Every business needs a strategic rewarding system to attract, motivate and retain staff. Shares and options plans are common long term remuneration incentives in Australia and practitioners will be well aware of the way our domestic tax legislation treats shares and options granted under an employee share scheme (“ESS”).
Employees only benefit from an ESS where they are able to sell the shares and realise a profit. This can present a problem for shareholders of private companies as there is a lack of a ready market for their shares. Further, the tax concessions under Division 83A ITAA 1997 (i.e., $1,000 exemption or deferral) are only available to those businesses whose legal form is that of a company to the exclusion of other legal structures such as trusts, partnerships, joint ventures etc.
An interesting form of quasi equity-linked compensation that we encounter is phantom share/option plans. Instead of actual shares, virtual equities are granted by employer companies and can be extended to be used by any business vehicles.
The concept of phantom plans
Phantom plans vary and are usually adopted for a selected group of employees, most commonly the leadership team. Generally, a phantom plan is a contract between an eligible employee and an employer. The contract defines the number and value of phantom shares/options that would be granted by the employer to the employee as well as the conditions that trigger a cash payment (or a series of cash payments). The cash payments would generally be aligned to the market value of the business to allow for employees to participate in the business profits. Holders of phantom shares/options are not entitled to dividend or voting rights in the employer company in the way allowed by traditional shares/options plans. Business owners would continue to retain their equity in the business.
In the absence of actual shares being granted, Division 83A would not apply. For income tax purposes, cash based phantom awards are cash bonuses received in the context of an employment relationship and therefore are assessable when paid, or otherwise made available, to the employee on receipt (refer IT 2534). Employers will get a tax deduction for the payment of the cash bonus but are subject to the usual Federal/State taxes and super obligations.
Quasi-equity phantom rights with features such as the one outlined in CR 2007/104 are also quite common. In CR 2007/104 eligible employees were offered performance rights that would only vest on satisfaction of specified performance conditions. On vesting of a right, an employee would be entitled to receive shares in the employer company or an equivalent cash payment, previously determined at the discretion of the Board. The Board would exercise its discretion to determine how the rights granted to an employee would be satisfied prior to the testing of the performance conditions.
The Commissioner’s long held view is that where an employee is granted a right under a scheme that purports to be a right to acquire a share (e.g., in CR 2007/104), and the scheme is operated so that the employer makes the ultimate decision as to whether an employee actually receives a share or cash in lieu of a share, the right will not be considered to be a right to acquire a share at the time it is granted. However, where the Board exercises its discretion to determine that a right will be satisfied by the issue or transfer of a share, an eligible employee will be taken to acquire a right under an employee share scheme for the purposes of Division 83A at the time that the Board exercises its discretion. This accord with the view expressed in taxation determination TD 2016/17 which is about indeterminate rights. In light of this there may be an opportunity for employers to structure their traditional share/option plans in a way that will give rise to similar tax outcomes.
Phantom shares/options are a way for employees to share a stake in the business without the hassle of making them shareholders. Employers are able to retain their skilled staff and avoid the risk of diluting equity ownership. Phantom shares can also be used by start-up companies, in lieu of shares or options, to provide prospective contributors with the success of the start-up.
For employees who are near retirement age salary sacrificing their prospective cash bonus payments may be a tax effective way of increasing their retirement benefit provided they stay within their contribution caps.