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ATO releases guidance on when employees are ‘genuinely’ restricted from disposing of their ESS interests and on ESS establishment and administration expenses

King Tan Patrick Huang ||

Employee share schemes continue to be an area of focus for the ATO with the recent release of two Taxation Determinations, TD2022/4 [1] and TD2022/8[2]. Both are important tax rulings that outline the ATO’s latest thinking on how employee share schemes can be structured and are expensed for tax purposes.

TD2022/4 – “genuine restriction”

Taxation Determination TD2022/4 outlines the ATO’s views on when an employee is “genuinely restricted” from immediately disposing of an interest under an employee share scheme.

To give context – under the current employee share scheme rules [3], employers can establish equity incentive schemes as “deferred” tax schemes so that employees are not taxed on the equity upfront, but taxation is deferred until a later point in time.

A properly structured deferred tax scheme “genuinely restricts” an employee from immediately disposing of their shares (or rights) under that scheme[4]. An employee is then taxed on the equity when that restriction is lifted (i.e., the deferred taxing point).

TD2022/4 is the first time that the ATO has expressed a view on the meaning of “genuine restriction”. From the ATO’s point of view:

  • a scheme ”genuinely restricts” an employee from “disposing” of their shares or rights, if the scheme imposes serious and enforced consequences when the restriction is breached;
  • a disposal restriction is not genuine if it does not, in a real practical sense, limit the disposal, or if the restriction is open to manipulation; and
  • where a board of a company that has a discretionary power to approve requests to trade (based on subjective criteria) and the board routinely approves requests, then the discretionary power is not a genuine restriction.

(On the other hand, if there are clear, fixed and objectively measured criteria to be applied by the board, then the discretionary power is more likely to be a genuine restriction.)

  • Furthermore, if a participant in the scheme, due to being in a position of power in the employer (such as a director), is able to control the decisions of the scheme administrator (e.g. because the administrator is an associate of the director), then the scheme’s disposal restriction is considered “illusory”; and
  • A disposal restriction may still be genuine if it is lifted in exceptional and extraordinary circumstances, for example, severe financial hardship.

There are a range of examples outlined in TD2022/4 that illustrate the ATO’s thinking.

It is important to note that TD2022/4 applies both before and after the date of issue.

TD2022/8 – deductibility of employee share scheme expenses

TD2022/8 outlines the ATO’s views on the deductibility of expenses associated with establishing and administering employee share schemes.

Unsurprisingly, the ATO follows the general principle on tax deductibility of expenses by distinguishing between expenses that are “capital” in nature (not generally deductible) and those expenses that are revenue in nature (deductible).

At first glance, one could take the view that offering equity to employees is designed to motivate and incentivise employees and attract new employees. On the basis that the costs of hiring and keeping employees are (generally) deductible, then the costs of employee share schemes should also be deductible.

However, in TD2022/8, the ATO takes the view that the purpose of an employee share scheme, being a one-off scheme, is for the scheme to be part of the employer company’s ”business structure” and thus, is the related expenses are capital in nature. The ATO’s view is that expenses incurred to establish the employee share scheme is capital in nature and not deductible under section 8-1. Expenses incurred to amend an employee share scheme also fall into this category.

That being said, the ATO accepts that establishment and amendment expenses are considered “black-hole” expenses provisions in section 40-880 and thus deductible in equal proportions over a period of 5 years.

The ATO clarifies that ongoing expenses associated with the administration of an employee share scheme, being regular and recurrent expenses, are deductible under section 8-1. These expenses include brokerage fees, audit fees, bank charges, making new offers to employees under an existing employee share schemes.

It is important to note that TD2022/8 applies both before and after the date of issue.

What should you do?

As both TD2022/4 and TD2022/8 have retrospective application, there may a risk that either:

  • an existing employee share scheme of yours or of your clients may not “genuinely restrict” an employee from disposing of their interest (and thus the scheme may not be a deferred tax scheme); and/or
  • expenses incurred in establishing and/or amending an employee share scheme may not be deductible upfront (but rather, deductible over a 5 year period).

Going forward, greater care is required to ensure that your equity scheme genuinely restricts your employees from disposing of their shares or rights in the scheme. If there are no genuine restrictions, then the employee does not get the benefit of deferred taxation and may be taxed at a point in time when they may not have the ability to fund the liability – and this would make for unhappy and disgruntled staff!

You should review existing employee share schemes to see if they remain compliant, having regard to TD2022/4 and TD2022/8.

We would be more than happy to assist you in conducting a ”health check” of employee share schemes. Contact King Tan and Patrick Huang to find out more information.

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[1] Taxation Determination TD 2022/4 Income tax: when are you genuinely restricted from immediately disposing of an interest provided under an employee share scheme?

[2] Taxation Determination TD 2022/8 Income tax: deductibility of expenses incurred in establishing and administering an employee share scheme

[3] See generally, Division 83A of the Income Tax Assessment Act 1997 (ITAA 1997).

[4] Sections 83A-115(4)(b) and 83A-120(4)(c).

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