Explanatory MemorandumCirculated by the authority of the Treasurer, the Hon Wayne Swan MP
Chapter 2 - Employee share schemes - election mechanism and removal of double taxation
Outline of chapter
2.1 Part 2 of Schedule 1 to this Bill amends the Income Tax Assessment Act 1936 (ITAA 1936) and the Income Tax Assessment Act 1997 (ITAA 1997) to:
- restore the intent of the legislation by changing the method of making an election that allows a taxpayer to choose between two tax concessions available for qualifying shares or rights acquired under an employee share scheme (ESS) thereby ensuring that income is properly included in the taxpayer's assessable income; and
- remove double taxation that arises in relation to certain ESS that use an employee share trust.
Context of amendments
2.2 Division 13A of the ITAA 1936 provides for the taxation treatment of shares and rights acquired under ESS. Any discount from the market price of the shares or rights is assessable income. An employee participating in an ESS can, subject to certain conditions, choose one of two tax concessions on the discount they receive - the tax-upfront concession or the tax-deferred concession.
- Under the tax-upfront concession, an employee is taxed on the discount received on shares and rights in the income year in which they are acquired. If the shares and rights are acquired under an ESS that meets certain exemption conditions the taxpayer can disregard the first $1,000 of the discount.
- Under the tax-deferred concession, an employee can defer paying tax on the discount received on shares or options until a cessation time. A cessation time occurs at the earliest of:
- when restrictions on sale are lifted;
- an employee sells the shares or exercises the options;
- employment ceases; or
- ten years pass from the time the shares or rights were acquired.
2.3 There is a risk with the election mechanism whereby taxpayers may seek to manipulate when amount of the discount is included as assessable income and thereby reduce their liability for tax. To address this risk, the law is being amended to ensure that taxpayers properly include ESS income in their tax return.
2.4 Subdivision 130-D of the ITAA 1997 deals with the capital gains tax (CGT) consequences of an ESS which falls under Division 13A of the ITAA 1936.
- For the tax-upfront concession, the cost base of the rights or shares is the market value of the shares or rights on acquisition. The cost base of any shares acquired as a result of the exercise of rights includes the market value of the rights on acquisition and the exercise price paid plus brokerage fees and other costs. The effect is that any gains or losses from the time of acquisition of the shares or rights will be dealt with under the CGT regime.
- For the tax-deferred concession, the CGT consequences depend on whether the relevant CGT event happens to the shares or rights (or shares acquired as a result of the exercise of the rights) in an arm's length transaction within 30 days of the 'cessation time'.
- If the relevant CGT event happens to the shares or rights (or shares acquired from exercising a right) within 30 days of the cessation time any capital gain is disregarded. This is because any gain that has arisen up to the cessation time will have been subject to income tax under Division 13A.
- If the relevant CGT event happens to the shares or rights (or shares acquired from exercising a right) outside 30 days of the cessation time, the cost base is the market value of the shares or rights at cessation time. The effect is that any gains from the cessation time will be assessed as a capital gain.
2.5 Subdivision 130-D of the ITAA 1997 provides CGT relief where the shares or rights are held by a trustee before being passed to an employee. The relief is available for the tax-upfront concession and the tax-deferred concession. The provisions ensure that the trustee or beneficiary will not be taxed on a capital gain that reflects either a discount that is assessed to the employee under Division 13A of the ITAA 1936 or a capital gain that arises later when a CGT event occurs in relation to the shares.
Making an election
2.6 Where in a year of income a taxpayer acquires qualifying shares or rights and wishes to be taxed upfront, section 139E of the ITAA 1936 requires the taxpayer to make an election. The election, which must be in writing, must be made before lodging the tax return for the year in which the shares or rights are acquired, or within such further time as the Commissioner of Taxation (Commissioner) allows. The election is not required to be lodged with the tax return or otherwise provided to the Commissioner.
2.7 There is a risk with the election requirements in relation to rights and options provided by an employer to an employee under an ESS. If the value of shares or rights increases significantly, a taxpayer can substantially reduce their tax liability by claiming to have made an election to be assessed under the tax-upfront method and, through an oversight, omitted to include the discount in their income tax return in the earlier income year. If the taxpayer makes this claim outside the two year amendment period, it may not be possible to include the discount in their assessable income via an amended assessment.
Carlos works for a public company and is granted 500,000 options in May 2003. The options are valued at 20 cents each and can be exercised after three years. If he were to be taxed at grant he would be assessed on $100,000 (500,000 × 20c) in his 2003 tax return, but he chooses not to - he makes no section 139E election - or makes the election but fails to include the income.
The company does very well in the current economic boom and by 2006 the options are worth $2 each. Carlos exercises all the options in 2006 and his tax agent tells him he will be taxed on a total of $1 million in 2006. Carlos regrets that he did not make an election back in 2003. His tax agent advises him that elections are not provided to the Australian Taxation Office (ATO) and the Commissioner has no knowledge of whether a taxpayer has made an election.
Carlos writes to the ATO advising that he made an election before lodging his tax return but now realises that through an oversight he omitted the income in that year. He requests an amendment to his 2003 tax return to include the $100,000, which is accepted under self assessment.
By claiming to have made an election for the 2003 year, Carlos avoids being assessed on $1 million income in 2006.  If questioned, Carlos produces a document purporting to be an election prepared in 2003. Forensic testing of the document provided generally will not provide the necessary evidence that the document was fabricated and is of little use.
2.8 To ensure the law operates as intended, requirements surrounding the making of an election will be tightened so amounts acquired under an ESS are appropriately returned.
2.9 Under the new arrangements an election to be taxed upfront on shares or rights is made under section 139E by making the election and including the amount of discount in the income tax return of the year of acquisition.
2.10 Double taxation can arise in relation to certain ESS that use an employee share trust. Under these schemes, an employee acquires shares from the trustee of an employee share trust on the exercise of rights that they acquired under an ESS.
2.11 These ESS do not fall within the schemes to which the CGT relief applies. This is because the CGT relief only applies where the shares or rights held by an employee share trust were acquired under an ESS. The CGT relief does not extend to shares held in the trust that the employee acquires by exercising rights they acquired under an ESS. 
2.12 Under these arrangements double taxation can arise because the trustee cannot access the CGT relief available because the requirement that the share must have been acquired by the employee under an ESS cannot be satisfied. In these circumstances, it is the right to the share and not the share itself which has been acquired under an ESS.
2.13 The capital gain that arises to the trustee or beneficiary reflects wholly or partly:
- the discount amount (being the difference between the market value of the right and the amount the employee paid for the right) on which the employee has been or will be taxed under the ESS provisions in Division 13A of the ITAA 1936; or
- any capital gain arising later when a CGT event occurs in relation to the shares (such as a sale).
Comparison of key features of new law and current law
|New law||Current law|
|An election to be taxed upfront in relation to shares or rights is made under section 139E by the taxpayer making the election. The taxpayer must also include the amount of the discount in the income tax year of the year of acquisition. This does not apply where the discount is below $1,000 and the shares or rights are acquired under an exempt scheme.||An election to be taxed upfront in relation to shares or rights is made under section 139E by making an election in writing before lodging the tax return for the year in which the shares or rights are acquired. The election is not required to be lodged with the tax return or otherwise provided to the Commissioner.|
|Section 130-90 of the ITAA 1997 provides a trustee or beneficiary of an employee share trust relief from CGT when an employee becomes absolutely entitled to ESS shares or rights held in the trust and shares held to satisfy an exercise of rights held under an ESS.||Section 130-90 of the ITAA 1997 provides a trustee or beneficiary of an employee share trust relief from CGT when an employee becomes absolutely entitled to ESS shares or rights held in the trust.|
Detailed explanation of new law
Making an election
2.14 Subsection 139E(2) of the ITAA 1936 is replaced with a new method of making an election to be assessed under the tax-upfront concession.
2.15 Under the changes, a taxpayer must make an election to be assessed under this concession by making the election and including the amount of the discount in the income tax year of the year of acquisition. If the value of the discount is $1,000 or less and the taxpayer is eligible for the $1,000 exemption under subsection 139BA(2) of the ITAA 1936 because the exemption conditions under section 139CE of the ITAA 1936 are satisfied, the taxpayer will be taken to have made the election. [ Schedule 1, item 11 ]
Helena is a store manager on a salary of $85,000. Helena's employer has an ESS which is available for all staff to participate in. Helena decides to participate and acquires 800 qualifying shares at $1 per share on 22 September 2009 where the exemption conditions in section 139CE of the ITAA 1936 are met. The market value of the shares at that time was $2.00. The discount Helena receives is valued at $800 (market value of $2 × 800 shares = $1,600 less $800 - the amount Helena paid for the shares).
Helena does not have to include the discount in her assessable income for the 2009-10 return as the discount is less than $1,000 and the exemption conditions in section 139CE of the ITAA 1936 are met. Helena is taken to have made the election to be taxed upfront on the discount.Example 2.3
Assume the same details in Example 2.1 but the amount of the discount is more than $1,000. In relation to the amount in excess of $1,000 Helena must indicate in her return that she has made an election and include the discounted amount in excess of the $1,000 in the year of acquisition. If this is not done, Helena will be taken to have chosen the tax-deferred alternative.
2.16 The Commissioner is currently provided with a discretion to allow additional time to make an election. This discretion will continue. A taxpayer seeking an extension of time must make the request in writing in an approved form. [ Schedule 1, item 11 ]
2.17 Subsection 139E(4), which sets out how an election must be made for the purposes of subsection 139E(3), is also modified to reflect the new election mechanism contained in subsection 139E(3). [ Schedule 1, item 12 ]
2.18 Subsection 130-90(3) of the ITAA 1997 describes the shares or rights for which a trustee or beneficiary of an employee share trust is able to access the CGT relief provided under section 130-90 of the ITAA 1997. These amendments extend subsection 130-90(3) so that the relief also applies to the following shares:
- shares which are acquired as a result of exercising a right acquired under an ESS; and
- shares acquired as a result of exercising a right which was acquired as a result of a corporate takeover or restructure and section 139DQ of the ITAA 1936 applies to treat the right as a continuation of the right that existed before the corporate takeover or restructure.
[ Schedule 1, item 14> ]
2.19 The new election procedures under subsections 139E(2), (2A), (2B), (4) and (5) will take effect in relation to assessments for the 2008-09 income year and later income years. [ Schedule 1, item 13 ]
2.20 The amendment to subsection 130-90(3) of the ITAA 1997 will apply to CGT events happening at or after 7.30 pm (Australian Eastern Standard Time) 13 May 2008. [ Schedule 1, item 15 ].