Employee Share Schemes: Much Needed Simplification to Aid Small Businesses and Start-Ups

On 3 April, the Australian Government Treasury office released an Employee Share Schemes (ESS) Consultation Paper (Paper). The Paper called for submissions to be made in order to better assist small businesses and start-ups offering ESSs.

The Paper makes the point that legislative developments in this area will have widespread impacts. 99% of all businesses in Australia are small businesses, which employ 5.7 million Australians.

What is an ESS?

An ESS is an offer of shares by a business to its employees. The offer might take the form of options or other financial products which are built into the employee’s salary package, or added to it as a bonus.

Shares of this kind usually vest over time, creating an incentive for the employee to remain with the enterprise as it grows. The Paper refers specifically to this concept: the Government wants to ensure small businesses and start-ups are supported in attracting and retaining their employees. Tax concessions have applied to certain ESSs since 2015, reinforcing the message that the Government recognises that ESSs have a positive economic influence.

An ESS that offers options creates a right, but not an obligation, for the employee to purchase shares in the company. The share that is promised does not come into being until a later, specified date. The ESS nominates a price – known as the exercise or ‘strike’ price – to be paid in order to exercise the option.

Vesting refers to the length of time until the employee who holds the option is able to sell or otherwise deal with the shares. This may be tied to the employee’s length of service, and is typically set at three to five years.

An ESS promotes loyalty, as options will customarily lapse if the employee leaves before the vesting date.

The Tax Breaks

For an employee to benefit from the ATO’s tax breaks, the exercise price must be at least the fair market value of a share in the company, as at the date on which the start-up granted the option. Specific methodologies apply for establishing fair market value.

To qualify for tax breaks, the ESS offeror must be an Australian private company, incorporated for less than ten years and have an annual turnover of less than $50 million. The employee, for their part, must hold the shares for at least three years, and cannot hold more than 10% of the company’s capital.

When the employee invokes the option to purchases shares, they will often need to either enter a shareholder agreement with the employer, or sign a ‘deed of accession’, agreeing to be bound by the terms of any shareholder agreement. That agreement often provides for the terms of any disposal of the shares. Occasionally, such terms are also documented in the ESS plan itself.

What are the proposed changes to the ESS rules?

The Government aims to simplify the ESS scheme by suggesting a number of changes. Submissions were open until 30 April via the Treasury website, which called for parties to present further proposals and feedback on how the law in this area can be improved.

The Paper outlines concerns such as:

    • that the current regulatory framework underpinning ESSs is too complex and fragmented;
    • ASIC class order relief (being an instrument that exempts a person from certain provisions of the Corporations Act 2001 (Cth) (Act)) is widely considered too restrictive and has resulted in businesses having to seek individual relief from ASIC; and
    • there is a perception that disclosure obligations are a disincentive to small businesses using ESSs, as they may compel public release of commercially sensitive information (having in mind that some disclosure is always necessary for investor protection).

The key proposals and present regulatory framework are outlined in the table below.

Present Framework

Potential Reform

Consolidate and simplify the current exemptions

The current regulatory framework provides exemptions that are ‘complex’ and ‘fragmented’.

One example of this is seen in the definition of ‘ESS offers’, which differs between what is contained in the Act in comparison to the broader scope of ESSs covered by the ASIC class orders.

The Government proposes to consolidate and simplify exemptions from disclosure, licensing, advertising, anti-hawking, managed investment schemes and on-sale obligations.

More specifically, the Paper proposes potential reforms such as:

    • that the definition of ‘eligible ESS’ be expanded; and
    • that the ASIC class order relief for disclosure, licensing, advertising, hawking, managed investment schemes and on-sale obligations be moved into the Act and consolidated with existing statutory exemptions.

Increase the offer cap per employee

Unlisted companies can currently only offer $5,000 in eligible financial products per employee per year, in the absence of a disclosure statement (despite there being no monetary consideration for the financial products by the employee).

Stakeholders have suggested that the relatively high administration costs that are created with small shareholders may constrain the ability to offer employees ESSs.

One proposal is to increase the value limit of financial products that can be offered in a 12-month period from $5,000 to $10,000.

Facilitate the use of contribution plans

Unlisted companies cannot make offers under an employee incentive plan that includes a contribution plan, in which an employee may make a monetary contribution to acquire eligible products.

The intended purpose of this prohibition was to protect employees from financial risk associated with providing monetary consideration in exchange for shares. The consideration being in the absence of a reliable market price and regulated disclosure document.

A potential reform is to expand relief for unlisted companies to include contribution plans.

The Paper proposes that:

    • the monetary contribution be capped at $10,000 per employee per year; or
    • an independent valuation be provided to employees where this cap is exceeded.

Allow small businesses to offer ESSs without public disclosure

Presently, disclosure documents may be required to be lodged with ASIC for certain ‘ESS offers’. The costs associated with preparing such documents can be cumbersome.

The exemption from the requirement for disclosure is available for certain ‘ESS offers’ (as defined in the Income Tax Assessment Act 1997 (Cth)) made by ‘start-ups’ (as defined by s 1274(2AA) of the Act. The definition of ‘ESS offers’ under income tax law is narrower than the Act’s definition, which limits the application of this exemption.

The Government proposes to permit small businesses to offer ESSs without publically disclosing commercially sensitive financial information. This proposal would involve expanding the current exemption so that it applies to a broader ambit of companies. As a result, small businesses could offer an ESS under a disclosure document that may still be required to be lodged with ASIC but would not be publicly accessible.

More specifically the Government proposes to:

    • expand certain ‘ESS offers’ to include broader eligible financial products;
    • expend eligible participants; and 
    • remove the restriction whereby offers must be made by a company no more than 10 years since it was incorporated.

It is unknown at this stage whether the upcoming Federal Election on 18 May will have an impact on the foregoing proposed changes. The Paper emphasises small business is a key contributor to the Australian economy. As a result, a degree of bipartisan support could be expected in regards to simplifying the ESS regime.

Clarendons view the Paper as a welcome opportunity to refine and simplify the rules in this area. ESSs offer benefits both to small businesses in attracting and retaining motivated staff and to workers who want to see their commitment reflected in a financial incentive.