Tax Bites: Incentivising key employees through options

A great way of retaining staff is to provide them with equity with retention and/or performance hurdles.

Division 83A of the ITAA97 provides special rules for the taxation of equity provided by a company to its employees.

The base-case position under Division 83A is that any discount associated with the granting of shares or options to employees will be assessed to the employee up-front (i.e. as and when the interest is granted). However, Subdivision 83A-C states that where certain conditions are satisfied, the taxing point on the grant of the shares or options can be deferred.

Options especially are commonly given to key staff in business. This is because unlike the granting of shares which requires the scheme to be widely available to at least 75% of all staff to qualify for tax deferred treatment (per section 83A-105(2) of the ITAA97), options can be selectively granted to key staff and still be potentially eligible for tax deferred treatment.

Amongst other things, section 83A-105 states that in order to be eligible for tax deferred treatment, the options granted must either (i) have forfeiture conditions attached to them (e.g. performance hurdles such as KPI’s or simply requiring the employee to remain an employee of the company as at a future vesting date in order to be eligible to exercise the options); or (ii) must specifically prevent the employee from immediately disposing of the options and must specifically refer to the application of Subdivision 83A-C of the ITAA97.

In many instances, the taxing point for the grant of the options can be deferred until the time at which the options are actually exercised (provided they are exercised within the maximum 15 year tax deferral period). This is the case even though the vesting period attached to the options may be a significantly shorter period. For instance, options granted to a particular key staff member might vest over the course of 4 years but might have a maximum time period before the options lapse of say 10 years. In this instance, the employee could potentially defer the taxing point associated with the grant of the options for up to 10 years by not exercising the options until the end of the 10 year period. This may be beneficial from a cash flow perspective where the employee wishes to align their taxing point with the proceeds received from the sale of their shares.

Of course, it needs to be remembered that there are a couple of ramifications of deferring the taxing point on the options granted:

  1. At the time of the deferred taxing point, the taxable discount associated with the grant of the options under Subdivision 83A-C of the ITAA97 will be based on the value of the options as at the date of exercise (which might be significantly higher than when the options were first granted); and
  2. A higher amount of the overall capital growth will be taxable on revenue account (i.e. under Subdivision 83A-C of the ITAA97) rather than as a capital gain (which would otherwise have arisen if the option was assessed at the grant date and the amount assessed subsequently became the cost base of the shares for CGT purposes).

If you have any further questions, please do not hesitate to contact Tim Olynyk on (03) 9810 0700 or at t.olynyk@banksgroup.com.au.

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