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Chapter 6 - Start-up companies

6.1 Employee share and option schemes can be an attractive form of remuneration for start-up companies, such as technology companies, as they allow companies to reward employees with the prospect of future share price gains rather than payment of cash wages and salaries. Tax rules are sometimes seen as a barrier to start-up companies using these schemes.

6.2 In particular, concerns have been raised that if the tax impost arises without a sale or an active market for the shares, it is difficult to determine their value so as to work out the tax liability. Even if the shares can be valued, the employees are often unable to sell a portion of their shares to meet the tax liability and therefore have to fund the liability from other income or borrowings – thus making the scheme less attractive. In principle, the employer could provide cash income to pay the tax. But, start-up companies typically experience cashflow problems as well and therefore the problem is simply transferred to the employer.

6.3 The lack of deductibility of costs associated with the issuance of shares may also deter their use as the after-tax cost of providing share-based compensation is higher than alternative cash-based compensation that would give rise to a deduction.[18] The proposal to allow an explicit deduction – discussed in Chapter 3 – would remove this disincentive.

6.4 There may also be other tax issues that hinder the ability of start-up companies to offer employee share schemes.

Submission points

We are interested to hear from readers:

  • whether valuation and liquidity issues are barriers to start-up companies offering employee share schemes; and
  • whether there are other tax obstacles to start-up companies offering employee share schemes.

Timing of taxation

6.5 The fundamental tax issues for start-up companies offering employee share schemes concern the timing of taxation. These issues can be illustrated with a simple example that modifies the examples in the previous chapters to better reflect a start-up company’s situation. Assume that shares with a current value of $100 will be listed on the stock exchange at a value of $1,000 in period 10, 10 percent of the time. Otherwise the company fails and the shares will be worth nothing. Over the period, the start-up company pays no dividends. Again, assume for simplicity a zero interest rate. This situation is illustrated in Example 6.

Example 6: Start-up company share valuation

  Period 1 Period 10 Probability
High value $100 $1,000 10%
Low Value $100 $0 90%
Average value $100 $100  

6.6 Companies have considerable flexibility in determining the timing of taxation of employee share scheme benefits through their choice of scheme. The company can choose between providing discounted shares and paying tax upfront or providing an option that is taxed when it is exercised (at which time valuation and cashflow problems may be resolved). Example 7 demonstrates that the distribution of the net of tax benefits to the employee over different share price outcomes is the same.

6.7 Consider an unconditional employee share purchase scheme offered with a full discount. The $100 benefit would be subject to tax when the share is issued, so that the after-tax amount of shares held would be $67.

6.8 Alternatively, the company could offer an option over the share with a strike price of zero, exercisable if there is a liquidity event (assumed to be in year 10). A liquidity event, such as public listing of the shares or a large trade sale would avoid valuation and liquidity problems. The full $100 of value could be held as an option.

Example 7: Deferral of taxation

The table compares the net of tax outcomes from receiving a fully discounted share or a fully discounted option.

On one hand, the employee receives $67 of shares at a full discount on which tax of $33 has been paid upfront; equivalent to $100 of income. In period 10, either:

(a) the underlying shares increase in value to $670; or,

(b) the shares drop in value to zero.

On the other hand, if the employee receives $100 of options in Period 1, but does not pay tax until Period 10, then either:

(a) the shares go up in value, the employee buys $1,000 worth of shares for $0, makes a pre-tax gain of $1000 and, after paying tax of $330, ends up with $670 of shares; or

(b) the shares go down in value to zero.

The employee’s after-tax benefit in both the high price and low price states of the world is the same regardless of whether they pay tax upfront on a fully discounted share purchase or pay tax at exercise on a fully discounted option.

  Period 1 Period 2 High price (shares worth $1000) or low price (shares worth $0)
Tax on share purchase
Before tax benefit $100 $670 High price
0 Low price
Tax paid $33 $0 High price
$0 Low price
After-tax value of benefit $67 $670 High price
$0 Low price
Tax on share option
Before tax benefit $100 $1000 High price
$0 Low price
Tax paid 0 $330 High price
$0 Low price
After-tax value of benefit $100 $670 High price
$0 Low price

6.9 The example demonstrates that for start-up companies that do not pay dividends, where the employee receives the shares at a full discount, there is a simple way under current rules to avoid valuation and cashflow problems, while yielding equivalent after-tax benefits to the employee.

Submission point

We are interested to hear from readers whether this flexibility in the choice of scheme structure is likely to be sufficient to resolve the liquidity and valuation issues for start-up companies, or whether there is a need for legislative solutions to be explored.

Possible statutory deferral for start-ups

6.10 If valuation, liquidity and possibly other issues are likely to continue to present a significant barrier to start-up companies offering employee share schemes, we would like to explore ways to ameliorate these tax issues within the proposed framework (discussed in Chapter 2). To be consistent with the policy framework, any proposals should not result in material under-taxation of employment income nor increase the risk of non-compliance.

6.11 For example, a possible way to address the valuation and liquidity problems would be to allow employees of start-up companies who receive shares under an employee share scheme to defer the taxing point until the shares are sold or listed. This would address both the valuation and liquidity issues – at the time the shares are sold, there is an established market value and the employee has cash with which to satisfy the tax liability. Ordinarily income received in-kind is recognised when received rather than being deferred until the asset is sold.

6.12 This potential deferral differs from the self-help deferral discussed above (that is through using an option scheme), since, in this case, the employee actually receives the shares. With an option, the receipt of the shares is delayed.

6.13 Under a statutory deferral approach, income tax would be imposed at the time the shares are sold on the sale price of the shares less any amount the employee paid to acquire the shares.

6.14 Deferral might seem unattractive to taxpayers. Employees entering into employee share schemes will often do so on the basis that they believe the shares might increase significantly in value. If the corollary of deferring the recognition of income from the receipt of shares in an employee share scheme is that the taxed income is equal to the value of the shares at the time of the deferred recognition, employees may prefer not to defer.

6.15 Perhaps counter-intuitively, Example 8 demonstrates that, if shares are offered at a full discount, deferral of taxation yields equivalent after-tax outcomes for the employee. As with the discussion on tax at issue versus tax at exercise for options in Chapter 4, the apparent taxation of the capital gains is in fact equivalent to upfront taxation, without the attendant problems of valuation and cashflow. The intuition is that scaling down the amount invested at the beginning through taxation is equivalent to scaling down the benefits by the same percentage through taxation at a later time, such as a sale or listing of the shares.

Example 8: Simple comparison of tax at issue and deferred tax

The employee receives $100 of wages, pays tax (or not if tax is deferred), and invests the after-tax proceeds in shares of the company.

Tax at issue

Tax of $33 is paid upfront, leaving an after-tax amount of $67 to be invested in shares of the company.

The shares go up 10 times to $670.

Deferred tax

No tax is paid upfront and $100 is invested in the shares of the company.

The shares go up 10 times to $1,000, and tax of $330 is paid when the shares are sold, leaving the same net position of $670.

Conclusions

Tax at issue and deferred tax at sale are equivalent.

Reducing the amount invested by 33% upfront is equivalent to reducing the proceeds by 33% at the end.

The small amount of tax of $33 upfront leaves the employee in the same net position as the large amount of tax of $330 at the end.

6.16 If the employee makes a payment for the shares, deferral can result in an increase in taxation for the employee. Possible remedies for this can be explored.

6.17 This approach allows the deferral of the payment of tax which could result in an effective decrease in tax revenues to the Government. When no dividends are being paid, the deferral would be expected to be compensated for by the collection of a greater amount of tax (because the shares increase in value over the deferral period). However, if the company pays dividends, the expectation will be that the value of the shares would not increase sufficiently for the increased tax to compensate for the deferral benefit.

6.18 For example, assume a 5% after-tax discount rate and a 33% tax rate. An employer grants to an employee the right to acquire a number of shares in three years for no consideration if the employee is still employed at that time. The option is exercised in year 3 when the shares are worth $900. Ordinarily tax of $297 would be payable at that time. However deferral of payment of tax until the shares are sold would have a cost to the Government if dividends are paid. If dividends of $45[19] per annum are paid on the shares, the shares would be expected to remain worth $900. The shares are sold in year 5. If tax of $297 is levied at that time there would be a time value of money cost to the Government (though this cost would be reduced by the benefit of deferring the employer’s deduction).

6.19 If the shares did not pay dividends, then the shares would be expected to appreciate by 5% per year to $992[20] in year 5, leading to tax of $327 (with a present value of $297) – the same present value of tax as taxing at exercise. Accordingly, the Government would be equally well off if it allowed a deferral of tax until sale as if tax was imposed at exercise.

6.20 One possibility would be that deferral could be made available only on shares that do not pay dividends. This may not be too great an issue as many start-up companies do not have the cash to pay dividends in any event. However, tax would need to be triggered once the share starts to pay dividends to avoid the under-taxation issue described above. Providing a precise targeting of eligibility for the deferral to cash-strapped start-ups might also alleviate this concern.

6.21 An alternative deferral approach, which would deal with situations with less than a full discount and the cashflow issue – though not the valuation issue, would be to determine the tax liability at the time of vesting, but alleviate the liquidity issue by deferring the payment of the tax until the shares are sold with use-of-money interest (UOMI) applying to the outstanding tax liability.

6.22 Any deferral of the taxing point for the employee would need to be matched by a deferral of the proposed deduction for the employer.

Scope of any deferral measure

6.23 An important issue to decide is which companies would be eligible to use a start-up concession? There are difficulties associated with defining a “start-up company”. In Australia’s recently enacted start-up concession, a “start-up company” is, broadly speaking, an unlisted Australian company which, along with all group companies, is less than 10 years old and has turnover of less than A$50 million. One issue with this approach is that it creates a “cliff face” – once a company earns $1 more than $50 million or is 10 years and one day old, it is ineligible for the regime. This could, in theory at least, create perverse incentives at the margins – for example, a company would not want to earn more revenue because it would lose eligibility to adopt the deferral approach.

6.24 Moreover, the Australian definition seems very broad and would appear to include companies that would not have the same liquidity and valuation problems that start-ups do.

6.25 Deferral raises various design issues; most obviously, should it be elective or mandatory. If elective, on what basis (scheme by scheme, employee by employee) and who should make the election? How would PAYE be dealt with in the case of income triggered by a sale? How would the system be made robust, so that if tax is not paid at the usual time, is it collected on deferral? Should there be a “sunset” clause, for example, so income cannot be deferred for more than five years?

Submission points

We are interested to hear from readers:

  • whether deferring tax until sale or listing would be beneficial;
  • whether this option should be limited to non-dividend paying shares;
  • which companies should be eligible to adopt the deferral option? How should this class of companies be defined?
  • whether providing an option to defer the payment of tax (with UOMI applying) would be beneficial; and
  • what are the best answers to the questions raised in paragraph 6.25?

Administrative measures to remove barriers to the use of employee share schemes

6.26 There is a range of other measures that could potentially reduce barriers to the use of employee share schemes, particularly by start-up companies.

6.27 Most obviously, keeping employee share scheme taxation simple and predictable, particularly in relation to the relatively simple and straightforward employee share schemes which a start-up company might be expected to enter into, is of considerable value to such companies. This reduces the need for expensive or complex advice.

6.28 Other countries (including Australia) have provided specific safe harbour valuation methodologies to reduce compliance costs associated with valuing shares. The question is whether it is possible to develop methodologies that provide reasonable results.

6.29 For example, valuation methods based on balance sheet information are likely to significantly undervalue a company and this is inconsistent with the employee share scheme framework of neutral taxation. In particular, in relation to start-up companies, intangible assets may constitute a significant part of the value of the business and these assets are generally excluded from the safe harbour valuation methodologies or, if included, are still notoriously difficult to value. Abandoning the usual valuation standard, (ultimately, what would a willing buyer pay a willing seller), has considerable risk. Deferring tax until the sale of the shares would be a more robust way to deal with valuation difficulties. We are interested in readers’ views on this issue.

6.30 Another measure recently adopted in Australia is the publication on the Australian Tax Office (ATO) website of sample employee share scheme documentation, along with guidance notes on the implementation of the documentation and the tax consequences.[21]

6.31 In addition, the ATO partnered with software developer LawPath to create an online tool – “Easy ESS” – that allows employers to quickly and easily generate employee share scheme documentation by filling out a simple questionnaire. The documentation includes an offer letter, a standard form agreement and a board resolution approving the scheme. The tool also allows the employer to assess its eligibility for the start-up concession and has a market value calculator which determines the value of the shares under the ATO’s safe harbour rules. The tool can be accessed at: http://sem.lawpath.com.au/easy-ess/.

6.32 Easy ESS also advises employers about disclosure requirements under the Australian Corporations Act (as in New Zealand, employers must provide employees with certain information before they participate in an employee share scheme). This means the employer can access the information it needs to offer an employee share scheme (about both its tax obligations and its general corporate law obligations) in one place.

Submission points

We are interested to hear from readers:

  • how valuation and liquidity issues are currently dealt with in practice;
  • whether readers think providing approved valuation methodologies are possible and would result in reliable and robust valuations;
  • whether the provision by Inland Revenue of standard documentation and guidance would be helpful;
  • whether an online tool like the Australian Easy ESS would reduce the costs associated with offering an employee share scheme – thus reducing barriers to offering such schemes;
  • whether it would be useful to have a tool/guidance covering both the tax and securities law requirements for offering an employee share scheme; and
  • whether there are any other options to address barriers to offering employee share schemes that fit within the proposed framework.
 

[18] For start-up companies without income, the tax deduction may not be useable until sometime in the future.

[19] The tax on dividends is irrelevant for the purpose of comparison as these are taxed with or without deferral.

[20] Assuming a compounding 5% appreciation.

[21] This documentation can be found at https://www.ato.gov.au/general/employee-share-schemes/in-detail/standard...