Appendix 2 - Fringe benefit tax and employee share loans
A number of employee share schemes make use of interest-free loans. Interest-free loans provided to employees by their employer are generally subject to FBT. However, FBT is not payable in respect of an interest-free loan provided by an employer to enable an employee to purchase the employer’s shares, provided certain criteria are satisfied (see section CX 35 of the Income Tax Act 2007).
This naturally raises the possibility that one way to correct the problems identified with some employee share schemes would be for FBT to be applied to the interest-free loans associated with an employee share scheme. However, as outlined below, the current FBT treatment is not the source of the problems, and so applying FBT to the benefit of the interest-free loan does not address the underlying issues which are the timing of taxation and the character of income.
The FBT exemption is appropriate because it ensures the tax treatment of the interest-free loan is the same as if the employer had charged interest, but paid the employee extra salary to meet the interest cost (the “grossed-up transaction”).
The reason interest-free employee share scheme loans are exempt from FBT, whereas other interest-free employer loans are not, is that in the case of a share scheme loan, the interest on the grossed-up loan would be deductible as there is the necessary nexus with income (that is, the dividends on the shares). This is the reason one of the criteria for the FBT exemption for employee share scheme loans is that the shares must maintain a dividend-paying policy. In the case of other employer interest-free loans, the money may be spent on non-deductible expenditure – for example, to buy a home. Therefore, it is not appropriate to exempt employer interest-free loans from FBT more generally.
The following example illustrates this point.
An employer is prepared to give an employee an interest-free loan of $1,000 to buy the employer’s shares. Suppose that the market rate of interest is 5%. The employer can either:
- lend the employee $1,000, charge interest of $50, but also pay the employee $50 extra salary to meet the interest cost; or
- lend the employee $1,000 interest-free (forgoing $50 of interest income).
Neither the employer nor the employee has any preference between these two options. Pre-tax, the two options are obviously neutral – neither party ends up with any more or less cash.
The outcome is the same once tax is taken into account. In the first case, the employee receives $50 of assessable income, but has a deduction for $50 of interest (as the loan is used to purchase dividend-generating shares). Similarly, the employer is entitled to a $50 deduction for the salary payments, but also derives $50 of assessable interest income. Accordingly, there is no tax payable as a result of this arrangement.
If FBT was charged in the second case, employers and employees would simply adopt the counterfactual transaction – charging interest on their employee share scheme loans, but funding it with an equivalent salary payment. It is inefficient for tax to drive the commercial arrangements between the parties. To ensure tax neutrality between the two economically equivalent transactions described above, it is necessary to exempt the interest-free loan from FBT.