Motivating and incentivising employees in a downturn
There is no question that the COVID-19 pandemic is placing unprecedented stress on businesses. With many businesses having to stand down employees, request that their staff take a reduction in salary, or simply looking to conserve cash, offering equity incentives in the current environment might sound counter-intuitive. However, cash strapped companies seeking to reward, motivate and retain key employees need look no further than employee incentive plans.
Incentive plans can take a number of forms and there is no ‘one size fits all’ approach. A well-structured plan is simple, efficient and extremely cost effective relative to other reward and retention mechanisms available to companies and, as a consequence, are well suited to our current economic climate.
The following article aims to provide a snapshot of incentive arrangements that businesses might look to implement in the current environment with a view to motivating and rewarding their employees.
The current landscape
The employee share scheme rules in Division 83A of the Income Tax Assessment Act 1997 (ESS Rules) apply in all circumstances where individuals (including prospective and former employees, directors and consultants) are offered shares or rights to acquire shares (ESS Interests) in respect of their employment or services, for a price less than the market value of the ESS Interests.
The underlying concept of the ESS Rules is that the value of any right or share received under an employee share scheme is property received for services provided by the employee and should therefore be fully assessable as ordinary income. Generally an employee will be required to include the ‘discount’ on the shares or rights they receive in their assessable income in the year of receipt. Although the term ‘discount’ is not defined in the tax legislation, it is generally understood to mean that amount which is equal to the market value of the share or right, less any amount paid to acquire.
However, this general rule is subject to a number of concessions and the structure of any such equity incentive plan will largely determine its tax treatment.
In the current environment, the ‘start up’ or deferral concessions might each provide a mechanism for businesses looking to reward and retain key employees.
Start up concession plans
Having regard to the current range of alternatives available to businesses offering incentive arrangements to their staff, the ‘start up concession’ is often considered the holy grail for those companies and plans which qualify.
A ‘start up’ company is one which:
- is unlisted, and holds no interests in listed entities;
- is an Australian resident company, with aggregated (i.e. group) turnover of less than $50 million;
- has been incorporated for less than 10 years at the time the ESS interest is granted; and
- is not part of a group which includes entities more than 10 years old.
The impact of issuing shares or options under the start up concession is that, for employees ofeligible companies, no taxing point will arise upon the issue of options and shares (at a small discount), nor the vesting or exercise of options. Instead, tax is deferred until the sale of the underlying shares (at which time the sale of the shares will be subject to capital gains tax). This is a significant concession and enables a ‘start up’ company to, in effect, align the employee’s tax outcome with an ultimate disposal of the shares.
Even at the point of sale, the availability of the capital gains tax discount for ESS Interests issued under the start up concession is tested from the original grant date of the ESS Interest, rather than the exercise of the option. This means that, unlike ESS Interests issued under other plans, the 50% general discount will be available if any ultimate sale of the shares occurs more than 12 months after the options (or shares) were issued.
In addition, there is no tax cost to the company of issuing shares or options and any compliance costs associated with the issue of shares and options to the employees are greatly reduced.
As part of the introduction of the start up concession, legislative instrument ESS 2015/1 was also released. This instrument provides two ‘safe harbour’ valuation methodologies which may be used for the purpose of valuing shares for the purposes of the start up concession – provided that relevant requirements are satisfied.
Outside of the start up concession, deferred taxation treatment is often preferred by employees – to ensure that no tax is payable at the time the options or shares are granted (particularly where those interests remains subject to vesting or performance criteria).
For plans where there is a real risk that the employee will forfeit the shares or rights before they vest, or in respect of options, the plan rules state that the deferral concession applies (and restrict employees from immediately disposing of the rights they acquire), a deferral of tax for up to 15 years in relation to the shares and options granted to employees is available provided the relevant requirements are satisfied.
This means that, where the deferral conditions are met, rather than being taxed upfront (i.e. in the year the interests are granted), taxation arises at the ‘deferred taxing point’. It is at this point that the market value of the ESS interests needs to be determined and this amount, less the cost to the employee of acquiring the interest, will be included in the employee’s assessable income (as ordinary income) for the relevant year.
Even where there is no immediate tax impact of implementing a plan which will qualify for the deferral concession, implementation and design of a plan now can act as an incentive for employees to remain with the company in the interim (and participate in the growth of the business after the crisis is over).
Indeterminate rights plans
Under an ‘indeterminate rights plan’, formal contractual arrangements are put in place under which an employee is granted a right to receive either options or shares, or a cash payment which is equivalent to the value of shares to which the employee would otherwise be entitled. Determination as to whether the employee is entitled to cash or shares is determined by the company upon satisfaction of the relevant conditions.
These plans allow a ‘wait and see’ approach in relation to the taxation of the indeterminate rights granted to the employee. If the employee ultimately receives:
- cash, they will be required to pay tax on that cash payment when received (at their ordinary marginal rate); or
- a right to acquire an interest in a share (e.g. an option), they are treated as having always held the option (i.e. from the time the original right was granted). In this scenario, the terms of the plan must then be analysed to determine whether the interest would have been subject to upfront or deferred taxation. In practice, where shares or options are ultimately issued under an indeterminate rights plan, the Plan will be drafted so as to ensure access to deferred taxation treatment.
Of course, if the rights are forfeited or the vesting criteria re not satisfied, then no taxation consequences will arise.
Therefore, in the present circumstances, an indeterminate rights plan may provide companies with a mechanism to motivate key employees, but provide the benefit of allowing the company to wait until the economy recovers and business improves to decide whether to fund the incentive by way of cash payment, or issue of shares or options.
Even outside of the typical ‘concession’ arrangements, a reduced market value of shares in the company as a result of depressed economic conditions, may provide astute employees with the option of investing in the company at a lower price.
For example, key employees may choose to pay tax upfront on the (decreased) value of shares in the company. In addition, where options are issued, the valuation tables in the regulations, which are generally considered ‘concessional’ may enable employees to both (a) ensure that the tax paid upfront is manageable, and (b) ‘lock in’ CGT treatment on any future increases in value of the shares moving forward.
Under a loan funded share plan, eligible employees are invited to acquire shares in the Company, with the acquisition price for the shares funded by way of an interest-free, limited recourse loan from the Company. The aim of a loan funded share plan is to ensure that employees are only taxed on disposal of their interest. In the current context, again this may allow employees to take advantage of a temporary reduction in value of the company.
In a slightly different context, a widely available share plan designed to take advantage of the $1,000 ‘discount concession’ will now provide employees with a greater opportunity to participate in the company and reap the benefits when share prices increase.
Whilst the impact of COVID-19 is devastating and having an obvious impact on the ability for businesses to reward and remunerate their staff, for companies looking to incentivise and retain key employees but needing to conserve cash, or are suffering short term liquidity issues caused by COVID-19 restrictions, the implementation of a suitably designed employee incentive plan now can assist in motivating employees throughout this period and rewarding their loyalty thereafter.
This publication covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. It is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.