For many, receiving shares or options from your employer is a welcome benefit. There are usually no immediate tax or cash flow implications and you simply get access to a new investment that, hopefully, will grow in value.
The May 2009 budget proposed changes to the treatment of these benefits which are likely to affect both the issuance and immediate implications of employee share schemes in the future.
Currently, as a recipient of shares or options under an employee share scheme, you get the choice on when to pay tax on the benefit you receive. If you do nothing, you will be deemed to defer the tax until a later date (the “cessation time”). Alternatively, you can elect to pay tax on the discounted benefit upfront by making an election in your tax return.
Under the new rules the tax treatment will flow from the structure of the scheme rather than from a choice made by the employee. Based on the terms of most current schemes, many recipients will be required to pay the tax upfront from now on.
While this may seem like bad news, it may not be as bad as you think. In addition, those who received employee shares or options prior to the announcement have a last chance opportunity to exercise their right to make an election that will affect the taxation of these securities.
Employee Share Scheme tax deferral not always a good thing…
The ability to defer tax is an alluring proposition. However, you need to consider the consequences associated with the deferment.
The best way to understand the benefits of an employee share scheme is to consider what you forgo in exchange.
Imagine you are are offered a cash bonus of $100,000. You take the benefit as cash and are left with $53,500 as disposable cash (after PAYG tax). You choose to invest the $53,500 in the shares of your employer.
Now consider an employee share scheme. In this case, instead of the $100,000 bonus, you receive $100,000 worth of your employer’s shares at no cost. Prior to the proposed changes, you could defer the tax on this benefit for up to 10 years and you get almost twice the number of employer shares that you could have voluntarily purchased from the after tax bonus proceeds.
It sounds like a far better proposition, but is it?
Under the employee share scheme you have not eliminated the tax liability, you have simply deferred it. You need to add this liability to the equation.
By accepting the employee share scheme you are effectively investing the deferred tax liability in your employer’s shares. While this may pay off handsomely, many fail to realise that they are contributing some of their own capital to the investment.
Another consideration that is often overlooked is the level of concentration risk you are accumulating in relation to your employer. Becoming increasingly reliant on the prospects of your employer, for both income and investment growth, can be a recipe for disaster.
But, why pay tax upfront when you can defer it?
A consequence of deferring the tax is that any subsequent growth on your investment is taxed at your marginal tax rate. Electing to pay the tax upfront means that future growth can be taxed under the discounted capital gains tax (CGT) regime.
Electing to pay tax upfront can therefore result in lower overall tax.
Generally, as the investment growth rate increases, the benefits of paying tax upfront increase – i.e. the higher the growth rate, the greater the benefit.
If you’re interested in a detailed comparison of deferring tax versus paying tax upfront for both shares and options, please click here.
While on the surface, deferring tax seems like a great option, in some circumstances it may be better to make the election to pay the tax upfront. On this basis, the new rules, which require you to pay tax upfront, may not be as bad as you think.
Immediate opportunities… 2008/09 Employee Share Schemes
Those who received employee shares and/or options during 2008/09 may find that this is their last chance to have a choice over when to pay the tax. If you were fortunate enough to be issued with these securities during the lows of the global financial crisis, you may consider that 2008/09 is a good year to opt for the tax election.
However, there are a number of issues you will need to consider, not least of which is your ability to fund the tax upfront from your own resources. Investing the time in a review of your options may prove to be well worth the effort.
Please be aware that this is a complex area in which you should seek advice from a competent expert.