Unwinding Australia's ESOP experiment

01 October 2014


In 2009 sweeping changes to the tax treatment of Employee Share Option Plans (ESOPs) delivered a significant blow to Australian entrepreneurs and start-ups.

Imposing tax at the time a share or option was granted to an employee rather than when it was sold or converted, meant that ESOPs were no longer as effective a mechanism as they had been previously in Australia, particularly in the entrepreneurial and start-up market segment.

Under these provisions, start-ups were (and still are) burdened by a series of compliance hurdles; they need to organise and pay for market valuations when cash is often in short supply; and employees needed to pay tax on shares or options that had yet to be fully tested with regard to their worth.

ESOPs are however still available and encouraged, internationally - and that was enough of a spur to prompt a significant proportion of local entrepreneurs to take their businesses offshore, permanently.

After five years' ESOP experimentation the current Federal Government has indicated that it wants to tackle the problem as part of its National Industry Investment and Competitiveness Agenda. It's a welcome move - but coming more than a year after first promised, and with no detail yet available - there are lingering concerns that the changes risk being too little too late for at least a generation of start-ups, many of which have already embraced more favorable international options.

Supporting start-ups

ESOPs have been used widely by start-up companies to reward key staff and build loyalty; they represented a tax effective and financially attractive way to reward employees with equity rather than money at a point in the company's development when money is often in short supply, and in the process nurture employee loyalty.

Before 2009, most ESOP options or shares did not attract tax until they were sold or converted (unless an employee chose to pay tax upon granting, which is certain circumstances could be favorable). Under the Capital Gains Tax rules, on future disposal the top rate was 23.25 percent which was half of the top income tax rate of 46.5 percent - so it was a generous scheme.

Worried that this ‘tax generosity’ encouraged senior executives, rather than entrepreneurs and start-ups, to grant themselves shares or options, the previous Federal Government clamped down and after 2009, in many cases, levied tax when the ESOP share or option was granted.

While it remains possible to defer the tax payment (for example where there is a reasonable risk of forfeiture), even such a deferral often resulted in tax being imposed well before the employee could sensibly dispose of the options.   

Following the introduction of the budget repair levy, people granted shares or options under ESOPs can currently face a top marginal tax rate of up to 49 percent.

The effect - one has to assume unintended - has been to significantly dampen entrepreneurial activity and there has been a marked movement of entrepreneurs out of Australia and into more favorable overseas jurisdictions.

Can we get them back? Certainly not all of them - and the longer the current situation persists the greater the chance that more start-ups will abandon Australia.
What's missing still however is the detail surrounding the planned changes to the tax treatment of ESOPs.

There has been scant consultation with business about the proposed changes. Business hungers for greater transparency and genuine dialogue on this issue, it is too important to warrant a token invitation to comment on a draft proposal at the eleventh hour.
And while the Government waits, start-ups continue to explore international options or defer ESOPs, potentially risking the loss of key staff.

Further challenges to the ESOP reforms also loom.

Given the current make-up of the Senate there is a chance that getting the ESOP changes through Parliament will take months of wrangling.  

One hopes that as this reform is good for business and national prosperity, it shouldn’t become a political football but the last 12 months have proven that we live in challenging political times.

Competitive capability

As a country we already lag other nations in our ability to provide incentives to business. We can learn a lot from Singapore and Hong Kong where the tax rates are a third to a half of ours and where there are incentives to invest in technology - both tangible and intangible. Countries in APAC and the UK are low tax countries to begin with and they give higher concessions.

Certainly start-ups, particularly those selling into a global market such as technology businesses, need to have an international focus and reach from the get-go. But this can be achieved while maintaining local Australian headquarters, research and development and intellectual property.

But Australian bases will only be attractive to start-up businesses if the tax settings are right - and this requires reform beyond ESOPs alone.

The Controlled Foreign Company rules are a case in point. When an Australian business sets up offshore a lot of its activities can still be taxed back here in Australia.

Despite a series of discussion papers exploring the issue the status quo persists around this very antiquated set of rules from the early 1990s that are out of sync with the rest of the world and which effectively encourage Australian companies to move offshore rather than expand offshore.

A comprehensive competitiveness agenda should demand that this issue is also revisited, urgently.