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The good, the bad and the ugly: Here is how the new changes in employee share scheme law will affect your start-up

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By now everyone in the Australian start-up space should be aware that the government has made significant changes to the way in which equity or options issued to employees will be taxed.

In 2009, in a bid to close a tax loophole which encouraged big corporates and investment banks to remunerate their senior executives in share and options rather than cash, the government of the day passed legislation that meant shares or options issued to employees of any size or type of company were taxed at the point of issuance.

This rather dumb piece of legislation had the unintended consequence of significantly increasing the cost to Australian start-ups of issuing stock or options to their employees.

The problem with the old rules is that they were too complicated.

In particular, shares and options were taxed up-front based on a future valuation of the company, making them a less appealing option for employees. In other words, employees had to pay tax on an asset that they hadn’t made any money from yet.

Prior to the Labor government’s 2009 rules, start-up companies used employee share schemes to attract quality employees in lieu of paying the full market rate for salaries, as well as retain good talent and give them a sense of ownership over the company.

The recent changes, which came into effect on the 1st of July, have solved a number of issues. There are, however, a number of outstanding issues which the start-up community will need to deal with.

1. The Good

For most start-ups (classified by the ATO as businesses with revenues less than $50m, incorporated for less than 10 years, and not listed on the stock exchange), the 1st July changes mean that employees who’ve been issued with options will only pay tax on the options at the time of exercise.

Of course if an employee holds options in a start-up the only time at which it will make sense to exercise the options is when the employee is selling his or her shares.

The effect of the legislation, in most circumstances, will therefore be that the employee will only pay tax if he or she cashes out and actually gets some value out of the grant.

Overall this is a good result for start-ups. It’s now much easier to issue options to employees, which can only be good.

2. The Bad

Unfortunately the news isn’t all good. As anyone who knows anything about the Australian start-up space will tell you, many of the most successful Australian start-ups over the past 5 or so years have been global marketplaces.

The likes of 99Designs, Freelancer and DesignCrowd are all marketplaces. A marketplace generally keeps around 10 per cent of the revenue it generates.

A marketplace generating $50 million of revenue would only be keeping $5 million or so, after paying out $45,000 to the suppliers on the marketplace. That’s not a big business!

If you’re launching a marketplace you could find your start-up excluded from the start-up tax concession system pretty early on. It doesn’t really make sense.

3. The Ugly

Most start-ups looking to take advantage of the start-up concession won’t be marketplaces, so arguably the $50 million revenue cap problem isn’t such a big issue.

There is however one huge issue with the new rules that will affect pretty much every start-up that uses them; the fact that the deferred taxation point for options is the earlier of “

  • when there is no real risk of forfeiting the right and the scheme no longer genuinely restricts disposal of the right
  • when your employee ceases the employment in respect of which they acquired the share
  • when your employee exercises the right, there is no real risk of forfeiting the underlying share and the scheme no longer genuinely restricts disposal of the resulting share
  • 15 years after your employee acquired the right.” (ATO Website).

Start-up employees leave for other opportunities all the time. In many cases an employee’s options may have vested, but this doesn’t mean the employee can exercise the option and sell the shares.

Firstly most shareholders agreement require a special resolution of the board to be passed before any shareholder (including employees) can sell shares.

Secondly, shares in a start-up are incredibly illiquid. Even if a start-up has raised a couple of rounds of capital there is no guarantee an investor will turn up to purchase the shares at the exact moment that the employee wants to sell.

The reality is the government has messed up by setting the deferred taxation point to be when the employee leaves the start-up.

This won’t stop start-ups setting up employee share schemes (we’ve set up a whole stack since the 1st of July!), but there will be a day of reckoning for many start-ups in a few years’ time when employees shares are vested, the three year exercise period is over, and they decide to leave for another opportunity.

Hopefully the government will pick up on this issue and make the necessary changes but if not at least you’ve been warned!

Lachlan McKnight (pictured) is the CEO of LegalVision which offers a high-quality, cost-effective solution for Australian businesses seeking legal assistance, advice or documentation through their primarily online service.

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