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Submission No. 255 Back to full list of submissions
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Ernst & Young Submission regarding Employee Share / Option Plans

This submission relates issues which have not been directly raised by or mentioned in discussion papers issued by RBT. We refer in particular to the taxation rules and the administration of those rules governing offers of and participation in employee share and option plans and the disposition of property arising from that participation.

In this submission we refer to the subject generally as "ESAS".

ESAS participation is essentially a corporate issue because the subject property is equity or rights to equity in the company offering participation. However, the taxation rules are aimed at the employee participants most of whom would be unlikely to adequately understand the impact or potential impact of those rules and/or the administration of those rules without substantial guidance from the employer. In fact, following the insertion of Division 13A into the Income Tax Assessment Act and the associated changes to the Capital Gains Tax rules, there has been a great deal of confusion and concern regarding how the law should be interpreted and administered. Many corporations and their advisers have had a number of meetings with Treasury and the ATO regarding these matters of concern but only a handful of changes have been made to the law and it remains the case that without a statement of the Commissioner’s opinion it is virtually impossible to construct and administer ESAS plans with any certainty of outcome. Unfortunately, whilst there are a number of errors, ambiguities and unintended consequences in the legislation, there are many more issues which, with the benefit of hindsight, reflect a lack of understanding of the issues at the time the policies were developed. As it now stands, only amendments to the law will achieve an appropriate outcome.

Having stated that ESAS is essentially a corporate issue albeit, in relation to the employees, Ernst & Young explains that its focus on these issues has arisen from many years of worldwide experience in ESAS plans and particularly since 1994 when the Australian Tax changes were first flagged. Since then, we have been working with a very large group of Australian and Internationally based public companies regarding their concerns with the new rules. This work included a number of meetings with Treasury and ATO officers following submissionsand the discovery of specific issues but we have concluded that the significant barrier to resolution of these issues is a reluctance of the Government to make further amendments having already absorbed a number of sessions of Parliament to achieve the handful of amendments already made.

ESAS plans are a critical factor in achieving profitability and shareholder value. This fact has been proven in the United States and many other countries where the taxation rules have been developed over many years to achieve a stable and reliable basis for the development and operation of appropriate plans.

We wish to emphasise the fact that we are not talking about abusive plans which of concern to the ATO. This submission discusses only the issues which arise from participation in plans generally covered by Division 13A and usually implemented by listed or about to be listed companies. These could sensibly be described as "plain vanilla" plans based on precedents established over many years in the United States, UK, Canada and other countries and adapted specifically to accord with the taxation rules in Australia. Unfortunately, the existence/discovery of other types of plans has created an aura of suspicion around the very mention of employee share/option plans. This aura has often inhibited rational discussion regarding plans of the type discussed in the submission.

Attached is an outline of "some ESAS issues" demonstrating the existence of errors, ambiguities, unintended consequences and inappropriate policy applicable to ESAS plans.

On behalf of the many corporations and employees affected by the inadequacies referred above, Ernst & Young submits that RBT should recommend to Government that meaningful consultation be established, in a spirit of cooperation, to get Australia’s ESAS rules and administration much closer to the international benchmarks to which we aspire.

Should you have any inquiries regarding this submission, please call Mr Jon Kirkwood of this office (02-9248-4717).

List of ESAS Issues

1. How can there be any certainty about the value of a share (or right) where an offer is made based on the then current price of a listed share but the price changes through the acceptance period. Uncertainty is a huge issue for shop-floor/blue collar employees. The date of acceptance should be the date of acquisition and the market value at the date of offer should be the value for ESAS purposes. Shares that have not been traded or are only traded on the particular day appear to fall outside the rules.
2. The width of the "no forfeiture" provision in Section 139CE (the exemption provision) operates too harshly and should not apply where the reason for the forfeiture is a bona fide allegation of fraud/dishonesty or misconduct.
3 Many plans are now subject to amendment / replacement / termination as a consequence of a take-over or merger forcing acquisition of shares / options from employees. The resultant "disposition", whether or not replaced by shares in the acquiring group,appears to give rise to a CGT liability and a "cessation" event under Div13A. Surely this was not intended? Worse, where it is an "exemption"plan, the requirement that the shares / options be held for three years is breached and the exemption claimed is jeopardised. Surely this was not intended?
4. ESAS trusts have a primary purpose of preventing transfer of shares/options before conditions are met. For example, no transfer is permitted before a loan is repaid or a specified period of service is completed or a price hurdle is reached, etc. Accordingly, the establishment of the trust, transfers to the trust and from the trust to or for the benefit of the employee, should not be taxable transactions. This should be made clear by a special exception provision for both Section 26AAC and Division 13A (and now in the rewrite - 130-90 "PAYE earner").
5. The valuation tables are very unfair and inappropriate where the share or right cannot be transferred or realised. In addition, the tables do not recognise an amount paid for an option, nor do they recognise a restricted open period for exercise and/or price hurdles for exercise (often the hurdle is substantially above the exercise price). Where the share or option cannot be traded, the value should be determined as the simple difference between the market value of the share and determined in accordance with Section 139FA or FB, less the amounts which must be paid to obtain the share (including amounts for and the exercise of an option where relevant). There are also problems where the exercise price is variable but cannot be determined until it is paid. 139C(3) consideration for the right does not include exercise price.
6. Both the qualification and amendment rules apply harshly where an associate of the employee is the participant. Given that the employee is the person taxable under Division 13A, qualification for the shares or rights should be available under Section 139CD on the basis that subsection (3) refers to the taxpayer or the employee in respect of whom the taxpayer acquired the share or right.
7. Why is cessation of employment a cessation time? Is this intended to catch retirees? What if the participant retires and the option lapses (139DD(3))? Why is the exemption forfeited because the participant retires? Why is a participant taxed because they have retired but have not exercised options? Why does Section 139DD apply only to options (not shares)?
8. Div 13A gives rise to ordinary income but if no amendment or a loss arises there is only a capital loss! Should be an ordinary loss! The Div 13A view on MV is entirely speculation and there is no certainty of income or gain! Alternative revenue deduction in year of lapse/loss should be introduced.
9. What is the ATO view on the application of 26AAC and Div 13A to non residents:

(i) No service connection with Australia/shares in foreign company/never become resident.
(ii) No service connection with Australia/shares in Australian company/never become resident.
(iii) Service connection with Australia/shares in foreign company/never become resident.
(iv) Service connection with Australia/shares in Australian company/never become resident.
(v) Same as (i) but become resident before shares are sold.
(vi) Same as (i) but become resident before rights are exercised.
(vii) Same as (ii) and (v).
(viii) Same as (ii) and (vi).
(ix) Same as (iii) and (v).
(x) Same as (iii) and (vi).
(xi) Same as (iv) and (v).
(xii) Same as (iv) and (vi).

10. How is S139C(3) [and (4)] intended to operate? Why is the exercise price for an option excluded from "consideration" for a right? What if there is consideration for the right equal to or greater than the Div 13A discount? What happens to cost base calculations if no amount is included in assessable income under Div 13A? (include rewrite)
Is it intended that "no discount" participation cannot be included in 139CD(5) umbrella? What if the consideration for the option exceeds the "discount"?
Why can’t the umbrella rules look back to all participation before Div 13A and/or have a 3 year rolling test period?
11. The third qualification condition (in S139CD (1)) requires all the relevant shares to be "ordinary shares". Whilst this requirement is understandable where the relevant shares represent only a small percentage of issued shares or are not widely held or easily tradeable or listed, the requirement is onerous, unduly restrictive and not sensible where there is a ready market for the securities (eg. listed preference shares or preferred ordinary shares), or the shares/securities represent a fair percentage of all issued shares. Perhaps the requirement should simply be "ordinary shares or widely held or listed" shares or similar securities (listing usually requires widely held).
12. The cost base rules in the 1936 and 1997 Acts do not work as intended. For example, the amount included in assessable income under Div13A should form part of the cost base but faults in the law prevent this from happening.
13. What does "right" mean? A right to anything? What if a new or "escalating" employee acquires (or is granted) a right to (additional) remuneration. S139C(1) appears to apply. But clearly, 139CD cannot apply therefore 139B(1), (2) applies 139CC(2) 139FC 139FE; but there is no share.
14. Where shares or options are offered to employees with less than 3 years’ service (not permanent employees) the company should be able to elect to include all employees in the denominator and all offerees in the numerator. This is a big problem for companies with very few permanent employees, most of whom are not intended to be covered by the "egalitarian" plan. 139CD(5)/CE/GB/GF
15. The tests for employment in 139CD(3) and DD(3) should only apply at the time of acquisition, otherwise a takeover will trigger a failure. Also the tests should cover employment in joint ventures, partnerships and trusts where the shares are in a company which has say 25% or greater interest in the venture/ partnership/ trust. Further, proxy votes should be disregarded for 139CD(7) and 139CD(6) is unworkable if it requires a prediction of the position at any future time. There are also difficulties in determining the "permanent employee" status of a person who moves employment from one group company to another before 3 years are attained.
16. What is a restriction (s139CA and CB) "preventing the employee from disposing of the share". A trading block which will only be removed when:
3 years employment is attained?

A particular employment status is attained?

The price of the share reaches $x?

A loan is paid off?

The employee retires?

A call option over the share?

17. Why should the FIF rules apply to unvested interests in shares or rights under ESAS?
18. The Commissioner should quickly promulgate "reasonable methods" of valuation of unlisted shares (otherwise little private company ESAS arrangements wil be inhibited).
19. Why should S139E apply to all qualifying participation by the employee in that year instead of selected participation?
20 How is Section 139G intended to operate? Is it the earliest of the events or the most relevant of the events that counts? What if a beneficial interest arises before the transfer / issue / allotment occurs and how does the outcome align with the valuation rules re a "particular day"?