Inland Revenue’s ESS U-turn

By Jayesh Dahya & Mila Robertson

Employee share schemes can be a powerful incentive tool for employers in a globally tight talent market. They can act as ‘golden handcuffs’ to lock in key staff members for a fixed amount of time, a tool for cash-strapped companies to compete by providing market remuneration and are widely used to incentivise employees to work hard to increase the value of companies' stock by giving them an ownership share.

Unlike some other countries, New Zealand has limited tax incentives available to employees who are remunerated in part via shares or options. Broadly, employees in New Zealand should be indifferent to receiving their pay in cash or shares, options, or related rights. This is consistent with New Zealand’s overall tax policy settings of having a broad-based, low-rate system.

In 2018, New Zealand’s employee share scheme (‘ESS’) taxing rules were overhauled to increase certainty in the application of the ESS rules, clarify the corporate deductibility of share scheme costs, and tighten up the taxability of ESS.

While the new rules largely work as intended, there continues to be some technical uncertainty in the application of the rules at the fringes and where more complex arrangements are established.  To address this uncertainty, Inland Revenue recently released five draft interpretation statements and a “Questions we’ve been asked” (QWBA), looking to clarify technical matters concerning employee share schemes:

• PUB00364/A– IS: What an employee share scheme is, the taxing date and apportionment.

• PUB00364/B – IS: Deductions for parties to employee share schemes.

• PUB00364/C – IS: Trustee of employment share scheme trust treated as nominee.

• PUB00364/D – IS: Employee Share Scheme benefits paid in cash – PAYE and KiwiSaver obligations.

• PUB00364/E – IS: PAYE – How an employer funds the tax costs on an employee share scheme benefit.

• PUB00364/F – QWBA: Fringe benefit tax – employee share loans and associates.

These guidelines largely clarify existing practices in relation to ESS, with varying levels of relevance to employers, from corporate tax considerations, such as ESS deductibility in capital transactions and the available subscribed capital considerations associated with ESS, to more of an employment tax focus, such as the apportionment formula for calculating ESS income of cross border workers.

We expect that the change with the most widespread impact for employers will be Inland Revenue’s change in position on PAYE withholding on cash settled ESS benefits, as well as the change in the taxing point of options. 

Current state of play – optional PAYE withholding on ESS benefits

An employee share scheme is essentially any arrangement by an employer
(or associated entity) with the purpose, or effect, of transferring shares in
the employer’s business to an employee.

Currently, the widely held interpretation is that while PAYE reporting is required for ESS benefits, withholding PAYE and other related payroll deductions is optional for all ESS benefits, regardless of whether the benefit is delivered to the employee in the form of shares or cash (other than when cash is delivered under a ‘phantom’ share scheme/akin to a bonus scheme that tracks the value of the shares).

This approach to PAYE withholding tax on cash-settled ESS is not just the view of overzealous tax advisors across New Zealand. In their draft interpretation statement, Inland Revenue also acknowledges that this has historically been their interpretation. To illustrate this point, Inland Revenue’s Employer’s Guide released in April 2023, notes that: 

“You can choose to tax ESS benefits as an “extra pay”. Deducting tax is optional because it will not suit all schemes.”  

Practically, this means that currently all employees have their ESS income reported to Inland Revenue via PAYE reporting and if PAYE is not accounted for on the ESS income the employee must make arrangements to settle their own tax due via the terminal tax/provisional tax rules.

This can at times be complex for employees to manage as they may not be  familiar with paying tax in this way. However, it reduces compliance costs for the employer. 

Inland Revenue’s proposed change to PAYE withholding

Inland Revenue’s draft interpretation statement proposes that PAYE withholding on cash-settled employee share schemes will be required on a “go forward basis”, once the draft statement is finalised.

The basis for this change of interpretation is that essentially all cash payments from an employer to an employee, as a starting point, should have PAYE withheld. Whereas non-cash payments from an employer to an employee are  not ordinarily caught by the PAYE rules (usually these are dealt with via the FBT regime). Therefore, Inland Revenue’s revised position is that the rule that makes PAYE withholding ‘optional’ on ESS benefits is not a ‘carve out’ of the withholding rules for all ESS benefits, but it is simply the legislative basis for allowing employers to withhold PAYE on share-settled ESS if they wish to do so.

While this interpretation statement is still in draft, employers should be ready to withhold tax on cash-settled ESS. Inland Revenue notes that whether employers will be required to ‘gross up’ for the PAYE or deduct PAYE from the gross ESS amount, will depend on the contractual agreements in place. 

So, what do I need to withhold?

Withholding will be required under the extra pay rules (lump sum payment/extra emolument rules), meaning tax will be withheld at the flat extra pay rate applicable to that employee, calculated with reference to the employee’s prior four weeks of earnings.  

If the scheme is a cash-settled ESS, ACC earners levy will need to be withheld but KiwiSaver will not need to be withheld. If the scheme is a share-settled ESS, then no KiwiSaver or ACC deductions are required.

If the scheme is not a cash-settled ESS, nor a share-settled ESS (i.e. a phantom scheme), the treatment will revert to how other amounts of extra pay are taxed, e.g. the treatment applied to bonuses will apply. This will mean ACC earners levy, KiwiSaver and other payroll deductions will need tobe withheld. Therefore, employers need to be aware of whether they have a ‘cash-settled’ ESS or scheme that is more akin to a bonus or a ‘phantom’ scheme as it will determine whether withholding KiwiSaver is required.  Further, Inland Revenue has signalled that the treatment of ESS benefits is under closer scrutiny.

Some examples of Inland Revenue’s current thinking on what a ‘cash-settled’ ESS are: 

• Arrangements where performance rights (e.g. Restricted Stock Units (RSUs)) are granted to employees, and it is at the employer’s discretion whether or not cash or shares are delivered.
• An option scheme, where at the employer’s discretion the options
  can be cancelled on vesting and cash provided.
• An option scheme, where at the employee’s discretion they can choose on exercise of the options whether they receive the shares or take an equivalent cash payment.
• On the sale of a company where the employee’s performance rights (e.g. RSUs) are accelerated to vest, in return for a cash payment.
• At the unwind of an ESS, where cash is received in return for the cancellation of the related rights to the ESS (e.g. at the point of cancellation of RSUs)..

Some examples of Inland Revenue’s current thinking on what is not a ‘cash settled’ ESS are:  

• Share-settled schemes, including RSU, options, etc. (the existing optionality for withholding for ESS will remain for these schemes).
• Phantom share schemes, where the employee is entitled to participate in an ESS scheme and shares are never offered, however, the employee’s entitlement is linked to the company’s share price.
• Incentive schemes involving a combination of cash and shares e.g. the employee is entitled to receive $100,000 after three years delivered 40/60 in cash and shares respectively however the cash component of $40,000 will be treated like a bonus, rather than cash-settled ESS, meaning all relevant PAYE deductions would be required (including KiwiSaver and ACC). 

While the interpretation statements are still in draft, we recommend that employers begin to consider how these rules will impact any ESS offered to their employees, and whether their current scheme plans require a ‘gross-up’ of PAYE.

Taxing date for options

Another important change for employers to be aware of is the share scheme taxing date for options.

In the case of options, often once an employee exercises their rights under the scheme, the employer will need to arrange for shares to be issued and then delivered to the employee, which is a process that can take time. 

Before the 2018 rules overhaul, the taxing date for options was the date the employee exercised their options.  While we have been aware of some technical uncertainties in applying this view under the legislation, Inland  Revenue had previously made it clear that the policy intention is that the share scheme taxing date for options is the date the employee exercises their right to receive the shares/cash under the scheme.

Inland Revenue’s revised interpretation of the rules is that the taxing point for options is not the date of exercise, but rather it is the first date the shares are ‘held’ by or for the benefit of an employee. This is the date the employee has their name entered on the company’s share register.

This position change, if finalised, would mean that employers and employees can no longer rely on the exercise date being the share scheme taxing date for options (i.e., the date that triggers the valuation of the benefit, reporting and potential withholding requirements). This may cause difficulties as employers will now need to seek information on the date the employee is recorded as the owner of the shares, rather than adopting the date of exercise or vest for valuing the benefit.

This change may a so impact other ESS arrangements to the extent the shares are not ‘held’ by or on behalf of the employee at the time the employee is entitled to receive the shares. For example, if there is a trading restriction meaning shares cannot be issued on the RSU vest date, the share scheme taxing date may now become the date the restrictions lift.

These are only a few of the key proposed changes included in the draft interpretation statements. Therefore, if you offer an ESS to your employees, we recommend that you discuss how these proposed changes may impact your schemes with your Deloitte Advisor.