Chapter 6 - Deferred taxing point
6.1 The issues the deferral proposal is trying to address are the lack of liquidity and difficulty of valuing shares.
6.2 Once employees have sold their shares, obviously both of these issues have been resolved, so tax should be payable no later than that time.
6.3 However, there are other events that should also potentially trigger the taxing point for shares – either because the liquidity and valuation issues have been resolved, or there are important integrity reasons for tax to be triggered.
6.4 Therefore in addition to the sale of the shares, we believe the following events should also trigger the taxing point:
- an initial public offering (IPO) of the shares on a recognised exchange;
- sale of the company’s assets followed by distribution to shareholders when the company is wound up;
- cancellation of the shares, including on the company being struck off (this will be a relatively common occurrence for start-up companies);
- ceasing to be a New Zealand tax resident;
- a “sunset” date – for example, recognition of income cannot be delayed by more than 7 years.
6.5 The occurrence of any one of these events will give rise to a tax liability to the employee and a deduction to the employer if the shares are worth more than their cost to the employee, and an obligation on the employer to report the amount of the benefit on the employer monthly schedule (EMS). This assumes that the usual share scheme taxing date has already passed. For example, if the employee holds a share option, at the time one of these events occurs, the event will not trigger income or a deduction.
6.6 An IPO will establish an objective market value for the shares and will also provide an opportunity to sell some shares to pay the tax. Share values often fluctuate significantly in the period shortly after an IPO, therefore if the employee actually sells their shares within a set period of time after the IPO, we suggest that it is the sale price – not the listing price, or some other weighted average value – that is used to determine the employee’s tax liability in relation to the shares sold.
6.7 We are interested in submissions on what may be an appropriate period to allow the shares to be valued on their sale price rather than the IPO listing price. In Australia if shares are sold on-market within 30 days of the deferred taxing point the sale proceeds from the shares can be taken as their market value.
6.8 Employers will need to take steps to ensure they are aware of these values. As the deduction will arise immediately after the IPO, the employer’s deduction will not be affected by any IPO-related ownership changes which otherwise might see the employer forfeit previously carried forward tax losses from unused ESS deductions. This is another advantage of deferring the taxing point.
6.9 Start-ups can reach a liquidity point by selling the company’s assets to a third party. The start-up would then distribute these assets (often cash or shares in the acquiring company) to its shareholders when the company was wound up. Due to earn-out periods it can be difficult to ascertain the value of the shares even at the point the assets are sold. It would not be appropriate to value the shares provided under an ESS when the shares were cancelled as at this point they will have zero value. One option would be to tax shareholders with deferred ESS benefits on the value of distributions to the extent it exceeds what they paid for the shares. We invite submissions on this issue.
6.10 At the point shares are cancelled the employee no longer holds an interest so there is no benefit in deferring the taxing point beyond this.
6.11 When an employee ceases employment with a group they may be entitled to retain shares or options that have yet to reach a taxing point. This creates an administrative risk whether these now former employees will comply with their obligations.
6.12 The Australian start-up rules use leaving employment as a trigger for the taxing point. In Australia, an employee is considered to have ceased their employment with the company if they are no longer employed by any company in the same group. Cessation of employment would likely occur once a person receives the last payment they are entitled to which is subject to PAYE.
6.13 Implementing an equivalent rule in New Zealand would provide a tax incentive for an employee to stay with the same company when in the absence of tax they would not.
6.14 If employees did not trigger the taxing point upon leaving employment, former employees would continue be required to return tax on the ESS benefit even though they were no longer employed by the company.
6.15 Enforcing these obligations, however, will be much easier if the former employee continues to be a New Zealand tax resident. Therefore, we propose the deferral period should only continue while the former employee remains New Zealand tax resident.
6.16 The rules should not encourage New Zealand employees to leave New Zealand to escape their tax obligations and requiring tax to be paid at the time the individual left New Zealand would achieve this. This is also consistent with many other sections of the Income Tax Act 2007 where a liability is crystallised at the point the person ceases to be a New Zealand tax resident.
6.17 We believe it is desirable to provide a finite date at which deferral lapses. This is to prevent the start-up rules allowing an indefinite deferral of tax liability. For instance, we understand that in some jurisdictions bespoke financing packages are available to allow employees in successful start-ups to monetise the value of their share scheme benefits without triggering a taxing point – thus avoiding tax permanently on the employee share scheme benefits. To prevent this we propose a “sunset” period. When this period expires, the taxing point will be triggered regardless of whether one of the other events has occurred.
6.18 The Australian rules include a “sunset” period of 15 years (recently extended from 7 years). After 15 years, tax becomes payable even in the absence of another liquidity event occurring, because it is considered that after that amount of time there is (or is very likely to be) either liquidity or no prospect of liquidity.
6.19 In our view, a company is likely to have a liquidity event – or fail – before the 15 year mark. Accordingly, we think something closer to 7 years would be appropriate. This would also be consistent with the period for which records are generally kept. At some point it will become difficult for employers, employees and Inland Revenue to keep track of the fact that an employee has a contingent tax liability with respect to shares the employee has owned for many years. We are interested in submitters’ views on this point.
6.20 In the absence of specific rules, a corporate takeover or restructure of a company could have unintended consequences for employees with employee share scheme benefits.
6.21 In Australia rules are in place so that when the company offering the ESS has been subject to a takeover or restructure, any employee share scheme interests in a company that was acquired in connection with the takeover or restructure are treated as a continuation of the old interests. This is only to the extent that, as a result of the arrangement or change, the employee has ceased holding the old interests, and the new interests can reasonably be regarded as matching the old interests.
6.22 The Bill provides rollover relief where a person’s ESS rights are cancelled and replaced with rights in a different scheme. The value of the replacement rights is not included in the person’s income arising due to the cancellation of the original scheme. The benefit provided by the replacement scheme will be taxed appropriately by applying the proposed new rules to that scheme. Officials consider that the rollover relief provisions in the Bill are sufficient to deal with any unintended consequences resulting from takeovers or restructures.
We are interested to hear from readers:
- Whether they agree with each of the tax point events identified.
- Whether there are practical difficulties with any of these events.
- Whether there are other events that should trigger a tax liability.
- Whether there should be a sunset period and, if so, how long it should be?
7 An earn-out period is where a portion of the sale price is dependent on the future performance of the acquired business. These are used to keep pre-acquisition employees involved or where there is uncertainty over future growth prospects.