Changes to the taxation of employee share schemes (ESS) aligns their use with other forms of remuneration – is this going to impact you and your business?
Legislative changes to the taxation of employee share schemes have been introduced with effect from
29 March 2018, aimed at modernising the taxation of ESS's so that they are simple, efficient and fair.
It is therefore timely to review existing share schemes to determine whether they can still be used or could create unforeseen tax burdens for employees. It may also be a good time to consider implementing a share scheme as a mechanism to attract and retain good staff.
The general objective of the changes is to achieve a neutral tax treatment of the ESS benefits so that the tax position of employer and employee is the same, irrespective of whether the remuneration for labour is paid in cash or shares.
Whilst some benefits have been narrowed down, concessions to employers have been provided to ease the tax burden.
The new rules effectively convert what were capital gains to employees to taxable employment income. This is to align the taxation of income under employee share schemes with other forms of employment remuneration, taxing the income when earned.
They also provide employers with an equivalent amount of expenditure, which may be tax deductible, treating remuneration provided under an ESS in the same way as cash.
Which share benefits will be subject to the new rules?
The rules apply to share benefits awarded to not only present employees, but also to past and future employees or shareholder employees.
They do not apply to arrangements where there is no connection to the recipient's employment or service.
The new rules will not apply to:
shares granted or acquired before 12 May 2016, or
shares granted within 6 months from 29 March 2018 where the shares were not granted with a purpose of avoiding the new rules, and the taxing date under the new rules is before 1 April 2022.
There is a drive by the New Zealand government to grow GDP through export of the high degree of technology innovation that comes out of New Zealand. To capitalise on this hotbed of innovation it is vital for businesses in New Zealand to be able to attract and retain good talent. To do so, we need to compete on the global employment stage and be able to offer ownership options similar to those available in other global areas enticing such talent.
It remains to be seen whether the changes will meet these objectives. On the upside, there is potential scope for the deduction now available to employers to alleviate the increased tax cost to employees granted shares under an ESS.
Concerns raised about previous ESS rules were:
Uncertainty about how the rules applied to employers and employees.
Sophisticated schemes were used to treat employment income as tax-free gains.
Costs incurred by employers in implementing schemes were high and not specifically tax deductible.
Difficulties, especially for start-ups, in valuing shares.
Start-up companies not having the cash flow to meet upfront tax liabilities at both employee and employer level.
Effect of the new Rules - Changes to the share scheme taxing date
The effect of the changes is to convert what was previously treated as a capital gain to taxable employment income.
This has been achieved by shifting the taxing point from the time the shares were acquired to either:
the time when the employee holds the shares in the same way as any other shareholder would hold the shares (usually after all vesting conditions have been met)
when the shares are transferred to a third party by the employee or forfeited by the employee due to not meeting performance targets.
When would an employee hold shares in the same way as any other shareholder?
Three elements are required:
- There must be no material risk of a change in beneficial ownership – so, if the employee is only required to forfeit shares if s/he is a bad leaver e.g. dismissed for gross misconduct, the risk is of change in ownership is present it is not a material risk (note this was a change from the draft rules which referred to "real risk" and was therefore too wide).
- The employee must have no downside protection (in the case of an option over shares, this will only be when the option is exercised).
- There is no risk of material change to terms of the shares – this deals with reclassifications on occurrence of events such as performance targets being met.
What is the income derived under an ESS?
The income derived is the difference between what is paid or received and the share value, less any income previously recognised under the old rules is. The share value is the market value of the shares at the share scheme taxing date.
There is the possibility a portion of this amount may be treated as non-taxable in NZ where the person earning the income from the shares is not NZ tax resident and not being paid any salary in NZ by the employer who granted the shares.
What is the employer deduction?
The changes provide the employer with deemed expenditure that matches the amount of income to the employee both in timing and quantity.
There is an administrative issue around ascertaining what the taxable amount to the employee is, particularly where the shares have been transferred to a third party prior to the share scheme taxing date.
A point to note is that where shares decline in value and the employee is entitled to a deduction, the employer must recognise the corresponding amount as income. It will be interesting to see how this plays out in practice, particularly with cash poor start-up companies with potentially devaluing shares.
As a practical matter there is still need for the employer to show the issue of shares has the necessary connection with its business before being able to take a tax deduction for this deemed expenditure.
What other Employer Obligations are there?
From 1 April 2017 employers could choose to tax employee share scheme benefits as "extra pay". If this election is not made, employers need to disclose the taxable value received by employees under an ESS in the employer monthly schedule IR348 and a lump sum/extra pay amount.
The Commissioner of Inland Revenue has issued a statement on determining the value of shares issued under a share purchase agreement, which provides safe harbour valuation methodologies. This is in recognition of the inherent valuation uncertainty that can exist and in an effort to minimise compliance costs for employers.