Employee Share Schemes explained – do they work for small business?

In March 2022, the Australian government announced reforms to make it easier for companies to take advantage of ATO tax concessions for employee share schemes (ESS).

Have these reforms made it easier for small proprietary companies (often referred to as closely held or family companies) to put in place an ESS and take advantage of the ESS tax concessions?

Benefits of ESS

Employee share schemes help align the interests of employees with the employer and shareholders.

This can be a good way for employers to retain and motivate their employees.

It can improve productivity and workplace cooperation as employees feel that they have a direct interest in the performance of the company.

And when it comes to tax concessions, the key concession under a complying ATO ESS is that the value of any discount an employer gives the employee for the shares issued, is not taxed upfront but when the shares are sold. In tax terms, it allows an employee the ability to disregard the amount of the discount they receive in their assessable income until they dispose of the shares.

ATO Tax Concession Requirements

First let’s look at the ATO requirements that a company must meet in order to take advantage of tax concessions.

To qualify a company must meet the following conditions:

1. The company must not be listed on the stock exchange.
2. The company must have been incorporated for less than 10 years.
3. The company must not have an aggregated turnover exceeding $50 million.
4. The company must be an Australian tax resident.
5. In the case of a shares, the discount must be no more than 15% of their market value when acquired.
6. In the case of options, the exercise price must be equal to, or greater than, the market value of an ordinary share in the company when the options were acquired.
7. The ESS interests must only relate to ordinary shares.
8. Every acquirer of an ESS interest under the scheme must not be permitted to dispose of the ESS interests for a minimum three year period.
9. A participant must not acquire more than 10% of the shares in the company.
10. Participation in the ESS must be open to at least 75% of permanent employees who have completed at least three years’ employment (whether continuous or non-continuous) with the company and who are Australian tax residents.

Disclosure Requirements for a Complying ESS

If a company meets the above ATO requirements then a company must put together certain disclosure documents which are lodged with ASIC before an ESS offer can be made including:

1. Employee Share Plan (or Employee Option Plan).
2. Employee Share Plan Offer Letter (or Employee Option Plan Offer Letter).

In putting together the Employee Share Plan (or Employee Option Plan) the simplest type of disclosure document that can be used is an Offer Information Statement (OIS) noting that an OIS must include, among other things, an audited financial report on the company.

ESS for Small Companies

Having looked at the above, it becomes clear that there are three roadblocks that rule out an ESS from a practical perspective for the majority of small companies being:

1. The fact that a scheme must be “open” ie to at least 75% of permanent employees with at least 3 years’ service. Most small companies want to “target” any offer of shares they make to only certain key employees. They do not want a general employee share scheme under which all employees can participate because three years’ service does not always automatically qualify an employee as being worthy of special or senior status and/or worthy of being brought through to ownership level.
2. The fact that an employee must not acquire more than 10% of the shares in the company. Many company owners are looking to use share ownership as a means of succession planning and often want key employees to take up an ownership stake of more than 10%.
3. Excessive Cost and Administration. The cost and resources required to implement the ESS with preparation and filing of disclosure documents, audited accounts and ongoing yearly compliance costs including reporting to be filed with ASIC, and ATO and distributed to employees Is not realistic for a small company.

How then can Small Companies bring on Employees as Shareholders?

Just because a complying ESS is out of reach for the majority of small companies does not mean that small companies cannot bring on employees as shareholders. It simply means that employees will not get the tax concessions offered by the ATO under an ESS.

Section 113(3)(a)(ii) of the Corporations Act 2001 (Cth) allows a proprietary company to offer shares to its employees without the need for costly disclosure under chapter 6D of the Corporations Act. A small company can therefore issue shares to its employees without the need for an OIS and audited accounts. In addition a company owner could simply transfer (sell) a parcel of shares to an employee.

Whether the shares are issued or transferred to an employee, it is important that the transaction is documented correctly, typically by an experienced commercial lawyer. This means that a:

1. Share Subscription Agreement or Share Sale Agreement is entered into with the employee; and
2. A Shareholders Agreement is put in place between all shareholders of the company.

And when it comes to the Shareholders Agreement we recommend the inclusion of good leaver and bad leaver provisions coupled with a well drafted Employment Agreement to give the best protection to the company owner.