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Ruling

Subject: Employee share scheme - market value

Question 1

Will the Commissioner consider that shares issued to Australian employees of Company A are issued at a discount so that Division 83A of the Income Tax Assessment Act 1997 applies?

Answer

No, it is not considered that the scheme is one that offers shares at a discount. Accordingly, Division 83A does not apply to this arrangement

Question 2

Will a deduction be available under section 83A-205 of the ITAA 1997?

Answer

No, a deduction will not be available under section 83A-205.

This ruling applies for the following periods:

1 July 2010 to 30 June 2015

The scheme commences on:

1 July 2010

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The arrangement may be summarised as follows.

Company A is an indirect wholly-owned subsidiary of Company B. Company B is a company incorporated overseas.

Company B is 100% owned by its employees, directors and/or their holding companies. Shares in Company B issued to employees resident in another overseas country are held on their behalf by a legal representative. None of Company B's securities are admitted to trading on any recognised stock exchange or financial market.

Company B does not actively trade in its own right but, rather, acts as a holding company for other group companies.

Company A proposes to procure the issue of ordinary shares in Company B (Shares) to its Australian employees under an employee share plan (Plan).

Under the Plan, Shares will only be issued to Australian employees of Company A.

Shares issued under the Plan will be subject to a Shareholder Agreement to which each Company B shareholder is a party. Under the applicable overseas law, every director and officer of a corporation must comply with a unanimous shareholder agreement. The Shareholder Agreement is recognised by the overseas country's courts as being both a contractual document and a corporate constitutional document. The overseas law provides that a unanimous shareholder agreement may not be amended without the written consent of all shareholders. Under the Shareholder Agreement, all shareholders of Company B have consented to amendments by a resolution of shareholders in respect of which a quorum of shareholders holding at least 50% of all voting and non-voting shares must be present and 70% or more of the votes cast must approve of the amendment. Currently, there are several thousand employee shareholders of Company B.

The Shareholder Agreement relevantly provides that:

· only employees, directors, their personal holding companies and legal representatives can own shares;

· no body corporate may hold shares, other than an employee's corporation or an approved lender which realises upon security over shares;

· the price payable by Company B to repurchase shares is set by a formula based on the value of Company B's net assets (Formula Price) as set out in the Articles;.

· the Formula Price is required to be set by the directors of Company B within a set period after the end of each financial year and remains valid until the Formula Price is re-established following the end of the next financial year. In practice, the directors have determined the Formula Price in January each year;

· if an employee wishes to sell their shares to a third party, Company B has a right of first refusal to buy the employee's shares. If Company B exercises the right to purchase the shares from the employee, the purchase price payable is the lesser of the amount offered to the employee by the third party purchaser and the Formula Price. Although Company B is not obliged to exercise the right of first refusal, it has always done so without exception in order to preserve 100% employee ownership;

· if Company B fails to exercise the right of first refusal and the employee sells their shares to a third party purchaser, that third party purchaser will be bound by the terms of the Shareholder Agreement and the transfer of shares to the third party purchaser will be of no effect until the third party purchaser executes an acknowledgement stating that they are a party to the Shareholder Agreement. If a person other than an employee purchases the shares, Company B has the option to purchase those shares at the Formula Price;

· if an employee ceases employment with Company B (whether through resignation, dismissal or retirement), or an employee dies or becomes bankrupt, Company B has an option to buy back the employee's shares at the Formula Price. Although Company B is not obliged to exercise the option, it has always done so without exception in order to preserve 100% employee ownership;

· any transfer, dealing, assignment or declaration of trust over the shares is subject to the directors' approval which can be withheld for any reason;

· no shareholder may own more than a certain percentage of the total voting shares in Company B. A legal representative holding shares on behalf of certain overseas shareholders may hold more than that percentage of the total voting shares provided it does not hold any beneficial interest in such shares and provided none of those shareholders for whom it is holding shares own more than that percentage of the voting shares; and

· shareholders cannot mortgage, pledge, charge or otherwise encumber their shares except in limited circumstances (eg loans in favour of an approved lender, Company B or its Affiliate). If an approved lender takes security over the shares, it must agree to release that security upon payment of a sum not exceeding the Formula Price.

There is no secondary market for the sale of shares in Company B between employees. Shares are not bought and sold between employees.

Given Company B's history of exercise of its right of first refusal detailed above, many employees who wish to sell their shares do not seek a third party purchaser and instead request Company B to buy back their shares at the then-current Formula Price. Although Company B is not obliged to repurchase the shares, it has always done so on the request of a shareholder at the then-current Formula Price.

The constitution of Company B (Constitution) also states that the transfer of shares is restricted pursuant to the Shareholder Agreement. It further states that any invitation to the public to subscribe for shares in Company B is prohibited.

The Shareholder Agreement does not prescribe the price at which shares are to be offered. However, they have always been offered at the then-current Formula Price. Typically, share offerings are made in early each year and close shortly thereafter. On occasion, an offering may be made to an employee outside that time frame.

Accordingly, participants under the Plan will be required to pay the current Formula Price to acquire their Shares.

Shares acquired by participants under the Plan will not be held subject to a real risk of forfeiture.

Company B has broadly been 100% employee-owned for many years.

The board of directors of Company B has a policy of paying out substantially all of the earnings of Company B to shareholders by way of dividends (Dividends) and long term bonuses (Long Term Bonuses).

Long Term Bonuses are bonuses paid to employees who are shareholders of Company B based on the number of shares they hold.

Performance bonuses are also paid to employees, however, these bonuses are paid to employees regardless of whether they are a shareholder or the number of shares they hold.

The board of directors of Company B has expressed the view that, in the event of a takeover of Company B, it would expect that the price offered for the shares in Company B would significantly exceed the Formula Price. However, the Shareholder Agreement effectively precludes such a takeover because:

· any third party offer is subject to Company B's right of first refusal at a price not exceeding the Formula Price;

· any third party (other than an employee) would be subject to Company B's option to purchase shares at the Formula Price;

· the Shareholder Agreement precludes corporate shareholders; and

· the Shareholder Agreement precludes any person from holding more than a certain percentage of the voting shares.

Any amendment to the Shareholder Agreement would require a resolution with a quorum of shareholders holding at least 50% of all voting and non-voting shares and approval of at least 70% of the votes cast. Further, no takeover bid has been made since Company B became employee-owned and the board is not currently in discussions with any person in relation to a takeover.

Relevant legislative provisions

Taxation Administration Act 1953 Schedule 1 Section 392-5

Income Tax Assessment Act 1997 Division 83A

Reasons for decision

The Commissioner considers that the design of the scheme is one that seeks to provide employees with benefits commensurate with a beneficial interest in the employer's company over the period of employment. In order to achieve this outcome entry and exit price amounts are intended to reflect current market values. As the scheme is not designed to provide employees with a benefit on entry into the scheme by way of a price less than the market value of the shares at time of entry, there will not be an intended difference between issue price and market value that is provided as part of the benefits intended to be provided to employees. Accordingly, the Shares under the Plan will not be issued at a discount and Division 83A will not apply.

Paragraph 83-A 205 (1) (c) of the ITAA 1997 provides a condition for an employment deduction under section 83-A for employers, being that section 83A-35 reduces the amount assessable to an employee under section 83A-25 of Subdivision 83A-B. Accordingly, it needs to be considered whether an amount is assessable to an employee under section 83A-25 under the scheme described above.

Subsection 83A-20(1) provides that Subdivision 83A-B applies to an ESS interest if you acquire the interest under an employee share scheme 'at a discount'.

An ESS interest will be considered to be offered at a discount where the amount paid for the interest is less than the market value of the ESS interest at the time of issue. This principle is considered to be consistent with both the current Division 83-A and the former Division 13A.

In determining whether ESS interests are issued at a discount, it is considered necessary to determine their market value.

Subsection 995-1(1) provides that 'market value has a meaning affected by Subdivision 960-S'.

Subdivision 960-S (entitled 'Market value') provides:

Section 960-405

(1) The market value of an asset at a particular time is reduced by the amount of the input tax credit (if any) to which you would be entitled assuming that:

(a) you had acquired the asset at that time; and

(b) the acquisition has been solely for a creditable purpose.

(2) Subsection (1) does not apply:

(a) to an asset the supply of which cannot be a taxable supply; or

(b) in working out the market value of economic benefits, or of equity or loan interests, for the purposes of Part 3-95 (about value shifting).

Section 960-410

In working out the market value of a non-cash benefit, disregard anything that would prevent or restrict conversion of the benefit to money.

Section 960-415

To avoid doubt, apply the rules in this Subdivision to the market value component of any calculation that involves market value.

The ATO guide entitled 'Market valuation for tax purposes' (ATO Valuation Guide) summarises the relevant principles as follows:

(1) the willing but not anxious vendor and purchaser;

(2) a hypothetical market;

(3) the parties being fully informed of the advantages and disadvantages of the asset being valued; and

(4) both parties being aware of current market conditions.

When discussing the valuation methodologies for valuing unlisted shares, the ATO Valuation Guide states:

Where an ordinary share is held privately by an individual or group of shareholders, applying the appropriate valuation method (or methods) may be more complex.

When you value an unlisted share, we would expect you to take into account a number of factors that may affect its market value, including:

· many of the factors described in 'Valuation of a business' (accounting for the specific interest);

· adjustments - you need to adjust for factors such as liquidity (at the holdings level) and degree of control (actual or effective) and show that these adjustments are appropriate (for instance, you could benchmark a minority interest in an unlisted investment company against a listed investment company operating in a similar environment); and

· the rights of other equity and debt holders (which may influence the market value of an ordinary share).

Where an ordinary share is held privately by an individual or group of shareholders, applying the appropriate valuation method (or methods) may be more complex.

It is acknowledged in the ATO Valuation Guide that there are a number of valuation methodologies for determining the market value of shares. The ATO Valuation Guide states:

There are several approaches you can take to valuing a business, security or intangible asset. These are usually categorised as:

· market

· income

· asset

· cost, and

· probabilistic (this approach maybe included within other valuation approaches, such as the income approach).

It goes on to state that the asset based approach is commonly used to value investment or holding companies.

The restrictions in the Shareholder Agreement are relevant to the market value of the Shares as follows:

Company B has a right of first refusal to buy the participant's Shares where the participant seeks to sell their Shares to a third party purchaser. If Company B exercises that right, the price payable to the participant (the exiting shareholder) is the lesser of the Formula Price or the amount offered by the third party purchaser for the Shares. This means that a participant is unlikely to be able to realise their Shares for more than the Formula Price and, consequently, the Commissioner considers the market value will be equal to the Formula Price.

In the event that Company B does not exercise its first right of refusal and a participant is able to sell their Shares to a third party purchaser, that third party purchaser of the Shares will be bound by the Shareholder Agreement and, as a result, all restrictions attaching to Shares in Company B, including Company B's option to buy back the Shares at any time. For that reason, a third party purchaser would be unlikely to pay more to acquire the Shares than the Formula Price given that Company B has the option to purchase the Shares from the third party purchaser at the Formula Price at any time (ie if the third party purchaser is not an employee, Company B's right to acquire the shares can be exercised at any time).

If a shareholder ceases to be an employee for any reason, including (without limitation) death, dismissal (with or without cause), resignation or retirement, Company B has an option to purchase that employee's shares at any time at the Formula Price. It is unlikely that an employee would be prepared to pay more than the Formula Price to acquire shares, given the risk that they could be repurchased by Company B at the Formula Price at any time, should employment cease (either at the instance of the employee or the employer).

Any transfer, dealing, assignment or declaration of trust over a participant's Shares is subject to the directors' approval which can be withheld for any reason. In addition, the participant is limited in the circumstances under which they may mortgage or otherwise encumber their Shares and any approved lender taking security over the shares must agree to release the security upon payment of a sum not exceeding the Formula Price. These restrictions would be considered by a third party purchaser in determining the market value of the Shares.

It is recognised that a purchaser under a takeover might pay a significantly higher price per share (which would include a premium for control) than the Formula Price. Accordingly, this ruling will cease to apply if a takeover of Company B occurs.

Participants under the Plan, like current shareholders, will acquire Shares principally for the significant income stream (Dividends and Long Term Bonuses) and not with any expectation of significant short-term capital growth in the value of their Shares or a takeover offer being made for Company B.

Based on the above, the Commissioner considers that the market value of the Shares proposed to be issued to participants under the Plan will be equal to their Formula Price such that the Shares under the Plan will not be issued at a discount.

Subdivisions B and D of Division 83A will not apply. Accordingly, shares are not issued at a discount and no deduction is allowable.