How to do employee equity without getting caught in the share option tax trap? - BRW, May 23, 2014

http://www.brw.com.au/p/leadership/trap_share_option_employee_equity_n8qUWc4dRJZtxdDOFIMIiK

In a loan funded plan, the company gives an employee a loan to acquire shares in the business at market value, with tax only paid once the shares are sold. Employees are still being rewarded for capital growth in the shares, and the company is no worse off financially.

Businesses waiting for tax changes to employee share plans will have to wait longer still, as the federal budget failed to deliver any change to the controversial regime.

But for employers who want to offer equity incentives to their "star performers", there are alternatives which can be implemented now.

Employee share plans have been a popular way to give employees equity in the business and are seen as a tool for employee retention. But the scheme's effectiveness was considered to be diminished in 2009 when the government changed the tax rules, concerned that executives were trying to reduce tax by retrospectively making choices about when tax was payable.

Under the current regime, options are taxed once they vest, treated as income and taxed at the employee's marginal rate. Before the 2009 change, employees could elect to pay tax on the options up front when they weren't worth much. Any capital growth after that was only taxed at the CGT rates when the shares were sold.

The knock-on effect of the changes means the advantages of options are diminished because employees often have to sell part of their option holdings to pay their tax bill. It may even create an incentive to switch employers sooner - the opposite aim of share plans in the first place.

Business lobby groups argue that the post-2009 regime makes it difficult for Australian companies to compete in the global market, from start-ups to large corporates, which commonly entice employees with options - usually with a "vesting" period of several years to encourage employees to stay.

Even though both government and opposition have signalled a possible reversal of the 2009 rules, the date of any change is unclear, and it could be some time before any changes flow through to business.

Different options

Yet there are other ways which allow business to achieve the same outcome via different means. Loan-funded plans are widely available to Australian companies and avoid the tax problem with employee share options.

In a loan-funded plan, the company gives an employee a loan to acquire shares in the business at market value, with tax only paid once the shares are sold. Employees are still being rewarded for capital growth in the shares, and the company is no worse off financially.

With loan-funded plans, tax is only paid once the shares are sold, which means employees can theoretically hold the shares for many years. And only half the gain is taxed under the capital gains tax rules.

Economically, loan-funded plans mimic the way employee share options work, but without the adverse tax hit.

Companies keen to provide employees shares now can do so effectively, and would have the flexibility to adapt to any eventual change in the rules. Importantly, businesses are not locked into loan-funded plans and may consider them a useful way of filling the breach before any anticipated changes to the share plans scheme flow through.

•Loan-funded share plans are available to both public and private companies, though private companies have additional issues to consider, such as how to value the equity

•With loan-funded share plans, employees only pay tax once they sell the shares and any gain is taxed at CGT rates

•The company provides an interest-free loan to the employee which the employee uses to acquire shares in the company

•The company can impose performance hurdles and vesting periods on the shares so that the plan acts as a retention and performance tool

•The company can use a trust to hold or warehouse the shares until they vest and the loan is repaid

•Dividends received on the shares can be directed to repay the loan

•As the loan is interest-free and limited recourse, there is no downside for the employee

Anthony Bradica is a partner at leading independent business law firm Hall & Wilcox.