Edited version of your private ruling

Authorisation Number: 1012514636769

Ruling

Subject: Income tax - Employee share scheme - Loss on sale of options

Question 1: Can the loss the taxpayer incurred on the sale and/or lapse of these employee share scheme options be claimed as a revenue loss from an isolated transaction?

Answer: No.

This ruling applies for the following period:

2011-12 income year

The scheme commences on:

1 July 2009

Relevant facts and circumstances

In 2009 the taxpayer was offered employment with an Australian resident company (company X).

The position was a senior management role and warranted an incentive plan which included the offer of unlisted employee options under the company's Employee Share Option Plan. These options were to be in two tranches with the first tranche vesting after 12 months of continuous service and the second tranche vesting after 24 months of continuous service. The exercise price of the options was set by a formula based on the closing price of the company's shares on the date of commencement of employment. The taxpayer agreed to take up the options offered, entering into the transaction intending or expecting to derive a profit which would have been assessable income to the taxpayer.

Shortly afterwards, the taxpayer was offered further company options under a new Employee Share Option Plan by virtue of the taxpayer's senior management role. These options were exercisable immediately at a higher price and did not have a vesting period. The taxpayer took up the options offered, entering into the transaction intending or expecting to derive a profit which would have been assessable income to the taxpayer.

The taxpayer could not exercise these options for a range of reasons, including that it was difficult due to employment circumstances and also uncommercial to do so as the market price for the company shares was continuing to drop. With the continuing decline the share price became less than the exercise price.

The difficulty was caused by the fact that the taxpayer was a senior manager with the company, and any exercise of options at any time, not just the blackout periods, required the written approval of the Chairman of the company pursuant to a clause of the relevant guidelines issued by company X.

In addition to the restriction imposed by the relevant guidelines on the taxpayer as a senior manager, the taxpayer was advised by the Managing Director that due to a change in the priorities, direction and senior management requirements of the company the employment of the taxpayer would be terminated. A Deed of Settlement and Release was signed by the taxpayer and the company which covered the termination of the employment of the taxpayer. A clause of the Deed outlined a Settlement Sum that would be paid to the taxpayer on Termination Date. The Settlement Sum comprised payment in lieu of notice, pro rata STIP and accrued annual leave, all of which would be taxed as assessable income.

The Deed required the taxpayer to immediately assume 'Gardening Leave' and not be required to attend the office until the termination date. That clause also required the taxpayer to act appropriately for the term of the gardening leave and the company reserved the right to early termination of the gardening leave period in certain circumstances. The taxpayer was particularly concerned following discussions with the Managing Director that any dealing in the company securities during that period would be seen by the company as a lack of good faith and cause the company to terminate the gardening leave and possibly jeopardise the settlement sum.

In addition to the above, when the first tranche of options vested there was a blackout period applicable to dealing in securities until the release of the half yearly results.

The taxpayer remained extremely concerned at all times that any dealing in company securities following vesting and after the blackout period could jeopardise the gardening leave and settlement sum. Throughout this entire period the share price was continuing to drop. This has continued to be the case and at the date of the application by the taxpayer for a private ruling the company X share price has been trading significantly below the exercise prices of all of the options.

In 2012 the options with the higher exercise price, having not been exercised by the taxpayer during the taxpayer's employment or within one month of leaving or termination from the company, lapsed. At that date the share price was considerably lower than the exercise price. The taxpayer incurred a loss on this transaction based on the value of the employee share options discount as assessed to the taxpayer in the year ended 30 June 2011.

Subsequently, and after becoming aware of availability of a facility available through a commercial broker for the off market sale of the options, the taxpayer sold the first tranche of remaining options, incurring a loss (based on the value of the employee share options discount as assessed to the taxpayer in the year ended 30 June 2011). The share price at this date, and the price obtained from the off market transaction had dropped to a price that was considerably lower than the exercise price of these options.

At the same time, the taxpayer sold the second tranche of remaining options, incurring a loss (based on the value of the employee share options discount as assessed to the taxpayer in the year ended 30 June 2012).

Certain documents were provided by the applicant to support the above. They are to be read with and form part of the scheme for the purpose of this ruling.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5,

Income Tax Assessment Act 1997 Section 8-1 and

Income Tax Assessment Act 1997 Division 83A.

Reasons for decision

Summary

The loss the taxpayer incurred on the sale and/or lapse of these employee share scheme options cannot be claimed as a revenue loss from an isolated transaction?

Detailed reasoning

Generally, a taxpayer's assessable income includes their income according to ordinary concepts and they can deduct losses or outgoings to the extent that they are incurred in earning their assessable income.

A profit from an isolated transaction may be income according to ordinary concepts if both of the following elements are present:

· the taxpayer's intention or purpose in entering into the transaction was to make a profit or gain, and

· the transaction was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction.

The taxpayer's relevant intention or purpose (of making a profit or gain) is not their subjective intention or purpose. Rather, it is the taxpayer's intention or purpose discerned from an objective consideration of the facts and circumstances of the case.

It is not necessary that the intention or purpose of profit-making be the sole or dominant intention or purpose for entering into the transaction. It is sufficient if profit-making is a significant purpose.

The taxpayer must have the requisite purpose at the time of entering into the relevant transaction or operation. If a transaction or operation involves the sale of property, it is usually, but not always, necessary that the taxpayer has the purpose of profit-making at the time of acquiring the property.

If a transaction or operation is outside the ordinary course of the taxpayer's business, the intention or purpose of profit-making must exist in relation to the transaction or operation in question.

The transaction may take place in the course of carrying on a business even if the transaction is outside the ordinary course of the taxpayer's business.

For a transaction to be characterised as a business operation or a commercial transaction, it is sufficient if the transaction is business or commercial in character.

Some matters which may be relevant in considering whether an isolated transaction amounts to a business operation or commercial transaction are the following:

· the nature of the entity undertaking the operation or transaction

· the nature and scale of other activities undertaken by the taxpayer

· the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained

· the nature, scale and complexity of the operation or transaction

· the manner in which the operation or transaction was entered into or carried out

· the nature of any connection between the taxpayer and any other party to the operation or transaction

· if the transaction involves the acquisition and disposal of property, the nature of that property, and

· the timing of the transaction or the various steps in the transaction.

It is not necessary that the profit be obtained by a means specifically contemplated (either on its own or as one of several possible means) when the taxpayer entered into the transaction. It is sufficient that the taxpayer entered into the transaction with the purpose of making a profit in the most advantageous way and that a profit is later obtained by any means which implements the initial profit-making purpose. It is also sufficient if the taxpayer entered into the transaction with the purpose of making a profit by one particular means but actually obtains the profit by a different means.

A loss from an isolated transaction is generally deductible if:

· in entering into the transaction, the taxpayer intended or expected to derive a profit which would have been assessable income, and

· the transaction was entered into, and the loss was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction.

However, conclusions reached about the taxpayer's intentions when entering into an isolated transaction must also take account of provisions that modify the operation of the general tax law.

For a transaction that is related to shares or rights acquired under an employee share scheme, the profit-making intention must be determined using the market value of the share or right at the relevant taxing point. In effect, this removes the employment aspect (reward for effort) from any other determinations that are to be made about the taxation outcomes that apply to ESS interests.

Application to the taxpayer's situation

The capital gains provisions will apply to the sale and expiry of the taxpayer's options unless the loss the taxpayer made is deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

The operation of both the capital gains provisions and section 8-1 of the ITAA 1997 are modified by Division 83A of the ITAA 1997.

Specifically, section 83A-125 of the ITAA 1997 will deem the taxpayer to have acquired the two tranches of options immediately after the ESS deferred taxing point for their market value.

Similarly, section 83A-30 of the ITAA 1997 will deem the taxpayer to have acquired the higher exercise price options for their market value (rather than their discounted value).

Therefore, when considering the taxpayer's intentions in relation to the options, the starting point must be that:

· the taxpayer acquired the first tranche of options on the deferred taxing point at their market value

· the taxpayer acquired the second tranche of options on the deferred taxing point at their market value

· the taxpayer acquired the parcel of higher exercise price options on the grant date at their market value

Any profit making motive must be directly attributable to dealings that incorporate these amounts as the cost of the options, not the amount actually paid for the options.

We consider that the following matters are relevant for the purpose of determining whether or not the taxpayer was seeking to make a profit from these options that would be income according to ordinary concepts (as isolated transactions):

· the taxpayer was employed by company X at the time each parcel of options were granted to the taxpayer

· all of the options were granted to the taxpayer under employee share schemes

· the taxpayer was also employed by company X at the time they were deemed to have acquired the two tranches of options due to the modifications to the acquisition date by section 83A-125 of the ITAA 1997

· the Employee Option Plan states that the purpose behind the grant of the two tranches of options was to provide the taxpayer 'with an ownership interest in the company'

· the purpose behind the grant of the higher exercise price options was to provide the taxpayer 'with an opportunity to acquire a potential ownership interest in the company for the purpose of:

o providing the taxpayer with an opportunity to share in the growth in value of the company

o encouraging the taxpayer to improve the longer term performance of the company and its returns to shareholders, and

o assisting in the recruitment, reward and retention of employees of the Group'

· the stated purpose of each Employee Share Plan strongly indicates that they expected the taxpayer to exercise the options and hold the resulting shares for investment purposes

· there were exercise restrictions and forfeiture conditions attached to the two tranches of options

· there were exercise restrictions attached to the higher exercise price options

· the taxpayer was subject to general trading restrictions related to the taxpayer's position as a senior manager with company X

· the taxpayer was subject to special trading restrictions during blackout periods related to the release of sensitive company X information

· there were transfer restrictions on the two tranches of options according to certain clause of the Employee Option Plan

· there were transfer restrictions on the higher exercise price options according to certain clause of the General Employee Share Option Plan

· the two tranches of options could lapse due to the termination of the taxpayer's employment 'Unless the Directors in their absolute discretion determine otherwise'

· the higher exercise price options could lapse due to the termination of the taxpayer's employment 'unless the Board determines otherwise'

· the taxpayer had formed the impression that any dealings in company X securities in the lead-up to the taxpayer's termination of employment might jeopardise the taxpayer's severance entitlements

· the company X share price continued to fall after the termination of the taxpayer's employment without the taxpayer adopting strategies that might mitigate any further losses

· the taxpayer allowed the higher exercise price options to lapse

· it was some two months after the termination of the taxpayer's employment that the taxpayer learned that these options could be traded and it was only then that the taxpayer undertook this course of action

Generally, only the capital gains provisions apply to assets that are held for the long term, that generate income to the asset owner or are otherwise held by the owner for growth purposes.

However, a profit on the sale of options would be ordinary assessable income where the taxpayer had identified and bought a stock that was underpriced so that it could be sold when the price re-bounded. The turn-around time would generally be quite short.

In the taxpayer's case, the choice of stock and the timing of the acquisition of the stock was dictated by company X (the taxpayer's employer) and any price advantage to the taxpayer on acquisition was removed by the effect of the employee share scheme provisions.

Further, there were severe limitations on the taxpayer's ability to take advantage of any favourable price movements in the company X share price as to do so might constitute insider trading.

As such, the taxpayer was not able to act when the company X share price improved and a normal trader would have taken their profit.

It is also difficult to see how the taxpayer entered into the transactions (the acquisition of the options) with the view of making a profit from their sale, if the taxpayer was unable to sell the options while continuing to be an employee of company X and was likely to lose them if this employment was terminated.

There is sufficient evidence to support the conclusion that the taxpayer entered into the transactions (the acquisition of the options) as part of a standard employee share scheme whereby the taxpayer exercises the options if it is favourable to do so and then either holds the resulting shares to earn dividends or for long-term growth, or sell them for a quicker capital gain.

Given this conclusion, the taxpayer's sale of the options shortly after finding out that the sale alternative was available was a sensible act as the other choices available to the taxpayer were:

· to exercise the options (while they were out of the money)

· to continue to hold them until the company X share price improved, or

· allow the options to lapse.

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