Recent issues affecting employee share schemes

Recent issues affecting employee share schemes

Introduction

An officials’ issues paper from the IRD last month highlights one of two recent developments issues affecting employee share schemes – namely the difficulties faced by employers and employees in accounting for tax on the benefits accruing under such schemes and proposals to address those difficulties by allowing employers to account for tax on employee share scheme benefits at source on behalf of their employees.

The other recent development of note is the greater latitude for offers to participate in an employee share scheme provided by the disclosure exclusion in Schedule 1 of the Financial Markets Conduct Act 2013.

Tax collection issues

The officials’ issues paper begins by noting that, on the basis that shares and options provided under employee share schemes are substitutes for a cash salary (or another form of employment income), the benefits are taxed in an equivalent way to cash salary or wages – in the interests of tax neutrality. Consequently, the taxable “benefit” under an employee share scheme:

• in the case of an acquisition of shares, the amount by which the value of the shares when they are acquired is more than the amount paid or payable for them; and
• in the case of an option scheme, that benefit is generally not taxed until the options are exercised.

The taxable benefit arising under an employee share scheme is treated as employment income, but unlike most other employment income, it is not a PAYE income payment nor is it a fringe benefit. This means that, unlike cash salary or wages, the benefit is not subject to any form of taxation at source and it is the employee’s obligation to file an income tax return and pay the requisite tax.

This treatment triggers a number of not insignificant compliance issues (and costs) associated with filing the tax return, questions about exposure to the provisional tax regime for someone who is likely to otherwise be captured by PAYE regime. In addition, the scheme participant also needs to address the very real practical problem of funding the resulting tax liability from either their after-tax cash salary, borrowings or the sale of a portion of their shares (assuming there is a market for the shares and the employee share scheme allows them to do so).

These issues provide a tax disincentive to employee participation – and make pre-tax cash benefits more attractive.

As a result, officials have noted that there are cost and compliance benefits in allowing employers to account for tax on employee share scheme benefits at source on behalf of their employees. However, it is noted that the difficulty that arises in taxing the benefit in same way salary or wages is that the benefit is not payable in cash – making it difficult to apply a withholding tax such as PAYE because you cannot withhold from shares. This is not seen as a fatal flaw as FBT regime provides for source taxation of non-cash benefits.

Consequently, the officials’ paper suggests three alternatives (PAYE, FBT or a new employee share scheme withholding tax). Noting that it would better to use an existing income tax system – and whilst no definitive view was given, PAYE seemed to be the slightly better option on the basis that all employers use it. The disadvantage of using the PAYE system is that it is designed to deal with cash payments. As there is no cash to be withheld, the employer would have to either recover the tax from the employee (potentially by deducting it from after-tax salary), or selling a portion of shares on the employee’s behalf (again noting the problem of illiquidity I the case of small schemes). The alternative is to provide a cash gross-up to accompany the scheme benefit to fund the PAYE.

New Zealand Law Society comments

The Law Society’s response to the officials’ paper noted that:

• (In its view) source taxation for employee share scheme income should be elective – at the election of the employer.
• Source taxation will not suit every scheme – in many schemes (particularly option schemes, but also simple share schemes where beneficial interest in the shares does not vest in the employee at the), the taxable benefit derived by the employee will not be ascertainable upon entry into the scheme and may only be known some time later, upon exercise of the relevant options or vesting of the shares. This could represent a significant, and unquantifiable, contingent liability for the employer – which may not have the cash resources to fund this liability when it does crystallise.
• Share schemes are a popular means of incentivising and remunerating employees in start-ups or other companies undergoing significant change or growth. In such cases, cash flow is usually tight – and imposing source taxation could reduce, rather than increase, use of share schemes.

The Law Society also disagreed with the suggestion in the officials’ paper that employers might contractually agree with employees that the employee will bear the cost of the share scheme taxation. Whilst theoretically possible, such agreement is likely to be unpalatable or impracticable to employers, or achievable from
a practical perspective, because:

• Employers would have to assume the credit risk of employees for reimbursement (and risk incurring the administrative costs of collection);
• Where the benefits derived by the employee are significant (e.g. executive schemes) deduction from subsequent salary payments may not be feasible – and it assumes that the employees will remain in employment for long enough to reimburse the employer.
• Mandatory sale of shares to repay the debt owing to employers may be feasible in some, but not all, cases – particularly where the shares are listed and/or widely traded.

FMC Act

The new disclosure exclusion for an offer of ‘specified financial products’ provided by Schedule 1 of the FMC Act was part of the Phase 1 implementation that came into effect on 1 April 2014.

Under that exclusion offers of specified financial products to an eligible person (an employee or director of the issuer or any of its subsidiaries and persons providing personal services (other than as an employee) principally to the issuer or any of its subsidiaries) are excluded from the disclosure regime subject to certain conditions. Those conditions are:

• the offer is made as part of the remuneration arrangements for the eligible person or is otherwise made in connection with the employment or engagement of the eligible person; and
• capital-raising is not the primary purpose of the offer; and
• the total number of specified financial products issued or transferred under all of the issuer’s employee share purchase schemes to eligible persons in any 12-month does not exceed 10% of:
o those already on issue (in the case of voting products/options); or
o those of the same class (in the case of non-voting products).

The second limb, applying to non-voting products, does have the potential to be a stumbling block – for example where (say) the employee options to be issued under the scheme are the only non-voting products on issue. However, in order for that limb not to become a nonsense, I suggest that a purposive interpretation is needed (for example) where the options have been granted solely for the purposes of the scheme. That is, if the exercise of the options will ultimately yield voting shares then, relying on the definition of ‘financial product’ in the FMC Act which includes a right attaching to or an option to acquire, by way of issue – an option should be treated as being of the same class of financial product that is issued upon the exercise of that option.

Further information

If you would like more information about any of the matters discussed in this note, please contact me.