NSW State Taxes Seminar

Employee Shares and Options

Adrian ChekPartner

Allens Arthur Robinson

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1. Introduction 3

2. Background - The Federal and State Taxation of EmployeeRemuneration 3

3. Common Types Of Employee Share Schemes 43.1 Discounted share purchase scheme 43.2 Market price options 43.3 Zero exercise price options (Zepos) 4

3.4 Performance rights 4

4. Federal Taxation of Employee Remuneration and Employee ShareSchemes 54.1 Taxation of Salary and Wages 54.2 Fringe Benefits 5

4.3 Division 13A – purpose and basis of liability 54.4 Concessions available under Division 13A 64.5 Calculation of taxable discount under Division 13A 8

4.6 Valuation rules under Division 13A 84.7 Other significant aspects of treatment of rights under Division 13A 104.8 What is a "right" under Division 13A? 11

4.9 Availability of deductions for employers 12

5. Payroll Tax Provisions Relating to Employee Share Schemes 125.1 Relevant provisions 12

5.2 Basis of liability to payroll tax 135.3 Nexus with employment 135.4 The concept of a contribution 14

5.5 What is a right? 155.6 Valuation Rules 155.7 Issues arising under the payroll tax provisions 17

6. Summary of tax implications of common share schemes 196.1 Discounted Share Purchase Scheme 196.2 Market price options 20

6.3 Zero exercise price options 206.4 Performance rights 21

7. Stamp Duty Implications 217.1 Issue of Shares 217.2 Issue of options over shares 217.3 Transfer of shares or rights over shares 22

7.4 Issue and transfer of units 227.5 Rights to units 237.6 Mortgages over shares or units 23

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EMPLOYEE SHARES AND OPTIONS

by Adrian Chek, Partner, Allens Arthur Robinson

1. Introduction

The main focus of this paper is on the recently introduced New South Wales provisions imposing

payroll tax on employer contributions to employee share schemes.

These provisions (and their counterparts in Western Australia and the Northern Territory) add

another layer of complexity to the taxation of employee share schemes particularly when federal

income tax and fringe benefits tax is taken into account.

These payroll tax provisions have "borrowed" concepts from the relevant income tax provisions

(being Division 13A of Part 3 of the Income Tax Assessment Act 1936 (Division 13A)) but with

some significant modifications. Accordingly, in order to enable the reader to interpret the payroll

tax provisions, and to understand all the tax implications of employee share schemes, I will also

examine in detail Division 13A and the other federal tax implications of an employee share scheme.

2. Background - The Federal and State Taxation of EmployeeRemuneration

Of course, the taxation of employee share schemes both at federal and state level represents a

continuation of the general trend towards increased taxation of employee remuneration generally.

At the federal level, for example, fringe benefits tax was introduced in 1986 to substantially extend

the tax base to cover the taxation of mainly non-cash remuneration provided by employers to

employees, because of the perception that this represented a substantial gap in the tax base.

Division 13A (and its predecessor Section 26AAC of the Income Tax Assessment Act 1936) is a

specific regime introduced in 1995 to deal with the taxation of shares and options provided toemployees as remuneration for their employment.

The trend at the State and Territory level with payroll tax has been similar, with the states and

territories "following in the footsteps" of the federal government in expanding the tax base. For

instance, the legislation of all States and Territories now imposes tax on fringe benefits. With

certain minor exceptions, the liability to payroll tax of fringe benefits follows the rules at federal level

set out in the Fringe Benefits Tax Assessment Act 1986 and in the associated rulings issued by the

Australian Taxation Office. There is a certain efficiency in this "piggy-backing" since the liability to

fringe benefits tax and to payroll tax is that of an employer, so that, in broad terms, an employer

uses the same calculations for the purposes of self-assessing both its fringe benefits tax andpayroll tax liabilities.

This trend for the States and Territories to follow the Commonwealth has now extended to

employee share schemes. Western Australia and the Northern Territory have imposed payroll tax

on employee share schemes for several years, and New South Wales has now followed suit.

However, one important difference is that at the federal level, liability under Division 13A for income

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tax is imposed on employees. Payroll tax, of course, is imposed on employers. This difference,plus other differences in the way in which those three jurisdictions have adopted the federal

provisions, creates some issues which will be explored further below.

3. Common Types Of Employee Share Schemes

In order to help an understanding of how the relevant taxation provisions apply to employee share

schemes, it is useful to set out 4 types of common schemes.

3.1 Discounted share purchase scheme

Under this scheme an employee is entitled to acquire shares in its employer (or a holding

company of the employer) at a discount, of say 10% or 15%. The employee uses after-tax

salary to purchase the shares and commonly this is done at the direction of the employee

by way of deduction from the employee's salary or wages. The employer arranges thepurchase of the shares and may bear the cost of the relevant brokerage. The employee

will generally be free to dispose of the shares after acquisition.

3.2 Market price options

Under these schemes the employee typically is granted an option to acquire shares in theemployer, exercisable generally at some future date or range of dates. The exercise price

is set by reference to the market price of a share at the date of grant of the option.

For example, if the current market price of a share is $1.00, the option is granted to the

employee today with an exercise price of $1.00. However, the option may not be

exercisable until say, after 2 years, and then be exercisable at any time after that until it

expires in, say, 5 years' time. There may or may not be conditions or performance

hurdles, such as remaining in employment with the company and/or achieving certain sales

or profit targets.

3.3 Zero exercise price options (Zepos)

These are options granted to the employee for free with a nil exercise price. There will

generally be conditions and/or performance hurdles on the exercise of the option. The

options often will "vest" on a staggered basis over time, that is become exercisable say as

to 20% per year over 5 years.

3.4 Performance rights

These are in substance the same as Zepos except that they are not options in legal form,

but merely contractual rights to receive shares in the future if certain conditions and/or

performance hurdles are met. For example, they may vest over a period of 5 years, with

20% of the total entitlement vesting at each annual date, provided the employee remains in

employment and certain performance hurdles are met.

In the case of the last 3 types of schemes, the employer might not grant the rights directly to the

employee but might instead contribute money, rights or shares to an interposed trust established

for the purpose of acquiring shares for employees. The trustee in turn might grant rights to

employees and/or transfer shares to employees when the relevant conditions have been satisfied,

or alternatively rights might be granted directly by the employer to the employee, to be satisfied by

the trustee.

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4. Federal Taxation of Employee Remuneration and Employee ShareSchemes

It is important to understand the inter-relationship between the different federal taxation regimes

which are relevant to employee remuneration. This is particularly because the payroll tax

legislation to a large extent borrows from the federal legislation. For our purposes there are three

relevant regimes:

(a) the taxation of salary and wages;

(b) the taxation of fringe benefits; and

(c) the taxation of employee share schemes.

4.1 Taxation of Salary and Wages

Salary and wages in cash form are taxable in the hands of the employee. The employer is

generally under an obligation to withhold PAYG (Pay As You Go) instalments from salary

and wages paid to employees, and to remit those instalments to the Australian Taxation

Office. However, this is a withholding obligation and the liability to tax of salary and wages

is still ultimately that of the employee. Any instalments remitted to the Australian TaxationOffice are credited against the employee's personal income tax liability.

4.2 Fringe Benefits

Under the Fringe Benefits Tax Assessment Act 1936, non-cash benefits which are

provided directly or indirectly in relation to the employment of an employee are subject to

fringe benefits tax. The liability is imposed on the employer.

Two relevant and significant exclusions from the definition of fringe benefit are:

(a) a payment of salary or wages; and

(b) a benefit constituted by the acquisition by a person, share or right under an

employee share scheme (within the meaning of Division 13A of Part III of the

Income Tax Assessment Act 1936).

(c) an acquisition of money or property by an employee share scheme trustee.

There are a number of specific categories of benefits for which there are specific valuation

rules, for example car benefits, low interest loans, debt waivers and living-away-from-home

allowances. There are two residual categories, being property fringe benefits (ie. the

provision of property) and residual benefits. In broad terms the taxable value of such a

benefit is the arm's-length market value of the benefit less any contribution paid by the

employee towards the benefit. 1

A fringe benefit is treated as exempt income from the point of view of the employee. 2

4.3 Division 13A – purpose and basis of liability

Division 13A was enacted in 1995 to effectively replace the former section 26AAC.

According to the relevant second reading speech, the purpose of Division 13A was to:

1 Although the taxable value is "grossed-up" before the tax rate of 48.5% is applied.

2 Section 23L Income Tax Assessment Act 1936

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reduce the exploitation of the existing legislation and to ensure that the tax concessions that areavailable under the new arrangements are directed at share schemes which encourage employeesto own shares in the company in which they are employed or a holding company of the employer.The measures will increase the taxation benefits available to employees under these schemes."3

The basic liability arises under Division 13A if a taxpayer has acquired a share or right

under an employee share scheme. The discount given in relation to the share or right is

included in the assessable income of the taxpayer. 4 The taxpayer is treated as acquiring

the share or right under an employee share scheme if the share or right is acquired by the

taxpayer in respect of, or for or in relation directly or indirectly to, any employment of the

taxpayer or an associate of the taxpayer. 5

"Employer" and "Employee" are defined to have the same meaning as in Section 221A of

the ITAA 1936.

4.4 Concessions available under Division 13A

Two types of concessions are available which promote the purpose of encouraging the

ownership by employees of shares in their employers in order to align the interests of

employees and employers:

• The first allows the taxpayer to defer, for up to 10 years, the inclusion in the

individual’s assessable income of the discount given (the deferral concession);

• The second concession allows the taxpayer to elect to have the discount included

in the year of income the share or rights are acquired and be exempted from

paying tax on the first $1,000 of the discount (the exemption concession).

(a) Deferral concession

The deferral tax concession is available where the shares or rights are "qualifying"

in that they satisfy the requirements in section 139CD. In summary these

conditions are as follows:

• the share or right is acquired by the taxpayer under an employee share

scheme;

• the shares are ordinary shares in the employer of the taxpayer or a holdingcompany of the employer of the taxpayer, or in the case of rights, the rights

relate to such shares;

• after the acquisition of the share or right, the taxpayer does not hold a legal

or beneficial interest in more than 5% of the shares of the company, or

voting power of more than 5% in the company; and

• in the case of shares only, 75% of the permanent employees of the

employer are entitled to shares or rights under the scheme.

3 Second reading speech to the Taxation Laws Amendment Bill (No. 2) 1995.

4 Section 139B(1).

5 Section 139C(1).

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In the case of qualifying shares, if there are restrictions on disposal or conditionsof forfeiture, an employee can choose to defer taxation of the discount until the

earliest of:

(a) the time when the employee disposes of the share;

(b) the later of:

(i) the time when any restriction preventing the employee from

disposing of the share ceases to have effect; and

(ii) the time when any condition that could result in the employee

forfeiting ownership of the share ceases to have effect;

(c) the time when the employment in respect of which the share was acquired

ceases;

(d) the end of the 10 year period starting when the employee acquired the

share. 6

In the case of qualifying rights, an employee may chose to defer taxation of the

discount in relation to the right until the earliest of the following:

(a) the time when the employee disposes of the right (other than by exercising

it);

(b) the time when the employment ceases;

(c) the time when the last of any restriction on disposal of any share acquired

by exercising the right, or a condition that could result in forfeiture of

ownership of the share, ceases to have effect; or

(d) if the right is exercised and there is no such restriction or condition - the

time when the right is exercised;

(e) the end of the 10 year period starting when the employee acquired the

right. 7

Even though deferral may be available for a qualifying share or right, the employee

may nevertheless elect to be taxed at the time of acquisition of the share or right.8

(b) Exemption concession

The exemption concession is available, in summary, where the following conditions

are satisfied:

• the shares or rights are qualifying;

• the scheme does not contain any conditions which could result in

employees forfeiting ownership of the shares or rights;

6 Section 139CA

7 Section 139CB

8 Section 139E

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• the scheme must not permit any employee to dispose of shares acquired

under the scheme before the earlier of:

• 3 years after the shares or rights were acquired; and

• when the employee ceases employment with the employer group

• the scheme is operated on a non-discriminatory basis in that the essential

features of the offer are the same for at least 75% of the permanent

employees of the relevant employer.

As noted above, the employee must elect to be taxed upfront, but then has the first

$1,000 of discount exempted from tax.

4.5 Calculation of taxable discount under Division 13A

The rules for calculating the assessable amount of the discount vary according to whether

the discount is assessable in the year of income in which the share or option is acquired, or

whether the taxation of the discount is deferred to a later time. Even if the deferral

concession is available, a taxpayer may elect to be taxed upfront.

If the discount is assessable in the year the share or right is acquired, the discount is the

market value of the share or right when it was acquired, less any consideration paid or

given by the taxpayer (section 139CC(2)).

If the discount is taxable on a deferred basis, then, in the case of shares, the discount is

the market value of the share at the deferred taxing time, (or the actual sale price if sold

within 30 days of that time), less any consideration for the acquisition. In the case of rights,

the discount is the market value of the right at the deferred taxing time (or if the underlying

share is sold, the actual sale price), less the sum of any consideration for the acquisition ofthe option and the exercise price, if any.

4.6 Valuation rules under Division 13A

The rules in Division 13A for determining the market value of shares and rights distinguish

between quoted and unquoted securities.

Section 139FD provides that, in determining the market value of a share or right under the

rules set out below, the share or right, and any share that may be acquired as a

consequence of the exercise or operation of the right, is not taken to be subject to any

conditions or restrictions. Of course this would often cause the value determined under the

rules to be greater than the actual market value.

(a) Market value of listed shares or rights (section 139FA)

If a share or right is quoted on a stock market of an approved stock exchange, the

market value is:

(i) if there was at least one transaction on that stock market in shares or rights

of that class during the one week period up to and including that day - the

weighted average of the prices at which those shares or rights were tradedduring the one week period up to and including that day; or

(ii) if there were no transactions on that stock market in that one week period

in such shares or rights:

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(A) the last price at which an offer was made on that stock market inthat period to buy such a share or right; or

(B) if no such offer has been made - the value of the share or right that

would have been determined under rules for unlisted shares or

rights outlined below.

Where the share or right is quoted on more than one approved stock market, thetaxpayer may chose which stock market to which to apply the above rules. 9

A special rule applies where a share is acquired in the period starting 7 days

before and ending 7 days after the day on which shares are first acquired under a

public offer of shares in the company.10

(b) Market value of unlisted shares (section 139FB)

The market value of unquoted shares is to be determined by a formal valuation

from a registered company auditor or by a calculation in accordance with a method

approved by the Commissioner.

(c) Valuation of unlisted rights

It is worth looking at the valuation rules for unlisted rights in detail, because, as we

shall see below, the corresponding payroll tax rules are materially different.

Under section 139FC(1) the market value of an unlisted right is the greater of two

amounts:

(a) the market value, on the relevant day, of the share that may be acquired by

exercising the right, less the exercise price (or the lowest exercise price);

and

whichever of the following applies:

(b) if the right cannot be exercised more than 10 years after the date of grant,

according to certain formulas and tables set out in the legislation 11; and

(c) if the right can be exercised more than 10 years after the date of grant - the

greater of:

(i) the arm's length value of the right as specified in a written report

given by a qualified valuer; and

(ii) the value that would be determined under the formulas and tables

referred to in para (b) as if the right could be exercised 10 years

after the day of valuation.

There is an overriding rule that if the lowest amount that must be paid to exercise

the right is nil or cannot be determined, the market value of the right is the same as

9 Section 139FA(2).

10 Section 139FAA.

11 Sections 139FJ to 139FN.

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the market value of a share on the same day.12 Thus the market value of a Zepowould be equal to the market value of an underlying share at the date of valuation.

The formulas and tables referred to in para (b) above roughly approximate a more

sophisticated method of valuing options known as the Black-Scholes formula. This

formula takes into account the term of the option and the inherent variability of

prices on stock exchanges.

For example, assume a market price option is granted for no consideration with an

exercise price of $1. The market value of a share on the day of grant of the option

is $1. The option can be exercised at any time over a 5 year period.

Under para (a) of section 139FC(1), the market value is simply the difference

between the market value of the share, and the exercise price. 13 Thus the value

would be nil. However under para (b) of the section, applying the formula and

tables, the market value is 11.6% multiplied by the exercise price of $1, giving a

value of the option of 11.6¢. As the para (b) amount is greater than the para (a)

amount, the market value will be 11.6 cents. If instead the term is 10 years, then

the relevant percentage goes up to 18.4% and the value of the option isdetermined to be 18.4¢. That is, the longer the exercise period the greater the

value of the option.

In addition, the lower the exercise price as a percentage of the current market price

of a share, the greater the value of the option. To take the extremes, if the

exercise price is nil then the market value of the option equals the value of the

share on that day. At the other extreme if the exercise price is more than double

the market value of a share at the date of grant of the option, the value of the

option is treated as nil under the formula and tables.

4.7 Other significant aspects of treatment of rights under Division 13A

An important aspect of the way in which Division 13A operates in relation to rights is that

there is only one taxing point. If an option is taxed in the hands of an employee at the time

of grant, the employee is not then subsequently taxed again under Division 13A when the

employee acquires shares pursuant to the exercise of a right. This is made clear by

section 139C(4), which provides that a taxpayer does not acquire a share under anemployee share scheme if the taxpayer acquires the share as the result of exercising a

right that the taxpayer acquired under an employee share scheme.

In effect this provision is a codification of the principle applied by the House of Lords in

Abbott v Philbin (1960) 2 All ER 763 where it was held that where an option was granted to

an employee in respect of shares in his employer, the profit he made when subsequently

exercising the option and acquiring shares was not taxable as remuneration from his

employment. The profit he made from acquiring the shares was derived from his

ownership of the option, and was not part of the remuneration for his employment.

12 Section 139FE

13 This in fact was the method of calculation under the former section 26AAC.

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If an employer issues shares to an employee as a result of the employee exercising anoption, the employer does so because of a contractual obligation to do so under the option,

and not as additional remuneration for the employee's services.

Of course, even though the paper or actual profit an employee makes on acquiring shares

on the exercise of a right may not be taxed under Division 13A where the taxpayer has

previously been taxed on the right, the shares may subsequently be subject to capital gains

tax. Capital gains tax would apply equally to shares the employee had acquired on the

stock exchange independently of any employee share scheme. An important concession

is that a 50% discount of the amount of the capital gain applies to an individual selling

shares that had been held by the individual for more than 12 months.

If the deferral concession applies to the options, then typically the employee will be taxed

under Division 13A on exercise of the options. The amount taxed under Division 13A is the

paper profit (by comparing the then market value of the share with the exercise price and

any consideration for the option) or the actual profit if the employee sells the shares within

30 days of exercise. This is taxed at full marginal rates, and does not obtain the benefit of

the 50% capital gains tax discount.

On the other hand, if an employee is taxed up front on the grant of a right, but

subsequently loses the right without having exercised it, then a refund of the tax is

available under Section 139DD, provided the shares are shares in the employer or a

holding company of the employer.

4.8 What is a "right" under Division 13A?

There is no definition of right in Division 13A. The question is whether it is confined to

something in the nature of an option, or whether it extends more broadly, for example, to

any form of contractual right to receive shares. This question can be of critical importance

where employees obtain contractual rights to receive shares, but those shares do not vest

or are not received until subsequent years of income.

There is no guidance to be found in the relevant Explanatory Memorandum, or in any

cases or rulings issued by the Australian Taxation Office on Division 13A (or indeed its

predecessor, section 26AAC). On the one hand it might be argued that it is implicit in

Division 13A that rights are in the nature of options, because many of the provisions ofDivision 13A refer to the acquisition of shares on the "exercise" of rights.

However, the generally held view is that a "right" in Division 13A is broader than an option

and can extend to cover other forms of contractual rights to acquire shares. It is clear, for

example, that in the capital gains tax provisions of the income tax legislation the term

"right" has a different meaning to "option". For example, section 124-295 of the Income

Tax Assessment Act 1997 deals separately with "rights to acquire shares" and "an option

to acquire shares". Clearly the terms are not synonymous.

Further, it is strongly arguable that there is nothing in Division 13A which makes it

mandatory for a right to be able to be "exercised" in the way that an option is exercised.

Section 139FE provides a valuation rule for unlisted rights where there is no amount that

needs to be paid to exercise the right. This could cover a right which cannot be exercised

at all. Further, there are a number of provisions which refer to a share acquired "as a result

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of" a right.14 Section 139FD refers to a share "that may be acquired as a consequence ofthe exercise or operation of the right" (emphasis added). These words can apply to a

contractual right to receive shares, not involving any "exercise", as a result of the operation

of which a share is acquired by the employee.

4.9 Availability of deductions for employers

As a broad proposition, expenditure incurred by an employer on salary or wages, or otherremuneration of an employee, entitles the employer to an income tax deduction.

Generally, that deduction would be obtained under section 8-1 of the Income Tax

Assessment Act 1997, which is the general provision entitling a taxpayer to deductions for

expenditure incurred in the course of its business.

Generally speaking, an employer would not however be entitled to a deduction for the

issue of new shares as this does not involve any outgoing or expenditure. However,

where the exemption concession applies to exempt the discount given to employees,

section 139DC of Division 13A gives an employer an entitlement to a deduction for the

issue of shares or the grant of options effectively equal to the amounts exempted.

Expenditure incurred by an employer in purchasing shares or in funding a trust or other

entity to purchase shares for employees would be deductible under the general deduction

provision. However, section 139DB is a provision which affects the timing of the availability

of such a deduction where Division 13A applies. In summary, it provides that the employer

cannot obtain a deduction for such expenditure until the relevant employee has acquired

the relevant share or right. Thus the timing of the acquisition of the share or right by the

employee will affect the timing of the availability of the deduction for the employer.

In this regard section 139G of Division 13A defines when a person acquires a share or

right. In the case of a share, a person acquires a share if it is transferred to or allotted to

that person. In the case of a right it is acquired if a right is transferred to that person or

another person creates the right in the employee. In addition, the person will acquire a

share or right if they acquire a legal or beneficial interest in that share or right from another

person.

The person who transferred or created the share or right is then treated as having

provided that share or right.

5. Payroll Tax Provisions Relating to Employee Share Schemes

5.1 Relevant provisions

As noted above, three jurisdictions have now extended their payroll tax provisions to

impose payroll tax on employee share schemes. These are Western Australia, the

Northern Territory and New South Wales.

Western Australia was the first to introduce these provisions, with effect from 1 July 1997.

These provisions are contained in the Pay-roll Tax Assessment Regulations 2003,

Regulations 16 to 18. These prescribe a contribution to an employee share acquisition

14 Sections 139CE(3) and 139DE(b).

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scheme as a "specified taxable benefit" for the purposes of section 45(2)(b) of the Pay-rollTax Assessment Act (WA).

The Northern Territory adopted almost identical provisions with effect from 1 July 1999.

These are found in sections 27N-27Q of the Pay-roll Tax Regulations (NT), which make a

contribution to an employee share scheme fall within the definition of "prescribed benefit" in

section 3(1) of the Pay-roll Tax Assessment Act.

The New South Wales provisions were enacted with effect from 1 July 2003. The relevant

provisions are found mainly in the form of the insertion of new sections 3AD and 3AE and

Schedule 1A of the Pay-Roll Tax Act 1971 (NSW). The New South Wales provisions are

also quite similar to the WA and NT provisions, but go further in that they extend the

provisions to directors, members of governing bodies and contractors, and also contain

additional definitions of some of the key concepts.

In all three jurisdictions the valuation rules are obviously to a large extent borrowed from

Division 13A, although there is one important difference, and several minor differences

which will be examined in detail below.

In the analysis below I will focus on the New South Wales provisions, but noting any

differences in the WA and Northern Territory provisions.

5.2 Basis of liability to payroll tax

Fundamentally, payroll tax is imposed on an employer in relation to wages as defined

having certain specified territorial connections with New South Wales.15

The basic provision imposing a liability in respect of employee share schemes is section

3AD(1). Under that section, the value of any contribution (other than anything that is

otherwise wages) to a share scheme that is provided, or liable to be provided, to or in

relation to an employee is taken to constitute wages paid to the employee.

5.3 Nexus with employment

Section 3AD(2) defines a share scheme to be a scheme by which an employer provides

shares, rights to acquire shares, units in a unit trust scheme or rights to acquire units,

whether directly or indirectly, to or in relation to an employee in respect of services

performed or rendered by the employee.

In other words the nexus is very similar to that which applies for Division 13A and for fringe

benefits tax. That is, what is effectively taxed is remuneration for services performed by an

employee. Note that a liability will arise whether or not the contribution is made directly to

the employee or "in relation" to the employee. Thus a contribution, for example, to a trust

established for the purpose of holding shares, units or rights for employees would also be

caught.

Conversely a contribution made to an employee by a third party under an arrangement with

the employer is also caught, by virtue of Section 3AD(4). Division 13A and the FBT

legislation have similar provisions.

15 See sections 6, 8 and 3AA.

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Section 3AE extends the provisions to apply to a contribution made to a director or memberof the governing body of a company by way of remuneration. The provisions are further

extended to apply to contractors, by the insertion of section 3A(2)(f). WA and the Northern

Territory do not have corresponding provisions.

I note already an important difference as compared to Division 13A. That is, the payroll tax

provisions apply not only to shares and rights to acquire shares, but also to units and rights

to acquire units. Division 13A is confined to shares and rights to acquire shares. The

significance of this difference is discussed further below at 5.7(d).

5.4 The concept of a contribution

A central element to payroll tax liability is the concept of a contribution to a share scheme.

The liability to payroll tax arises when a contribution is provided or liable to be provided.

Provided is defined in section 3AD(5) to include paid, given, conferred or granted, and in

relation to the contribution of property, includes a reference to the conferral or disposal of

any right, title or interest in the property, whether legal or beneficial, by sale, gift,

declaration of trust or otherwise.

Western Australia and the Northern Territory do not have a specific definition of provided.

Section 3AD(3) recognises three separate valuation rules for three different types of

contributions as follows:

(a) if the contribution is a share, unit, or right to acquire a share or unit; the market

value of the contribution determined in accordance with the valuation rules in

Schedule 1A, on the day of contribution, less any consideration given by the

employee;

(b) if the contribution is money, the amount of money provided; or

(c) if the contribution is some other form of property, then the amount of money that

that property is worth at the time it is contributed.

Where an employer issues or transfers a share or unit directly to the employee, clearly

paragraph (a) will apply and it will be necessary to apply the valuation rules to the share or

unit.

However the position is not so clear where an employer contributes money (or property) to

a trustee or other fund in order to enable it to acquire shares or units, but at the same time

( or perhaps at an earlier time) the employee obtains a right to receive shares or units. It is

not clear then whether the relevant taxable contribution is the contribution of the right, or

alternatively is the contribution of money or property. There is no necessity that the value

of the money or property contributed by the employer will be equal to the value of the right

as determined by the valuation rules. There is a need to clarify how the provisions aremeant to operate in such circumstances.

I understand that the view of the New South Wales OSR is that the taxable contribution is

that which occurs first. If they occur at the same time it is the contribution by the employer

to the trust which should be taxed.

axcs S0111281700v1 150620 23.2.2004 Page 15

5.5 What is a right?

The Western Australian and the Northern Territory provisions do not have a specific

definition of right. Accordingly, given that the provisions are broadly modelled on Division

13A, it could be argued that for the same reasons as set out at 4.7 above, the provisions

extend to include contractual rights which are not options in legal form. I understand that

the WA Office of State Revenue takes the view that right applies to any legally enforceable

right, whether or not it is an option, and even if it is contingent.

In the case of New South Wales there is a specific definition of right which is as follows:

right to acquire a share or unit includes any right, or option, whether actual, prospective orcontingent, of a person to have a share or unit issued or transferred to the person.

This definition appears to have derived from the definition of right in the Duties Act 1997(NSW).

I submit that this specific definition of right makes it relatively clear that, in the New South

Wales provisions, the concept of a right extends beyond an option, and includes any

contractual right to have a share issued or transferred to a person. The words "actual,

prospective or contingent" further support this interpretation. Some of the implications of

the breadth of this definition are considered further below.

5.6 Valuation Rules

As noted above, the valuation rules have been largely borrowed from Division 13A, or at

least the version of those valuation rules as they stood in Division 13A on 1 July 1997,

when WA adopted them.

(a) Quoted securities

For quoted shares, units or rights, the valuation rule in clause 1 of Schedule 1A of

the NSW provisions largely corresponds to section 139FA of Division 13A. That is,

it is the weighted average trading price of the relevant securities in the one week

period before the day of valuation. Section 139FA was amended shortly after 1

July 1997 so that the relevant one week period in Division 13A now includes the

day of valuation. This is obviously a minor difference, but it would at least increase

the compliance costs of employers who, on the one hand, need to calculate their

payroll tax liability, and on the other hand, wish to advise their employees of therelevant market values to enable those employees to comply with Division 13A.

Similarly the payroll tax valuation rule where there were no transactions in the

previous week is the same rule as was formerly contained in section 139F, which

has since been amended.

There is also difference in the rule applying where the relevant security is quoted

on two or more recognised stock exchanges. Division 13A allows the taxpayer to

choose. Rule 1(2) of Schedule 1A allows the employer to choose, except where

one or more of the stock exchanges is Australian, in which case the employer must

nominate an Australian stock exchange.

axcs S0111281700v1 150620 23.2.2004 Page 16

(b) Unquoted shares and units

Rule 2(1) covers shares and units (other than units in unlisted public unit trust

schemes) which are not quoted. The rule is similar to that in Division 13A,

requiring basically a written report given by a company auditor.

Clause 2(2) of Schedule 1A provides for a specific method valuation of unlisted

public unit trust schemes, the basic valuation rule being the weighted average ofissue prices in the one week period before the relevant day. There is no

corresponding rule in Division 13A because Division 13A does not apply to units.

(c) Unquoted rights

An important difference between the payroll tax provisions and Division 13A is

found in the valuation rules for unquoted rights.

Under 12.2(3) of Schedule 1A, market value of an unquoted right is simply the

market value on that day of the share or unit that may be acquired by exercising

the right, less the exercise price.

By contrast, as discussed above at 4.6(c), under Section 139FC of Division 13A

the value of an unquoted right is the greater of the above amount and the amountdetermined by the formula and tables approximating the Black-Scholes formula for

valuing options.

It would appear that the drafters of the payroll tax legislation have opted for a less

sophisticated rule in the interests of simplicity. This difference is a concession to

the taxpayer, as the Black-Scholes formula will generally lead to a higher valuation

of an unquoted right.

As with Division 13A, the payroll tax valuation rules provide that if the exercise

price is nil or cannot be determined, the market value of a right on a particular day

is the same as the market value of a share or unit on that day.16

The payroll tax provisions importantly also have adopted from Division 13A the rule

that any conditions or restrictions are to be ignored in determining the market value

of a share, unit or right: clause 2(4). This corresponds to Section 139FD of

Division 13A as discussed above.

Unlike Division 13A, there is no provision for the refund of any payroll tax paid in

relation to rights which is subsequently not exercised.

Take the example of the market price option raised earlier, where the exercise

price is $1 and the market value of a share at the date of grant of the option is $1.

The option is exercisable over a 5 year period. Whilst this option had a value of

11.6¢ under Division 13A, it would have a nil value under the simplified valuationrule adopted under the payroll tax provisions. This, looked at in isolation, seems

favourable to the employer. On the other hand, if the option is subsequently never

exercised, the employee would obtain a refund of the tax paid under Division 13A

(assuming the option related to a share in his or her employer or a holding

16 Clause 2(5) of Schedule 1A

axcs S0111281700v1 150620 23.2.2004 Page 17

company of his or her employer). However the employer would not receive arefund of the payroll tax paid.

5.7 Issues arising under the payroll tax provisions

I will now examine some of the issues and difficulties which I believe arise under the New

South Wales payroll tax provisions.

(a) Is double taxation possible?

Is it possible that an employer will be liable for making a contribution when an

option is issued to the employee, and then again subsequently when the employee

exercises the option and the employer issues a share to the employee? Unlike

Division 13A, there is no provision which expressly negates the possibility that the

subsequent acquisition of the share will be subject to tax even though theunderlying right was previously subject to tax.

However, in my view it is relatively clear that this is the proper interpretation of the

operation of the provisions. When the right is issued to the employee, it is issued

as remuneration for employment. Therefore it is subject to payroll tax. If the

employee subsequently exercises the option, the employer issues the shares not

because of the employment relationship, but because it is under a contractual

obligation to do so pursuant to the option. That is, the share received by the

employee is a product of property that the employee owns, being the right. It is not

received directly or indirectly in respect of services rendered by the employer.Therefore it should not be subject to payroll tax.

Our understanding is that the WA and NSW revenue authorities interpret the

provisions in this way.

Equally, the policy of the provisions appears to be that, if the right is subsequently

never exercised, there is no refund of payroll tax. Tax is assessed on the value ofthe right when it is contributed; what happens subsequently is not relevant to the

payroll tax liability because it happens independently of the employment

relationship. There is a "once-and for all" taxation of the option on its value at the

time it is granted, with no subsequent adjustment up or down of the tax to reflect

the actual value of the benefit ultimately derived by the employee.

I understand that this is the view of the provisions taken by the WA and NSW

authorities. However I understand that the NSW OSR is currently considering

whether amendments should be made to the provisions to allow for subsequent

adjustments to more accurately reflect the value of the ultimate benefits derived by

employees. Ultimately it is the usual dilemma between balancing the desire forsimplicity against the desire for greater fairness or equity.

(b) Transitional application of NSW provisions

If the relevant contribution is the grant of the right, and that right was granted prior

to 1 July 2003, then it would follow that any subsequent share acquired pursuant to

the exercise or operation of that right would not have the relevant nexus withemployment, and therefore would not be subject to payroll tax. That is, the

contribution occurred prior to the start date of the provisions.

axcs S0111281700v1 150620 23.2.2004 Page 18

The same analysis applies where a contractual right to receive shares (as under aperformance rights scheme) was granted prior to 1 July 2003.

I understand that the NSW OSR accepts the above proposition.

(c) Rights granted on or after 1 July 2003 – timing of taxation

As noted above, where a market price option is granted, it will have little or no

value under the simplified valuation rules in the payroll tax provisions. Thus the

employer will be taxed on a nil or small amount of contribution at that time17. No

payroll tax will subsequently arise on any share acquired as a result of the right,

because the employment nexus would then be broken.

However, a potential difficulty arises for zero exercise price options or for

performance rights granted for nil or low consideration.

Under the valuation rules the relevant rights would, on the date of grant, be treated

as having a market value equal to the market value of an underlying share or unit

at that time. However, the right might be contingent on such factors as remaining

in employment and performance hurdles being met. Further, although there is a

contractual right, the entitlement to exercise the options or receive shares may not

"vest" until subsequently. In such circumstances it would seem very harsh to

impose payroll tax on the full value of the rights on the date of grant, particularly if

the employer does not contribute cash or shares until vesting occurs on the

subsequent dates.

It is strongly submitted that in such circumstances the authorities should consider a

more lenient interpretation of "right". Specifically, rights should not be considered

to be granted or created unless and until the various contingencies and

performance hurdles have been satisfied and the underlying shares have

irrevocably vested in the employee. It would generally be at this time that the

employer would contribute money or securities in order to then cover its

materialised liability to the employees as vesting occurs. This is accentuated by

the fact that there is no right of refund where options or rights to do not

subsequently vest.

An employer making contributions only at the time of vesting would obtain income

tax deductions at that time. Thus there would be an alignment of the timing of

deductions for employers under the income tax legislation with the timing of the

imposition of payroll tax. This is the most logical outcome.

I understand that the NSW OSR appreciates this issue and may be prepared in

practice to adopt the more lenient interpretation as suggested. However WAadheres to the view that any enforceable contractual right, even if contingent,

should be taxed on creation. I suggest that designers of these types of employee

share schemes consider making it clear that employees have no enforceable

17 Whether the value was exactly nil would depend on whether the "market" exercise price under the rules of thescheme was determined on the same weighted average basis as under the valuation rules in the payroll tax legislation.

axcs S0111281700v1 150620 23.2.2004 Page 19

contractual rights unless and until vesting occurs, although the FBT implications ofthis would have to be considered as well.

(d) Application to Units

The payroll tax provisions apply to units in unit trust schemes, whereas Division

13A does not. The payroll tax provisions accordingly, contain their own valuation

rules for units and rights to units.

However, there appears to have been a technical misconception in this regard

about the interrelationship of the different federal taxation regimes. A contribution

is only subject to payroll tax if it is not otherwise within the definition of wages. As

noted above, the definition of wages includes fringe benefits.

As also seen above, fringe benefits tax does not apply to benefits taxed toemployees under Division 13A. Thus shares and rights to shares are not taxed as

fringe benefits and are not otherwise in the definition of wages in the payroll tax

legislation.

However, because Division 13A does not apply to units or rights to units, they

constitute non-cash benefits which are subject to fringe benefits tax.

Therefore, for payroll tax purposes units and rights to units would be valued under

the fringe benefits tax rules which are incorporated by reference into the payroll tax

legislation. It follows that the specific valuation rules for units and rights to units set

out in the payroll tax provisions would simply never apply.

In any event, I understand that the grant of units or rights to units is not common

where the employer is the trustee or responsible entity of a unit trust. It is clear

that Division 13A does not apply to units or to stapled securities (where shares are

stapled to units). The fact that an FBT liability would arise for the employer has

tended to discourage such employers from providing units or rights to units to theiremployees.

6. Summary of tax implications of common share schemes

By way of summary I will now set out the income tax, FBT and payroll tax implications of the four

common types of employee share schemes we have examined.

6.1 Discounted Share Purchase Scheme

Let us assume that employees are entitled to purchase $1 shares for 90¢ each. The

employees pay for the shares from after-tax salary and there are no conditions or

restrictions on the disposal of the shares by the employee. The tax consequences are as

follows:

(a) The employee will include 10¢ per share in his or her assessable income under

Division 13A.

(b) The amount of 10¢ per share will be included in the amount of wages subject to

payroll tax (assuming the wages have the relevant territorial connection with New

South Wales, Western Australia or the Northern Territory).

axcs S0111281700v1 150620 23.2.2004 Page 20

(c) If the employer has funded the 10¢ discount, it will be immediately entitled to adeduction for that amount.

6.2 Market price options

I continue the example of an option to acquire a share with an exercise price equal to the

current market price of the share of $1, with an expiry date in 5 years' time. The tax

consequences are as follows:

(a) If the deferral concession does not apply, the employee is liable under Division 13A

at the date of grant on 11.6¢ per share. If the employee never exercises the

option, the tax is refunded, if the option relates to shares in the employer or the

employer's holding company.

(b) If the deferral concession applies, typically the employee will be liable to tax on the

paper or actual profit made when the option is exercised. For example if the

employee exercises the option after 3 years and immediately sells the share on

market for $1.60, the employee includes 60¢ in his or her assessable income

under Division 13A.

(c) If the exemption concession applies, the employee is taxed up-front, but the

discount is exempt up to a total of $1,000.

(d) The employer is liable to payroll tax on the grant of the option, but under the

valuation rules the taxable value is nil. This is the case regardless of whether the

exemption concession or deferral concession applies under Division 13A.

(e) If the exemption concession applies, then the employer is entitled to a deduction

on the grant of the options up to $1,000 of discount per employee. Otherwise the

employer will be entitled to a deduction for any amount expended to enable the

provision of the options (ie if it incurs an outgoing to enable the purchase of a fund

of shares from which it can meet its obligations under the exercise of options).

Such a deduction should be available immediately the amounts are expended as

the right is acquired by the employee on grant of the option.

6.3 Zero exercise price options

Assume that options are granted to an employee for free with a nil exercise price. Subject

to the satisfaction of conditions or performance hurdles, the options will "vest" or become

exercisable as to 20% per year over 5 years. Assume the market price of an underlying

share is $1 at date of grant, and increases by $1 per year over a 5 year period. The

employer expends money to arrange the purchase of shares on-market at each vesting

date. The tax consequences are as follows:

(a) If the deferral concession does not apply, the employee will be taxed on $1 per

option at the date of grant. If the employee subsequently does not exercise the

option, but it relates to shares in the employer or the employer's holding company,

the employee will obtain a refund of that tax.

(b) If the deferral concession applies, and the employee exercises his or her full

entitlement to options at each annual vesting date, then on each annual vesting

axcs S0111281700v1 150620 23.2.2004 Page 21

date the employee is liable under Division 13A on the market value of the shareacquired at that date.

(c) The employer will obtain a deduction for amounts contributed to it to enable the

provisions of the options, and would obtain those deductions as and when those

amounts are incurred.

(d) The employer would, on a strict interpretation of the payroll tax provisions, besubject to payroll tax of $1 per option when they are granted. There is no refund if

the options are never exercised. Equally there is no additional tax even though the

value of the shares ultimately obtained by employees exceeds $1.

6.4 Performance rights

The terms of these are, in economic substance, the same as for the Zepos under theprevious sub-heading. The difference is that the performance rights are contractual rights

to receive shares on the relevant terms, but are not options in legal form.

If it is correct that these contractual rights are treated as rights under both Division 13A

and the payroll tax legislation, then the tax treatment is exactly the same as set out for

Zepos under the previous sub-heading.

As noted above, I understand that the NSW OSR might be prepared to consider a more

lenient interpretation under which the rights are only treated as granted on the vesting

dates. If that is correct then, in New South Wales at least, the payroll tax liability would

only arise on the market value of the shares that vest at each vesting date.

In all of the above 4 cases, if units are offered instead of shares, then instead of the employee

being liable under Division 13A, the employer will be liable for fringe benefits tax on the value of the

benefit provided to employees. 18 The taxable value under the fringe benefits tax legislation is then

used to calculate the taxable value for payroll tax purposes.

7. Stamp Duty Implications

Typically stamp duty is not a significant issue in relation to employee share schemes. Some of the

possible issues are summarised briefly below.

7.1 Issue of Shares

Generally speaking the issue of shares would not be subject to stamp duty in any

Australian jurisdiction. In this regard it would generally be the case that an employee

would not be issued with sufficient shares in order to trigger a land rich liability. If the

relevant company is listed then land rich duty would not apply in any event to the issue of

its shares.

7.2 Issue of options over shares

The only jurisdiction which would potentially impose duty on grant of an option over shares

is Queensland, where the underlying share is not quoted and is in a company registered in

Queensland (or a foreign company with a Queensland share register). The grant of the

option is a dutiable transaction as the acquisition of a new right on its creation grant or

18 This value is "grossed-up" by a factor of 1.9417 under the fringe benefits tax legislation.

axcs S0111281700v1 150620 23.2.2004 Page 22

issue. 19 The definition of new right includes an option to acquire dutiable property if theacquisition of the property would be a dutiable transaction. The acquisition of unquoted

shares in a Queensland registered company (or a foreign company with a Queensland

share register) would be potentially liable to duty on this basis. However options over listed

shares would not be subject to duty.

The duty payable on the grant of an option liable to duty in Queensland would be the

greater of the consideration paid for the grant and the market value of the option. Generally

speaking the employee would not pay any consideration for the grant of an option under an

employee share scheme. The market value of the option will be a question of fact.

On this basis the grant, for example, of a Zepo would potentially be liable to ad valorem

marketable security rate duty of 0.6% calculated on the value of the option.

7.3 Transfer of shares or rights over shares

Where shares or rights to shares are quoted on a recognised stock exchange, no duty will

arise in any jurisdiction on the transfer of those shares or rights.

The transfer of shares which are not quoted would be subject to duty at the rate of 0.6%

except where the company is registered in Victoria, Tasmania or Western Australia, each

of which has abolished duty on the transfer of shares in all companies. Again, it is

assumed that generally land rich duty would not be an issue in relation to employee share

schemes.

The transfer of unlisted options over unissued shares is potentially subject to duty where

the company is registered in New South Wales, the ACT, Queensland, the Northern

Territory and South Australia (or where a foreign company has a share register in those

jurisdictions). Each specifically includes a right to be issued a share within the tax base.

This is the case even if the underlying share, on issue, would be quoted on a recognised

stock exchange.

The Northern Territory also imposes marketable security duty on a right to be transferred a

share.

It is not common under employee share schemes for employees to have the right to

transfer options. There are some schemes however in which employees do have a right to

transfer options to family members or other associates.

7.4 Issue and transfer of units

The issue of units under an employee share scheme would not generally attract duty in any

jurisdiction except conveyance rate duty in Western Australia or Queensland, where the

underlying property of the trust includes property located in the relevant State. However,

this does not apply if the relevant trust falls within the relevant definition in those

jurisdictions of a "public unit trust scheme".

The transfer of units will be subject to 0.6% duty in New South Wales, Queensland (if a

public unit trust scheme), the Northern Territory, South Australia or the ACT if the unit

19 Section 9(1)(g) Duties Act 2001 (Qld).

axcs S0111281700v1 150620 23.2.2004 Page 23

register is located in that State (or if the register is outside Australia, if the trustee ormanager is resident in the State). However there will be no duty if the trust is listed.

In the case of Queensland and Western Australia conveyance rate duty would be imposed

on transfer of units if the assets of the trust include property located in the relevant State,

unless again the trust satisfies the definition of a public unit trust scheme.

No duty would be imposed at all in Victoria or Tasmania.

7.5 Rights to units

The position is broadly the same as for rights to shares as described above, except that the

relevant territorial connection is primarily the location of the register as opposed to the

State of registration of the company.

7.6 Mortgages over shares or units

If the employee grants a mortgage over his or her shares or units to the employer to secure

a loan made by the employer to the employee, then mortgage duty potentially applies.

In all States except South Australia, shares are deemed to be located in the jurisdiction in

which the company is registered (or incorporated if foreign).20 In South Australia shares

will be located in South Australia if the share register is located there. A mortgage over

shares deemed to be located in one of the six States will be subject to mortgage duty of

0.4% of the advances (subject to certain duty thresholds). New South Wales has an

exemption from duty where the advances do not exceed $16,000. 21 Note that Victoria

proposes to abolish mortgage duty from 1 July 2004.

In all States except South Australia, units are deemed to be located where the unit register

is located (or where the trustee or manager is resident). 22 In South Australia a unit may be

treated as located in South Australia if it represents a beneficial interest in property located

in South Australia.23

20 Eg s212(a) Duties Act 1997 (NSW)

21 Section 222(2)(g) Duties Act 1997 (NSW).

22 Eg s212(b) Duties Act 1997 (NSW).

23 Section 3(4) Stamp Duties Act 1823