Tax considerations – incentivising key staff

As Tax Advisors we are often asked to provide advice to business owners who are wanting to incentivise key staff.  Whilst this is most likely a clear reward and recognition strategy, it is important to ensure that these employees are completely aligned with the goals of the owners.

We often see this occurring as a preparatory step to the business owners entering into some form of trade sale. Incentivising key staff from a financial perspective can involve multiple strategies and different forms such as salary, long term and short term incentive plans (LTI / STI cash bonuses), or equity rights. The most appropriate option will ultimately depend on what the business owners are seeking to achieve.

When we discuss the various options with owners and affected stakeholders, there are often a number of competing issues which need to be considered. Whilst not an exhaustive listing, some of the more relevant issues we raise with business owners include;

  • Obtaining preferential tax treatment in the hands of the employee (eg on capital account rather than revenue account).
     
  • Navigating minority shareholding issues (such as equity rights).
     
  • How the incentive will impact the P&L of the business (eg earnings impact versus balance sheet impact).
     
  • Whether the employee is left with an unfunded tax liability.
     
  • Whether the incentive creates other unintended tax issues (such as CGT, Div 7A and FBT).
     
  • What is the level of required investment from the employee (eg are they required to fund some or all)?
     
  • Whether the business is required to obtain a formal business valuation to determine its market value.

Take two simple but contrasting examples:

Where the proposed option includes the issue of equity in the underlying business (eg the company), considerations need to be made as to how the equity will be taxed in the hands of the employee. Under the current ‘employee share scheme’ (ESS) rules, the general treatment of the issuing of equity to employees depends on whether the equity is issued at a discount, and whether under the offer there is a real risk of forfeiture of the equity (assuming the ESS rules apply).

One common example we see is where the equity is issued at a discount (generally for nil consideration). Under the ESS rules, the employee would be taxed at their marginal rates on the discount at the time the equity is issued (assuming the deferral rules does not apply). Depending on the quantum of this discount, the employee would have an unfunded tax liability. Unless employers plan on funding the liability, this outcome is generally avoided.

However there may be instances (for various reasons) where being taxed upfront is a preferred option. Once the equity is taxed under the ESS rules, any subsequent capital growth in the value of the shares would be dealt with under the general capital gains tax regime. Additionally, determining the discount may require a market value of the underlying share capital, which may necessitate a formal market valuation.

In the alternative, providing key staff with cash bonuses gives the employee immediate cash flow, but is largely inefficient from a tax perspective. Providing cash bonuses requires the business to be able to fund this and will ultimately impact the profitability of the business (bonuses decreases the profit and EBIT of the business). This needs to be considered where the enterprise value of the business is based on a multiplier of earnings (or profit).

Whilst generally there is not a ‘one size fits all’ solution, navigating the complexities of the ESS rules and other associated tax rules needs to be carefully considered.

If you seek any further clarity or guidance around these changes and what they mean for you, we encourage you to contact your local Crowe Horwath adviser for more information.