TAX NEWS - JUNE 2010

Australia Tax: Employee share scheme valuation issues – the Board of Tax review and the government's response

The Board of Taxation (BoT) has completed a review into some elements of the taxation of employee share schemes (ESS). The Board of Taxation recommended that:

- the valuation methodology for listed and unlisted securities for the purposes of ESS arrangements should be based on the ordinary meaning of "market value", with this meaning supplemented by public guidance to be given by the Commissioner of Taxation outlining acceptable valuation methodologies;

- as an alternative to the ordinary meaning of market value, taxpayers who acquire unlisted rights should be able to elect to apply a "safe harbour" methodology to minimise complexity and compliance costs;

- the statutory valuation tables currently used to determine the "safe harbour" should be updated to better reflect market conditions, and should continue to be reviewed from time to time;

- the Commissioner of Taxation should develop an online calculator to assist taxpayers to calculate the value of unlisted rights under the statutory valuation tables; and

- the Government should not introduce special tax deferral arrangements for employees participating in an employee share scheme established by start-up, R&D and speculative companies. 

The Government has accepted these recommendations, other than the recommendation to update the statutory valuation tables. It has indicated that it will consult with the community before deciding whether to undertake this recommendation.

The Government requested that the Board of Taxation consider:

- the most appropriate method by which to determine the market value of securities subject to employee share scheme arrangements; and

- whether securities provided to employees of start-up, R&D and speculative companies under an employee share scheme should be subject to special tax deferral arrangements. 

The BoT delivered its report to the Government in February 2010. The Government released the report and its response in April 2010.


Valuation of securities for ESS purposes

Valuation of listed securities and unlisted shares

The Board of Taxation (BoT) confirmed that listed securities (shares and options) and unlisted shares should be valued based on the ordinary meaning of "market value". This approach allows taxpayers the flexibility of determining the most appropriate valuation methodology for their circumstances. It should also minimise the compliance costs for taxpayers in determining the appropriate value.

The BoT expressly rejected the suggestion that a "safe harbour" should be adopted for listed securities and unlisted shares because it was not able to identify an appropriate method for determining the "safe harbour" that would not disadvantage some taxpayers. Additionally, the introduction of a "safe harbour" would encourage taxpayers to perform multiple calculations to determine the best result from a tax perspective, compromising the integrity of the rules and resulting in increased compliance costs.

To reduce uncertainty and compliance costs relating to determining appropriate methodologies for calculating the market value of listed securities and unlisted shares based on the ordinary meaning of that phrase, the BoT also recommended that the Commissioner of Taxation provide public guidance setting out acceptable valuation methodologies for the purposes of the ESS rules.


Valuation of unlisted rights

As with listed securities and unlisted shares, the Board of Taxation (BoT) confirmed that unlisted rights (including options and performance rights) should be valued based on the ordinary meaning of "market value". This method allows taxpayers the flexibility to determine the most appropriate valuation methodology for their circumstances.

The BoT expressly rejected submissions that unlisted rights should only be valued based on their intrinsic value (ie the market value of the underlying share less the exercise price) due to the failure of this method to recognise potential profit resulting from holding the right between the taxing point and the expiry of the right. The Board of Taxation also notes that it is the intention of the legislation that employees may be taxed on a value they are not able to realise because their rights remain "out of the money".

However, the Board of Taxation also recommended that taxpayers be able to elect to apply a "safe harbour" in valuing unlisted rights they receive under an employee share scheme, as is currently allowed in the regulations. This measure should reduce compliance costs and complexity in undertaking the valuation process, which can be particularly difficult given the variables that are relevant to valuing unlisted rights.

The Board of Taxation approved the current rules which require that the unlisted right be valued at the greater of the intrinsic value and the value determined under the statutory valuation tables if the taxpayer chooses not to determine the market value according to ordinary concepts.

However, it indicated that the current tables are quite concessionary due to the fixed assumptions underlying them. Accordingly, the Board of Taxation (BoT) has recommended that the tables be updated to more accurately reflect current market conditions. This would involve increasing the assumed volatility of the underlying share price from 10% to 20% and reducing the assumed risk free rate of interest to 5%.

The Board of Taxation also recommended that the Commissioner of Taxation provide an online calculator to assist taxpayers to attribute appropriate values to unlisted rights.


Tax deferral arrangements for start-up, R&D and speculative companies

The Board of Taxation (BoT) recommended that special tax deferral arrangements not be established for employees in receipt of securities under an ESS set up by start-up, R&D and speculative companies.

The Board of Taxation (BoT) recognised that it is hard for these companies to satisfy the requirements for deferral of taxation under the ESS rules because of the requirements that:

- the employee not acquire more than 5% of the shares or voting power in the company (which may be difficult to satisfy where the company is quite small and looking to make the equity component a significant part of the employee's salary package); and

- there is a real risk of forfeiture (which may not be appropriate where the company wishes to make the equity component a significant part of the employee's salary package). 

However, the Board of Taxation did not recommend introducing special tax deferral arrangements for start-up, R&D and speculative companies because it was not persuaded that there was sufficient justification. It noted that there was no clear example overseas that could be adopted in Australia. It also stated that it would be difficult to determine appropriate eligibility criteria, which could compromise the integrity of the ESS provisions and the Government's desire to improve the horizontal equity between different forms of remuneration in the tax system.

The BoT recommended that if the Government wished to provide additional support to start-up, R&D and speculative companies, it should consider more targeted forms of support, rather than changes to the ESS regime.


Government response to recommendations

The Government has indicated that it fully accepts most of the recommendations made by the Board of Taxation. The one recommendation that it only partially accepts, at this stage, is the recommendation relating to the valuation of unlisted rights and, in particular, the recommendation that the statutory valuation tables be reviewed. The Assistant Treasurer, Senator Nick Sherry, has indicated that the Government will consult with the community before deciding whether or not to implement this aspect of the recommendations since it is likely to result in increased levels of tax on unlisted rights acquired under an employee share scheme.