New ESOP recommendations remove barriers for small business

shares, ESOP

In August, the House of Representatives Standing Committee on Tax and Revenue tabled its Owning a Share of Your Work: Tax Treatment of Employee Share Schemes report, recommending changes that have key implications for the small businesses considering an Employee Share Ownership Plan (ESOP).

An ESOP is a mechanism to allow employees to own a share of the company they work for. They can be suitable for both private and public companies, large and small.

In my work advising small to SMEs on succession planning and exit sought by business owners who want to gain benefits and strategic succession planning tool strategies, ESOPs are increasingly being immediate-term productivity and retention longer-term.

ESOP used in a small business can usually be a great economic multiplier with a disproportionate impact and a win-win-win scenario where employees, founders and the business are all better off. However, I have several clients where aspects of the current legislation are a real barrier. The proposed changes are likely to make a real difference to these business owners.

The report outlines two roadmaps and 18 detailed recommendations:

Roadmap Option A recommends that employee share schemes (ESSs) be treated as capital for the purposes of taxation and dealt with under the capital gains tax regime. If this option is taken up then most of the challenges that Australian businesses face in implementing ESSs fall away. The other significant recommendation of this option is the removal of most of the regulatory regime that was initially designed for retail consumers as opposed to employees working at the company. The regulatory regime is not useful as most start-ups cannot meaningfully value themselves and doing so is expensive. And, in any case, the employee is unlikely to be contributing financially to the scheme.

Roadmap Option B borrows from many of the recommendations made by the Nuttall review in the UK. It reduces conflicts between the tax system and corporations law. It further seeks to encourage the use of ESSs by reducing costs and complexity.

The key proposed changes are:

  • Public awareness program to better inform business owners of the benefits, including keeping and publishing data on ESS use.
  • Further review and refinement of the rules based on a Productivity Commission review of successful rules in other countries, including the use of employee ownership trusts.
  • Changing the definition of startups to include listed entities and larger businesses (which means more businesses can access the very generous startup tax treatment).
  • Expanding the use of safe harbour valuations for all unlisted entities (which makes valuation of shares for ESSs simpler, faster and cheaper).
  • Increasing the salary sacrifice limit from $1,000 to $50,000 ($1,000 is no longer a great benefit for most employees and allowing greater salary sacrifice will enable employees to better invest in the company they work for).
  • Removing the taxing point on cessation of employment (meaning employees don’t have to sell shares on exit – which may not be attractive to all SMEs).
  • Removing the maximum 15 per cent discount available (meaning businesses can better incentivise employees by offering a larger discount).
  • Confirming the fringe benefits tax exemption for ESS loans (a widely misunderstood issue when implementing plans that needs clarification).
  • Removing the real risk of forfeiture requirement (meaning there doesn’t need to be a risk of losing the shares) and the 75 per cent offer requirement (meaning that for SMEs looking to reward key people or to use the plan for succession they don’t need to be restricted by having to implement a broad-based plan).

Taken together, the recommendations are a massive step forward in encouraging the use of employee ownership by small businesses.