Getting down to business: Employee share schemes in private businesses
Deloitte Partner, Ian Fay, shares why New Zealand businesses will need to rethink how they implement share based incentive schemes as our country's tax rules do not provide any incentives for businesses to use these schemes.
Why share schemes?
Employee share schemes are an important incentive mechanism for recruiting, motivating and retaining talent; however, New Zealand tax rules do not provide any tax incentives for businesses to use these schemes. Instead, the rules seek to tax share-based remuneration and cash remuneration in a similar manner.
For listed companies, this approach arguably has some merit as shares given to employees can be turned into equivalent cash by way of sale on the stock exchange, meaning that cash and shares are to some extent capable of mutual substitution.
The same cannot be said for private businesses. Shares are often illiquid (not easily converted into cash) so the ability to finance tax payments by selling on-market (as with listed companies) is not generally available.
In addition, share valuations for private businesses, particularly start-ups with limited track records, are difficult. This can make use of share schemes problematic, as simply calculating the taxable income is a complex and costly exercise. This is particularly frustrating for start-ups as share-based remuneration can be a very useful, non-cash, method of remuneration that provides an alignment of interests between staff, founders and investors.
The nature of start-ups also means that there is a high risk that the shares may ultimately turn out to be worthless, so seeking to tax the value of the shares when they are issued to employees may result in tax on income that is never actually realised.
Currently many start-ups have resorted to share option schemes, which in effect, align the taxing point to a liquidity (sale) event. But employees may not have the same level of motivation or engagement from holding an option as from holding a real share.
There have been a number of recent developments in relation to share schemes which will mean businesses will need to rethink how they implement share based incentive schemes.
From 1 April, when an employee has taxable income from shares received from their employment, the employer needs to report the income through the payroll. This places the onus on employers to value the shares, so Inland Revenue has released guidance on how shares in private companies should be valued.
Inland Revenue has also started consultation on amendments to the general rules for share schemes (which have not yet been enacted) specifically for start-up companies. In essence, it is proposed that when start-ups issue shares to employees they can elect to defer the taxing point for the employees until the earlier of seven years or a liquidity (sale) event.
By deferring the taxing point, the proposal effectively taxes what could otherwise be a capital gain (although there is an argument that the employee has more shares and therefore a larger gain which can fund the additional tax). However, aligning the taxing point with a liquidity event addresses two key issues being valuation and the ability to fund the tax liability from the sale proceeds.
15 June, 2017 by Ian Fay,
As a Tax Partner, I enjoy helping my clients expand their businesses overseas and managing the inevitable tax challenges that arise. No matter what size a business is, from large corporates through to growing small to medium enterprises I am passionate about helping them reach their aspirations. Ultimately, what I do is find solutions that work best for the specific client – I don’t use a one size fits all approach.