Chapter 2 - Problem with current system
2.1 As shares and options provided under employee share schemes are substitutes for a cash salary (or another form of employment income), our tax rules seek to tax benefits arising under employee share schemes in an equivalent way to cash salary or wages. This is to ensure neutrality between different remuneration strategies and to prevent tax distorting commercial decisions to remunerate in one way rather than another.
2.2 Consequently, the current rules treat as employment income a “benefit” that arises under an employee share scheme. The “benefit” under an employee share scheme is, in the case of an acquisition of shares, the amount by which the value of the shares when they are acquired is more than the amount paid or payable for them. Share options provided to employees are generally not taxed until they are exercised, at which time the tax treatment of a share acquisition applies.
2.3 The benefit arising under an employee share scheme is treated as employment income under section CE 1(1)(d) of the Income Tax Act 2007, but unlike most other employment income, it is not a PAYE income payment (under section RD 3) nor is it a fringe benefit. This means that, unlike cash salary or wages, the benefit is not subject to any form of taxation at source and it is the employee’s obligation to file an IR 3 return and pay the requisite tax.
Potential problems with current collection system
2.4 The example below illustrates a potential problem with this approach.
John is offered 500 shares in his employer XCo for a purchase price of $10,000. The market value of the shares on the day he is able to acquire the shares is $50,000. If John chooses to acquire the shares, John’s employment income from the employee share scheme is $40,000 ($50,000 market value of the shares – $10,000 purchase price). As an alternative, XCo offers John a $40,000 cash bonus (which is currently his only source of income). John may choose to take either the shares or the $40,000 cash bonus.
2.5 Under our current tax rules, if John chooses to purchase the shares and receive his $40,000 employment income in this form, he would have to account for tax on this income himself. This would involve:
- John filing an IR 3 – which he would not otherwise have to file; and
- funding the resulting tax liability from: (a) his after-tax cash salary; (b) the sale of a portion of his shares (assuming there is a market for the shares and the employee share scheme allows him to do so); or (c) borrowings.
2.6 The receipt of the employee share scheme benefit also raises the issue of whether John will be subject to the provisional tax rules. As John’s residual income tax (RIT) in the year he receives the employee share scheme benefit is less than $50,000, the tax on his employee share scheme benefit for that income year is due in one instalment on the terminal tax date and therefore he will not bear use-of-money interest (UOMI) if he does not pay provisional tax.
2.7 John will be subject to the provisional tax rules in the following income year because of the inclusion of the employee share scheme benefit in the current income year. He will be required to pay provisional tax on the expectation that he will continue to be subject to the provisional tax rules whereas, in reality, receipt of the employee share scheme benefit may have been a one-off occurrence.
2.8 To avoid having to pay provisional tax unnecessarily in the following income year, and then request a refund once his tax return is filed, John would have to file a “nil” estimate of his provisional tax. However, this will also have the effect of dropping the threshold for liability for UOMI from $50,000 to $2,500. John will therefore be liable for UOMI if the RIT on any untaxed income he receives in the following income year is $2,500 or more because of the employee share scheme benefit he received in the current income year. This would not be the case if John had not received the employee share scheme benefit.
2.9 John’s compliance costs in accounting for his $40,000 of employment income in this case would be relatively high for a potentially unsophisticated taxpayer. He would likely need to seek expert advice on how to account for tax, including negotiating the provisional tax rules.
2.10 In contrast, if John chooses the $40,000 bonus, his employer will deduct and pay PAYE and John will simply receive the after-tax bonus. John will have no additional filing or provisional tax obligations and will not have to concern himself with how to fund his tax liability as a result of a potentially illiquid asset.
2.11 The current tax collection mechanism for employee share scheme benefits may therefore make a pre-tax cash benefit more attractive to an employee than an equivalent pre-tax benefit under an employee share scheme. This may provide a tax disincentive to employees participating in an employee share scheme and may distort behaviour.
Advantages of collecting tax at source
2.12 Based on this analysis, there appear to be compliance cost and neutrality arguments for allowing employers to account for tax on employee share scheme benefits at source on behalf of their employees. Providing at least the option for an employer to deal with the employee’s tax liability arising from participating in an employee share scheme would benefit both the employee (in the form of reduced compliance costs) and the employer (by making employee share schemes equally attractive, from a tax compliance perspective, as a cash salary equivalent).
2.13 From Inland Revenue’s perspective, the advantages of providing for taxation at source on employee share scheme benefits include:
- increased likelihood of compliance and improved tax recovery in relation to these benefits; and
- reduced administrative costs associated with auditing and enforcing compliance.
2.14 Example 2 illustrates these benefits.
YCo has 1,000 employees who participate in an employee share scheme that provides an annual taxable benefit of $4,000 for each employee. This means that for a single income year $4,000,000 of employment income is provided by way of the employee share scheme. Assuming all employees are taxable on the employee share scheme benefit at the 33% tax rate, the tax due on these benefits is $1,320,000.
If the tax is accounted for at a single collection point by the employer, the likelihood of recovery is improved (as the employer is likely to be a sophisticated taxpayer with resources to ensure compliance) and the cost of any administrative action to ensure compliance will be limited to interaction with the one taxpayer. Thus tax is collected in the most efficient manner.
If, alternatively, the tax must be collected from each individual employee, the chance of full recovery is reduced because this relies on voluntary compliance by 1,000 unsophisticated taxpayers who are not used to dealing with the tax filing system. In addition, the fact that each of these taxpayers owes only $1,320 may make enforcement action administratively inefficient.
Potential disadvantages of tax collection at source
2.15 The difficulty that arises in taxing an employee share scheme benefit in the same way as cash salary or wages is that, unlike cash salary and wages, the benefit is not payable in cash and therefore it is prima facie impractical to subject it to a withholding tax such as PAYE because you cannot withhold from shares.
2.16 This is not, however, fatal to taxation at source – for example, the FBT system provides for source taxation of non-monetary remuneration, and the provision of accommodation by an employer is subject to PAYE.
2.17 There may be some additional compliance costs for employers in applying a source taxation system to their employee share scheme. Officials expect, however, that the additional compliance costs should be minimal and less than those faced by individual employees trying to account for tax on the same employee share scheme benefit.
2.18 Some employee option schemes may not lend themselves to collection of tax at source. For example, under some schemes an employer may not know that an employee has sold their options, nor will they know the option purchase price. A less likely, but still plausible scenario, is that the employer may not know when the employee exercises their options and what the market value of the shares is on the date of exercise. In these cases, it is more appropriate for the employee to continue to account for tax on the employee share scheme benefit as they are in a better position to know the facts and circumstances of the sale or exercise than their employer.
Officials’ preliminary view
2.19 On balance, officials consider that taxation of employee share scheme benefits at source is a better approach to collecting tax on employee share scheme benefits. In addition to the benefits already outlined previously, it is a more consistent and coherent approach to taxing employment income. It is also consistent with the general policy of simplifying employees’ tax obligations. Subjecting an employee to a potentially complex filing requirement for what may be a small employee share scheme benefit when that employee would not otherwise have to file a return is inconsistent with the policy objective of simplicity and reduced compliance costs.
2.20 In addition, it is unlikely that the difficulties associated with taxing non-monetary remuneration present an insurmountable challenge, as this has been achieved in other circumstances.
2.21 Having come to this preliminary conclusion, Chapter 3 sets out some possible approaches to achieving taxation at source, while Chapter 4 raises some transitional and consequential issues that will arise if we move to a taxation at source model for employee share scheme benefits.
2.22 We are interested in receiving readers’ views on our analysis of the problem as outlined in this chapter.