is $1 per share. Suppose when the bonus is paid, the shares are worth $1,500 in total or $1.50 per share.

It clearly would not be appropriate for Jim to pay tax on only $1,000 of income in that case. $1,000 is the value of the shares when the offer was made, not when they are received. Jim should be taxed on $1,500, that is, the value of the shares when they are received and taxed. This is the same amount of income as Jim would have if his employer offered him a cash bonus equal to the value of 1,000 shares in a year. The principle is the same if the shares are worth only $0.80 when they are provided to Jim. In that case he should be taxed on only $800.

2.20 Taxing employee share scheme benefits using the share value at a time different from the time when the benefit is received is particularly undesirable from a neutrality perspective if it leads to an expected under-taxation or over-taxation of the benefit. As will be explored in more detail in Chapter 5, systematic under-taxation of the income can arise in circumstances where there is some contingency in the receipt of the benefit.

Establishing the border between income and capital gains

2.21 A fundamental issue in the taxation of certain sophisticated arrangements with option-like effects is establishing the appropriate border between income and capital gains treatment for the income earned under the scheme.

2.22 While New Zealand has a broad-based tax system, it does not have a general tax on capital gains. Accordingly, there is a benefit to be gained if taxable employment income can be recharacterised as a tax-free capital gain.

2.23 In ensuring neutral treatment between different ways of earning employment income, it is important to correctly determine the nature of that income, as capital gains or employment income. This is the central point at issue in the discussion of the taxation of option-like arrangements in Chapter 5.

2.24 The proposals in the following chapters seek to make this borderline clearer in concept and application.

Treatment of employer costs

2.25 In order to provide neutral taxation, employer costs of issuing employee shares schemes should be deductible to the employer to the extent they are taxable to employees. This would parallel the treatment of employment income paid in cash. Otherwise there is a bias against using employee share schemes, which would be inconsistent with the neutrality framework.

Submission points

We are interested to hear from readers whether they agree that a neutral framework is the best framework for assessing the tax treatment of employee share schemes. If not, why not, and what would be a preferable framework?

 

[3] Tax Review 2001, The Treasury (2001), http://www.treasury.govt.nz/publications/reviews-consultation/taxreview2...

[4] Ibid at pp 22.

[5] In support of this conclusion, see The Taxation of Employee Stock Options (OECD) 2005 at p11.

[6] Though in the unusual case where cash remuneration is paid in advance of the provision of employment services, it is likely that the income is derived only once those services are provided.

[7] Under current law, this transaction is not tax-neutral because there is no deduction for the employer. However, as discussed below we propose that the law should be changed so a deduction is allowed.