The discount provided to an employee for the issue of shares, or rights to shares is generally assessable to that employee under the employee share scheme (ESS) rules unless the conditions for deferral have been met. Additionally, a right that later becomes a right to shares (an indeterminate right), is treated under s83A-340 of the Income Tax Assessment Act 1997 as having always been a right to acquire shares. As such, the discount to market value of that indeterminate right is assessable at an earlier time point.
The scope of this ‘indeterminate right’ rule has always been uncertain.
Somewhat paradoxically, although the aim of the rule is to prevent such rights from escaping taxation under the ESS rules, employees will often benefit from the rule applying as the deemed right to acquire shares is often less valuable at the earlier point in time (assuming the shares were worth less then) and therefore the amount to be included in their assessable income (being the discount to market value) is less.
The cases of Davies v FC of T 2015 ATC 20-520 (Davies), Fowler v FC of T (2013) 212 FCR 149 and Commissioner of Taxation v McWilliam [2012] FCAFC 105 (McWilliam) have shed some light on the reach of the indeterminate rights rule and from these the Commissioner of Taxation has developed TD 2016/17 which was released on the 2nd of November.
Consistent with the very logical and systematic approach adopted by the Federal Court in Davies, the ATO states at paragraph 1 of TD 2016/17:
“1. Subsection 83A-340(1) of the Income Tax Assessment Act 1997 (ITAA 1997)1 applies, where:
- you acquire a right under a contract
- at the time you acquire it, the right is not a right to acquire a beneficial interest in a share
- at a later time, and because a condition in the contract is satisfied, the right ‘becomes’ another right, and
- at this later time, the right is a right to acquire a beneficial interest in a share (a right to acquire a share).”
Unfortunately, despite the seemingly clear approach adopted in Davies for determining whether a right is an indeterminate right, putting it into practice still remains difficult. TD 2016/17 provides four examples that help draw out the nuances relevant to deciding whether the right is an indeterminate right.
Based on the Federal Court’s observations in Davies, the ATO argues that critical to finding that an indeterminate right exists is a condition ‘precedent to performance’. That is, there must be a condition in the contract that must be satisfied and enforceable against the other party before the right to acquire a share is provided.
Example 1 seeks to inform readers that a very general presentation on the proposed features of an ESS and a general memorandum provided to employees doesn’t amount to an indeterminate right at that point as the employees have no contractual rights (that is no enforceable right arises).
Example 2 is the is the most conjectural of the examples given and implies that being notified of a right to acquire shares subject to performance hurdles being met is not, at that point in time, an indeterminate right as it doesn’t directly become a right to acquire shares. Only when the employee meets the performance hurdles does an indeterminate right arise (as an enforceable right arises). This pushes forward the taxing point in this example.
Similarly, in Example 3, rights to acquire shares that arise on executing an employment contract prior to commencing work only become indeterminate rights once employment actually commences (as an enforceable right arises).
Example 4 states that a right to acquire a right to acquire a share only becomes an indeterminate right when the employee pays a small premium to accept the offer as at that point a binding contract comes into existence.
Whether the ATO’s stringent view is correct is debatable but was obviously developed to make readers think that the bar is set high for what constitutes an indeterminate right.
Taxpayers and their tax agents should keep an eye out for whether the indeterminate right rule may have application to their clients’ ESSs. If, like in the cases of Davies and McWilliam, the value of the underlying right or share has continued to increase over time, there is a tax saving to be gained if an earlier indeterminate right was issued. Although it is more likely to be an issue for high level personnel like directors where there may be inducements, it may also apply to the common ESS interests offered to the majority of employees.
Bearing in mind the unlimited amendment period that applies to indeterminate rights, the continuing uncertainty around its application and the Commissioner’s lack of success in challenging the breadth of the rule in the courts, the terms of ESS contracts should be carefully reviewed to see if the indeterminate right rule applies.
