ESS: Speak now or forever hold your peace

By Robyn Walker

Start-up companies take note: if you have thoughts on the operation of tax rules for employee shares schemes (ESS) now is the time to have your say.

Consultation has begun on a proposal to allow a deferral of the taxing point of awards under employee shares schemes operated by start-up companies. The proposal comes with a bit of a serve from Inland Revenue officials, saying the proposal was originally consulted on in May 2017 but there was “relatively little reaction to the paper”. It is possibly unsurprising as start-up founders are rarely known to spend downtime reading tax policy papers, while the traditional tax submitters were bogged down in analysing and submitting on 191 pages of new tax legislation in the form of the Taxation (Annual Rates for 2017–18, Employment and Investment Income, and Remedial Matters) Bill (which featured a raft of complex other changes to the ESS rules), and reviewing new proposals to reform the taxation of feasibility expenditure (which was announced as part of Budget 2017). So it may be understandable that the reaction was not overwhelming – timing is everything if you want people to have the bandwidth to respond.

However, a lesson that can be learned from this saga is to ensure that people make their voices heard on tax policy matters – whether that is a short note of support, or more detailed comment and critique. Often the emphasis is put on submitting against proposals, with not enough emphasis put on proactively supporting proposals. For the start-up community, there is now a (rare) second chance – so speak now (or by 15 March 2025) or forever hold your peace on this topic.

What is proposed?

In a nutshell, an ESS can be a popular tool for start-ups as they can build strong connections between the company and its employees and can also incentivise and remunerate the employees with a low cash-cost for the business (which may be cash-constrained during the start-up phase). However, for most ESS’s the tax rules work to ensure there is a tax bill for employees on the difference between the value of shares received and the amount paid for them. When the shares vest to the employee, this is known as a share scheme taxing date. For start-ups, an issue exists that the shares in the company may be difficult to value and illiquid. Compared with listed companies where there is a clear market value and employees have the option to sell some shares to fund the resulting tax bill, start-up employees may not have this luxury. The outcome is that an ESS is a less effective tool for this part of the market.

The Issues Paper is proposing an alternative tax option, whereby the taxing point will be deferred. Sounds great, but the paper also makes it clear it’s not intended to provide a “tax concession”. Accordingly, there is a “cost” to the employee, being that they become taxable on any further appreciation in share value between the current taxing date and the deferred date. This amount could otherwise have been a tax-free capital gain for the employee (in most cases). The employer is also not entitled to any tax deductions until the deferred taxing date has been reached.

For start-ups using the Research and Development Loss Tax Credit rules, the Issues Paper helpfully recommends amending these rules to include ESS costs as part of labour expenditure for the purposes of calculating eligibility under those rules.

Who does it apply to?

The Issues Paper is targeted at “start-ups” and consequently it is proposed to legislatively define this term. Australia has a definition and it’s proposed to piggy-back off this approach. It’s proposed the deferral rule would be limited to unlisted businesses of a certain size and age. The Issues Paper puts forward NZ$15 million as the turnover threshold and remains silent on age (Australia uses AU$50 million and 10 years).

Would it be compulsory?

The paper seeks comment on whether the regime should be compulsory or elective, and whether any election should be made by the employer or the employee. Given that the issue is ultimately driven by the ability of the employee to fund tax liabilities, it would seem logical that the employee should have a say in whether the rules apply to them (if they can afford to fund the tax upfront, that may be more beneficial to them).

How long is the deferral?

The problem being solved with these proposals is valuation and liquidity, so it stands to reason that these problems are solved when the shares are actually sold or able to be sold (for example the company undertakes an initial public offering (IPO)). However, the paper also highlights that this won’t work in all circumstances and therefore the taxing point should also be triggered:

• When the shares are cancelled, including due to the company being struck off (not uncommon with start-ups, however the market value of the shares is likely to be very low or nil);
• When the employee ceases employment with the employer or ceases to be New Zealand tax resident;
• At a sunset date, proposed to be seven years (note, Australia uses 15 years).

These later two scenarios go back to square one as far as ignoring the valuation and cashflow problems the proposals are supposed to solve. Part of the drive for tax arising when employment ends is the proposal that the employer is not entitled to a deduction until the employee is taxed. If they are no longer employed it makes it more difficult for the employer to obtain this critical information. And, while there is some logic to try to tax individuals while they are tax resident, this proposal may also be problematic for employees who continue employment but move overseas as part of business expansion.

Speak now or forever hold your peace

As mentioned above, it may be necessary to get a critical mass of support for change in order for these changes to proceed. Start-ups and other interested parties should take the time to make their views known to officials. The process to make a submission is straight forward and outlined in the Issues Paper.

If you’d like to know more about the process of making a submission please speak to your usual Deloitte advisor.