In May 1968 millions took to the streets of Paris in protests that forced President Charles De Gaulle to temporarily flee the country. Students ripped up cobble-stoned streets to build barricades and at the peak of the protests roughly two-thirds of French workers went on strike.

Martin Luther King had been assassinated only a month earlier, and Robert Kennedy would follow a couple of months later. In Vietnam, the Tet Offensive was under way, and the USSR would soon invade Czechoslovakia to crush the Prague Spring.

And yes, this is a story about Employee Share Schemes (ESS).

Back to Paris. Students at the barricades captured the headlines, but in the background, workers across France occupied factories and locked out management, demanding better conditions.

Worker ownership is often associated with the left, with militant workers scaling factory gates or taking bolt cutters to chain-link fences. But it doesn’t have to be.

For many small firms and start-ups today, giving workers equity through employee share schemes (ESS) is a common way to incentivise and reward employees.

A 2017 research paper by the Department of Industry, Innovation and Science found that Aussie small firms paid 25 to 53 per cent of wages as shares, versus 3 per cent for large ones.

So, what is an ESS? How do they work? What are the tax implications? In this Morningstar Investing Basics article we examine worker ownership in modern Australia.

Employee share schemes

Employee share schemes give workers equity in their employer. From above, the process looks simple:

  • Getting equity: Equity is given to workers, generally, in the form of shares, options or performance rights (more on that later)
  • Vesting equity: Employers set conditions as to when that equity “vests”, or becomes economically useful for the worker, i.e. can be sold.
  • Paying tax on equity: The worker pays tax on the equity they have received.

But what form the equity takes, what kind of employer gives it, how and when it is given, and the tax liability quickly complicates matters.

Getting equity

Broadly, employees can receive equity in three forms:

  • Ordinary shares: For example, 1000 shares worth $100 each, today.
  • Options: An arrangement where the holder (the employee) has the right to buy shares at a certain price – the strike price – at a certain point in the future, i.e., 1000 shares at $100 each, three years from today.
  • Performance rights: An arrangement similar to an option, but instead of paying the strike price to get the equity, employees must meet some performance metric, i.e., 1000 shares on condition that sales growth 30 per cent annually for the next three years.

Companies can also create salary sacrifice schemes for employees to buy equity out of their pre-tax income, in the same way that they might make additional super contributions or pay off a mobile phone.

Vesting equity

Vesting conditions determine when an employee gets “economic use” of their asset. They can be time and/or performance based.

For example, an employee might be granted shares, be the legal owner of them, but be unable to sell them for three years, or until sales have doubled.

Vesting conditions can apply to both shares and options.

Paying tax on equity

So, the workers have equity in some form. How is it taxed?

The key word here is discount. Employees usually receive their equity at a discount to the market price, so if the market value of the share is $100, employees might receive it for $70.

The reason is simple: there is little incentive for a company to give employees shares at the same price as they could buy them on the ASX. By giving equity at a discount, employers can immediately reward a worker.

Enter the taxman. Where workers receive equity at a discount, they must pay income tax on the amount of the discount, in the same year the equity is given.

Keep this in mind, it’ll be back.

So, if Susy receives $100 in shares for $70 in May, when she files her income tax in October, she will have to pay income tax on the $30 discount she received. This is in addition to the capital gains she would have to pay whenever she sold the shares.

A variety of concessional schemes exist to minimise, delay or eliminate the tax bill. We discuss the major three here, but several others can be found at the ATO website here.

There are also a series of general conditions to qualify for any concessional scheme, they can be found at the ATO here.

Deferral scheme

Under a deferral scheme, employees can delay paying tax until the “deferred taxing point”. For shares, according to the ATO, this point is the earliest of the following:

  • When there is no real risk of forfeiture and the scheme no longer genuinely restricts disposal of the share
  • When the employee ceases the employment in respect of which they acquired the share
  • 15 years after the employee acquired the share

The conditions are the same for options, with the addition of the moment where employees exercise their option.

At the “deferred taxing point” employees must pay income tax on the discount between the market value of the asset at that point, and the cost base.

The “deferred taxing point” is also the starting point for calculating eligibility for capital gains tax concessions.

So, if an employee immediately sold their shares at the deferred taxing point, they would not qualify for the capital gains tax discount that comes after having held an asset for more than 12 months.

For more detail, see the ATO here.

Loan scheme

Employers can also give workers an interest free no-recourse loan to buy shares at their full value. With no discount, workers do not have an income tax liability.

Workers get capital gains without the tax liability. The loan can then be paid off out of dividends or share sales.

This is usually just a paper transaction and no money changes hand. The recourse conditions also mean the employee is protected if the value of the shares falls below the loan value.

Start-ups

Start-ups have access to the most generous of the three major concessional schemes. The start-up concession scheme allows employees who have been given options to avoid the discount related income tax liability.

To recap, when an option is normally granted, the employee must pay income tax on the discount between the strike price and the market price of the equity.

The deferral concessional scheme allows this to be delayed for several years, but it must eventually be paid.

The start-up concession allows the taxable discount income to zero. Employees will still have to pay capital gains tax if the shares are sold, but there is no income liability before then.

The condition is that the price of the equity must be at least equal to the net tangible assets (NTA) of the firm; they cannot be given for free.

The word tangible is crucial, because many start-ups, especially tech ones, have very few tangible assets – cash in the bank and the office coffee machine. Most of the important assets, such as the intellectual property, are intangible, and don’t need to be included in the NTA.

This allows options to be granted at a strike price that might be orders of magnitude below the market value, without employees needing to pay income tax on the discount.

For more detail see the ATO here.

Things to keep in mind: prospectuses and vesting

The tax issues surrounding ESS can be complicated and it’s easy to get confused, says Kieren Parker, managing partner at law firm Addisons.

“A lot of the reason for the confusion are the current tax rules. They drive people to put in place structures that try to make it fair for the employer and employee,” he says.

“Everyone needs to pay their taxes, but it’s a difficult starting point to say you need to pay tax on shares you get on day one, even when you may have no right to them and may not ever get them.”

With that confusion in mind, he outlined two common pitfalls.

First, employers need to remember that issuing shares or granting options must be done under a prospectus. There are some exceptions to this, but it’s easy to mistake when they apply.

Making an honest mistake here could draw heat from ASIC and even result in being banned as a director. Do it intentionally and you could be looking at 15 years in jail, says Parker.

Another common misunderstanding is that shares vesting creates a tax event. This is not the case.

Legislation in the recent budget has helped simplify matters, says Parker, but the government is still “tinkering around the edges”.

“There’s no revolution on its way, so we’re kind of stuck with this regime.”