We understand the Tax Office currently has a tax audit/risk review project in relation to employee share/option arrangements (see speech by Commissioner to Australian Institute of Company Directors Dinner, 11 September 2008). We note that a number of theses audits or reviews are starting just before the two or four year amendment period has finished in relation to the relevant tax year. In these cases the Tax Office auditors are asking taxpayers to allow an extension of the amendment period under section 170(7) ITAA 1936.
Our concern is that the Tax Office has not issued a comprehensive ruling on the operation of the employee share scheme provisions and is now taking a hard line on some issues that go back up to four years or more. There have been some interpretational issues surrounding many aspects of the Division 13A that the Tax Office have not as yet commented upon in public rulings or determinations, but are now being raised in these audits and risk reviews. For example:
- the 5% beneficial interest test and the 5% voting power test in subsections 139CD(6) and (7), and
- the date of acquisition of shares or options and the date on which the benefit should be calculated, for example, the date of contract or the date of issue (it is noted that TD 2008/D18 has recently been released but it is looking at this issue only in relation to subsection 139CD(6) and not in relation to the calculation of the discount).
The Tax Office auditors are taking a hard line stance on some of these issues when there are real interpretational issues that need to be resolved. Penalties of 50% are being imposed even though the Tax Office has not previously issued its understanding of the issues. We are concerned that many genuine employee incentive arrangements are not caught up in these current audits just because a particular and reasonable interpretation of Division 13A was taken when establishing the arrangement but a different interpretation is now being taken by the Tax Office auditor.
We suggest that the Tax Office issue a comprehensive public ruling outlining its interpretation of the employee share scheme provisions before conducting such an extensive audit programme.
This issue is of particular importance now due to the economic downturn and the effect on employee share options, many of which are now out of the money. Where the Tax Office determines in an audit that particular options are not qualifying share options under section 139CD, the taxpayers would be assessed on the value of the options at the time of issue. Where these options are now out of the money and it is likely once the qualifying period is finished they will lapse without being exercised, it is likely that there will need to be a further amendment reversing this audit assessment when the options lapse (assuming they continue to be out of the money until then, which is likely in most cases). We question the wisdom of conducting audit activity around this area at this time when so many of the options are out of the money and therefore any amendment action will have to be reversed once the options lapse.
Response
History
The main provisions covering employee share schemes are in as Division 13A of the ITAA 1936* and came into effect from 28 March 1995. In the words of the then Treasurer this was because the previous section 26AAC share schemes had become ‘no more than executive remuneration packages designed to convert salary into shares in order to take advantage of open ended tax deferral opportunities’.
Our risk assessment processes in 2002–03 identified highly paid executives as an area where more work could be undertaken to understand and scope potential risk. Following this, questionnaires were issued in 2003–04 to a sample of Chief Executive Officers to gather more information. From the risk analysis subsequently undertaken the high income individuals work program commenced to address compliance risks among highly paid executives and directors of public companies. The primary risk identified was under reporting of income resulting from employee share schemes.
The Compliance Program 2006–07 first highlighted a greater emphasis on examining the tax affairs of high income individuals and more information on our approaches in this part of the individuals market have been highlighted subsequently in the Compliance program 2007–08 and Compliance program 2008–09. Part of this approach has been informing tax professionals of our concerns in ways such as visits to the ‘Big 4’ accounting firms in 2007, regular articles in our tax agent publications and seminars.
The results of this work in 2007–08 included audits and reviews of 175 taxpayers resulting in voluntary disclosures in over 60% of cases. While other issues were identified in some cases the main issue requiring amendment was under reporting of employee share scheme income.
In 2008–09 this work has expanded and we continue to identify many instances of non-compliance with Division 13A requiring adjustment. We have also identified a wide range of non-compliant behaviours and this is reflected in the range of shortfall penalties imposed. Further details are provided below.
Technical issues
It is the Tax Office view that the operation of Division 13A is quite clear. The Master Tax Guide since 1996 has had a good explanation of its operation that is clearly indexed. The Tax Office has provided frequently asked questions on www.ato.gov.au and these have been reviewed and updated on a regular basis.
Through the NTLG there have been three recent employee share scheme issues raised, including the current issue, all of which have occurred in last six months.
Clarification was sought in relation to the beneficial interest in a share created when an option is granted and this was satisfied by the issue of Tax Determination TD 2009/3 on 11 March 2009.
A further question regarding the treatment of brokerage costs in relation to employee shares was raised and response provided that share brokerage costs incurred by a taxpayer in relation to the acquisition of employee share scheme shares or rights are not deductible as they are capital in nature (see ATO Interpretative Decision ATO ID 2002/1066).
We are aware that two employee share scheme related capital gains tax (CGT) issues were raised at the NTLG CGT Subcommittee in 2004. One of these issues eventually resulted in amendments to section 130–90 ITAA 1997.
Following representations to Treasury by certain large corporates, a number of significant amendments were made to Division 13A in 2005 including:
- incorporating roll over provisions for restructures and 100% takeovers, and
- cross border issues.
As a consequence of those actions, we understand that Treasury set up a consultative forum in 2005 to allow professional bodies to discuss and make a case for further amendments. The Tax Office was also invited to attend these forums. This forum continued until 2007 and the most significant amendment (there were other smaller changes) that came from this source was the inclusion of stapled securities in Division 13A.
One of the issues initially raised in this forum related to the market value of unlisted shares and revolved around requests under paragraph 139FB(1)(b) for approval by the Commissioner of a reasonable method of calculating the arm’s length value of such shares. This problem focussed on a range of practical issues that involved valuation methods and the Australian Valuation Office. That forum initially made representations to Treasury to consider a legislative fix but was not ultimately actioned when further support for the proposal was not supported by the majority of the forum participants.
There have been several requests for class rulings and a few PBR requests but none of these have raised issues with the basic operation of Division 13A.
The issues that have been raised have not been with the basic operation of Division 13A and as such we see no case for the preparation of a comprehensive public ruling.
Compliance issues
There is no specific targeting of cases with the intention of requiring an extension to the period of review as a matter of course but where an extension is needed to enable a taxpayer argument to be properly considered or to allow a taxpayer to properly consider the Tax Office position we will seek agreement to extend the period of review.
There is also no specific targeting of cases where options are ‘out of the money’. The compliance risk targeted in our case selection processes is under reporting of income. Where officers conducting the reviews and audits identify non-compliance with the law they will amend the assessment. As discussed further below we have commenced a consultation process to help us understand the issues arising from the share market decline and whether there is a need for further education or interpretative products around any new issues being encountered.
Audit officers continue to apply the law consistent with the Tax Office interpretation of Division 13A since its introduction. Tax practitioners may now be more aware of the Tax Office views because of the expansion of the audit program but our application has remained consistent.
One issue that we have identified is that some taxpayers have not been seeking the Commissioner’s discretion to include a late section 139E election. It has been difficult to determine in some cases when the elections were actually made and why discount income had not been returned, in other cases we have evidence that documents have been backdated.
Apart from the backdating of section 139E elections the main compliance issues arising from our audit activities are the failures to include the discount associated with the acquisition of shares or rights or the incorrect calculation of the discount amount.
Subsection 139B(2) states that unless subsection (2A) or (3) applies, the discount is included in the taxpayer’s assessable income of the year of income in which the share or right is acquired. Subsection (2A) is about shares acquired before the taxpayer become an employee and is not relevant to the examples that follow.
Subsection 139B(3) states that if the share or right is a qualifying share or right and the taxpayer has not made an election under section 139E covering the share or right, the discount is included in the taxpayer’s assessable income of the year of income in which the cessation time occurs.
For the 2008 and prior income years (to which all these examples relate) in order to make an election under section 139E a taxpayer may make the election that subsection 139(2) applies. The election must be in the approved form and be made before they lodge their return of income for the income year or within such further time as the Commissioner allows (this section aspect is referred to as the 'Commissioner’s discretion').
As a result of the non-compliant conduct around the making of section 139E elections a legislative amendment was sort and obtained. For the 2009 and later income years the election is made in the taxpayer’s return of income for the acquisition year.
Example 1
The taxpayer acquired options in the 2001 and 2004 income years. A section 139E election was made only in relation to the 2004 income year. No amount of discount was returned in the taxpayer’s return for the 2004 income year.
The taxpayer exercised the options acquired in 2001 in the 2006 income year. The taxpayer included an amount of discount arising as a result of the cessation event in their return for the 2006 income year.
The taxpayer was notified of the Tax Office’s intention to undertake a tax audit and provided the information requested within the period allowed.
In the course of preparing the information requested the taxpayer’s tax agent realised the taxpayer had not included the discount on the options acquired in 2004 in the taxpayer’s return for that income year. In responding to the Tax Office’s information request the tax agent provided a copy of the section 139E election, which had been made in the approved form pursuant to TD 97/23, and requested an amendment to the taxpayer’s return for the 2004 income year to include the discount amount.
Both amounts of discount were incorrectly calculated.
An election made in the approved from pursuant to Tax Determination TD 97/23 clearly states that the taxpayer is choosing to apply subsection 139E. Subsection 139B(2) clearly states that the amount of discount is to be included in the taxpayer’s assessable income in the year in which the shares or rights are acquired. As a result a 25% penalty for lack of reasonable care was imposed in relation to the shortfall arising in the 2004 income year.
For the 2006 income year the taxpayer had attempted to correctly calculate and declare the assessable discount arising from the exercise of the options (a cessation event). However they miscalculated the amount of the discount and as a consequence a shortfall amount arose. The taxpayer’s calculation was based on the market value of the underlying share obtained from a single source. This was found to be lower than the market value of those shares obtained by the Tax Officer from three other sources. As a consequence the taxpayer was found to have exercised reasonable care when making the misstatement that gave rise to the shortfall amount and no administrative penalty was imposed.
Example 2
The taxpayer acquired options in the 2004 and 2006 income years. The amount of the discount associated with the acquisition of these options was included in the taxpayers return for the 2006 income year but not for the 2004 income year.
The taxpayer disposed of both parcels of the options in the 2007 income year.
The taxpayer received a pre-lodgement advisory letter from the Tax Office prior to lodging his return for the 2007 income year alerting the taxpayer to the fact that the Tax Office was aware that they had disposed of their options and setting out the tax treatment that arose as a result of that disposal, both on the basis that they had made a section 139E election and if they had not.
Prior to lodging their return for the 2006 income year the taxpayer had sought to amend their return for the 2004 income year to include an amount of discount. This self-assessment amendment was processed and issued prior to the taxpayer lodging their return for the 2007 income year.
The taxpayer did not include any discount amount in their return for the 2007 income year, however, a capital gain was returned.
The taxpayer was notified of the Tax Office’s intention to undertake a tax audit and provided the Tax Office with the information requested within the period allowed. From the information provided it was clear that whilst section 139E elections were prepared in the approved form for both income years however, neither were signed or dated. Despite repeated requests by the Tax Office no explanation was provided by the taxpayer or their tax agent as to why the section 139E elections had not been signed. Thus despite the fact that the taxpayer had:
- amended their assessment for the 2004 income year to include an amount of the discount, and
- included an amount of discount in their return for the 2006 income year.
An administrative penalty of 50% was imposed on the shortfall amount arising from the taxpayer’s failure to include any discount amount in their return for the 2007 income year as a result of their recklessness as to the operation of a taxation law for the following reasons:
Subsection 139E clearly states that an election must be made before the taxpayer lodges the relevant tax return or within such further time as the Commissioner allows. The taxpayer had not made an election in the approved form before they lodged their returns for the 2004 and 2006 income year as neither of the prepared election forms had been signed or dated.
It is not sufficient to say that by the Commissioner accepting and processing the 2004 amendment request the Commissioner has accepted validity of the election. The request for the exercise of discretion is an administrative function separate from the assessment function that includes the processing of an amendment request and at no time had the taxpayer actually sought exercise of the Commissioner’s discretion.
Prior to the lodging of your tax return for the 2007 income year the Tax Office sent the taxpayer a letter advising them of the tax consequences of their acquisition and disposal of options and provided them with the phone number of a tax officer they could contact if they wished to discuss any of the issued raised by the letter. Neither the taxpayer nor the tax agent made any enquiries of the Tax Office and instead prepared the tax return in a manner contrary to the advice provided.
Example 3
The taxpayer acquired options in the 2000, 2002, 2003, 2004 and 2005 income years.
The taxpayer’s employer provided the taxpayer with a summary of the taxation treatment of options including detailed examples of how to calculate the discount associated with the acquisition of unlisted options and further advised the taxpayer to seek their own professional advice in relation to their acquisition of options.
The taxpayer made section 139E elections prior to lodging their return for the 2004 and 2005 income years.
Section 139E elections for the 2000, 2002 and 2003 income years were signed by the taxpayer in December 2004 and dated 1 September 2000, 12 September 2002 and 1 May 2004 respectively.
The taxpayer did not request the Commissioner to exercise his discretion to allow further time in which an election could be made for the 2000, 2002 and 2003 income years at the time the documents were signed. Such a request was, however, made after the taxpayer had been notified of the Tax Office’s intention to undertake a tax audit.
The taxpayer exercised the options they acquired in the 2000 income year during the 2003 income year. When lodging their tax return for the 2003 income year the taxpayer returned an amount of discount based on the happening of the cessation event. This discount amount returned had been correctly calculated. The taxpayer subsequently amended their return on a self assessment basis to remove the discount amount on the basis that they had made a section 139E election. However, the taxpayer did not amend their return for the 2000 income year to return the amount of the discount arising as a result of a section 139E election having been made.
The amount of the discounts return for the 2004 and 2005 income years was incorrectly calculated by some 52% and 25%, respectively, less than the actual discount amount. The tax agent stated that in calculating these discount amounts they followed the examples and explanations provided by the Tax Office on our website under the topic Employee share schemes – answers to frequently asked questions by employees (Employee share schemes – answers to frequently asked questions by employees (ESS FAQs)). However, it is apparent from the errors made by the tax agent in undertaking the calculations that they did not correctly follow the advice contained in the ESS FAQs and in particular did not use market value calculation prescribed by the legislation as the starting point for the calculating the discount amount.
An administrative penalty of 25% for lack of reasonable care in complying with a taxation law was imposed in relation to the shortfall amounts arising in the 2004 and 2005 income years. We considered the taxpayer and their tax agent to have been in possession of sufficient information to determine the correct calculation of the discount amount for these income years and failed to exercise reasonable care in following the examples provided in the ESS FAQs and information provided by the taxpayer’s employer.
An administrative penalty of 75% for intentional disregard of a taxation law was imposed in relation to the shortfall amounts arising as a result of the taxpayer’s failure to include the discount amounts arising from cessation events happening to the options they acquired in the 2000, 2002 and 2003 income years for the following reasons:
- the taxpayer was aware of the choice to make section 139E elections and that those elections needed to be made before the return for the relevant income year was lodged
- the taxpayer and their tax agent was aware of the tax implications of making section 139E elections and in particular the tax benefits from doing so in these circumstances (see for example the self-amendment to the 2003 income tax return), and
- the taxpayer did not take the opportunity to explain the events and details surrounding the back dating of elections in December 2004 and were evasive in responding to Tax Office requests for information about these events and in particular why it was that a request for exercise of the Commissioner’s discretion was not made at the time.
Example 4
The taxpayer was employed as an Executive Director of a publicly listed company at the time of the Tax Office audit. The taxpayer was previously employed as a Chief Financial Officer and General Manager of a publicly listed company. The taxpayer has a Bachelor of Commerce and a Masters of Business Administration and is also a Fellow of CPA Australia.
The taxpayer acquired options in the 2001 income year and did not make a section 139E election in relation to the acquisition of those options prior to lodging their tax return for that income year.
The taxpayer’s employer provided them with detailed advice on the operation of the Executive Option Plan which included a summary of the taxation treatment of the options. This summary included an explanation that the employee would be required to include the discount amount as assessable income, outlined the taxation consequences of making a section 139E election and advised that the rights were qualifying rights for the purposes of Division 13A.
In 2004, two days prior to exercising the options the taxpayer requested the Commissioner exercise his discretion to allow the taxpayer further in which to make an election for the 2001 income year. The Commissioner declined to exercise his discretion and advised the taxpayer accordingly. The taxpayer did not seek to have reviewed or challenged the Commissioner’s decision.
The taxpayer was a self preparer and lodged a self amendment request for their tax return for the 2001 income year to include additional income at label 22 – Other income and advised that the amount being included was the discount arising from the acquisition of options in that year.
The taxpayer was notified of the Tax Office’s intention to undertake a tax audit and asked to provide further information in relation to their acquisition of options in the 2001 income year. The taxpayer did not provide the Tax Office with a section 139E election for the 2001 income year or an explanation of the basis upon which they amended their return for that year.
The taxpayer lodged their return for the 2004 income year and did not include any discount arising from the exercise of the options (being a cessation event).
A penalty of 75% for intentional disregard of a taxation law was imposed on the shortfall amount arising from failure by the taxpayer to include the discount arising from the cessation event in the 2004 income year for the following reasons:
- the taxpayer had been given clear advice by their employer on the taxation consequences relating to the acquisition of the options
- the Commissioner advised the taxpayer they he would not exercise his discretion to allow a further period of time in which the taxpayer could make a section 139E election for the 2001 income year, and
- the taxpayer ignored the advice of the Commissioner, self amended his return for the 2001 income year on the basis that he had made a section 139E election when he had not done so in accordance with the legislative requirements and had failed to return the discount amount when the taxpayer knew that it should properly have been brought to account.
Example 5
In the course of examining the tax affairs of a range of executives, a number of clusters of individuals with apparent non-compliance in their taxation obligations have been found. In at least one case the common factor is their tax agent who is a chartered accountant employed by a ‘Big Four' accounting firm.
For these taxpayers, all of whom were self-preparers, it is clear that they have not made section 139E elections prior to lodging their returns for the relevant income year.
Having exercised, or contemplating exercising their options these taxpayers have sought advice of this tax agent and have then sought to amend their returns for those years without first asking the Commissioner to exercising his discretion and obtaining further time in which to make a section 139E election. This is despite the tax agent in other correspondence with the Tax Office having clearly demonstrated their understanding of the operation of Division 13A, the manner in which section 139E elections are to be made and the need to seek further time in which to make an election where one hasn’t been make prior to lodging the relevant return.
Consultation
At the ATPF on 27 February 2009 we invited members to both add issues to the table below and provide feedback on the priority of addressing the issues. We asked for feedback by 27 March 2009. We invite members of the NTLG to similarly participate and request feedback by 1 May 2009. The intention is to inform our marketing and education plans and to continue ongoing consultation and any co-design of products with the ATPF.
High income individual – employee share scheme issues
Issue
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Awareness of basics of tax treatment for ESS when shares or rights received.
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Legislative reference
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Division 13A
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Eduction/Law interpretation/ATO view clarification
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Education
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Comments
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Possible flyer or similar plain English brochure directing to more information.
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Proposed rating (1–3)
|
|
Issue
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Treatment of rights that have an exercise price greater than current value of share price – 'underwater options'.
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Legislative reference
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139DD
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Eduction/Law interpretation/ATO view clarification
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Education
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Comments
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Is the process to follow clear and well understood? Is the effect on associates understood?
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Proposed rating (1–3)
|
|
Issue
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Commissioner's discretion to allow further time to lodge an election after lodgment date.
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Legislative reference
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Section 139E
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Eduction/Law interpretation/ATO view clarification
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Education/ATO view clarification
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Comments
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Are the circumstances when the Commissioner will (and won't) allow a late election clear and understood?
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Proposed rating (1–3)
|
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Issue
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Timing of acquisition – when a share or right is acquired can have significant impacts on market value and discount calculation.
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Legislative reference
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Division 13A Subdivision F.
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Eduction/Law interpretation/ATO view clarification
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Education/ATO view clarification
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Comments
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Is it clear how the interaction between ESSs, employment contracts, board decisions and annual general meeeting (AGM) decisions determines timing of acquisition?
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Proposed rating (1–3)
|
|
Conclusion
The Tax Office sees its actions around employee share and option arrangements as appropriate given the risk and behaviours identified. There has been no change in view or practice in our administration of Division 13A. If members have issues relating to specific cases they should raise it with the manager of the team conducting the review or audit.
Members are invited to contribute to the consultation process outlined above by 1 May 2009.
Meeting discussion
Andrew Watson, Director Micro Enterprises and Individuals, attended the meeting to discuss this agenda item.
Members were provided with information on the difference between High Wealth and High Income Individuals and advised that compliance with Division 13A is currently under review. Information on the 2007–08 results were included in last years compliance program.
Consultation, as outlined in the response, has commenced and ATPF and NTLG members have been invited to provide feedback by 1 May 2009.
Members appreciated the comprehensive response provided and some discussion concerning the examples occurred.
There appeared to be an unresolved issue associated with the complexity of calculating the discount when there is a lengthy delay between the issue of shares and the time that the discount needs to be calculated. Members were advised that section 139E election issues were the most common issues raised.
Another issue, associated with section 139DD – reversal of assessment associated with section 139E election was raised. It was queried as to what occurred when shares are issued to an associate as the position did not appear to be clear. Members were advised that guidance and input on general scenarios was being sought and incorporated in FAQs currently being reviewed prior to publishing on the web site, see Employee share schemes. It was suggested that there might be a need for a guidance product.
CTC advised that the issue of deduction of brokerage costs would be reviewed in light of the issues raised in this discussion.
The Commissioner invited members to provide information on issues where additional guidance was required to PALU at PALU@ato.gov.au.
The management of guidance product development will continue through the current ATPF process.
Post meeting update
In the 2009-2010 budget the government has announced changes to the income tax concessions previously available to participants in employee share schemes. The changes will apply to shares and rights acquired under an employee share scheme after 7.30pm (AEST) on 12 May 2009.
The measure will eliminate the existing tax deferral option by removing the ‘election to be taxed upfront’ provisions. This will mean that discounts provided on shares or rights acquired under an employee share scheme will be assessed in the income year the shares or rights are acquired. The measure will also limit access to the existing tax exemption of up to $1,000 to employees with an adjusted taxable income of less than $60,000.
At the time of writing, legislation has not been enacted to give effect to the measure. Members can obtain information such as details as to how to complete the 2009/10 tax return and information about the progress of the Bill that includes this measure at New legislation which can be found at www.ato.gov.au
* All legislative references in this document are to the Income Tax Assessment Act 1936 unless otherwise stated
Sections within Agenda items
Last Modified: Friday, 3 July 2009
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