Edited version of private advice

Authorisation Number: 1051680329712

Date of advice: 14 August 2020

Ruling

Subject: Employee share scheme

Question 1

Will the irretrievable cash contributions by Company X to the trustee of the employee share trust (Trustee) to fund the acquisition of, or subscription for, shares in Company X by the employee share trust (Trust) be assessable income of the Trust under section 6-5 or 6-10 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2A

Will a capital gain or capital loss that arises for the Trustee of the Trust established pursuant to the Original Trust Deed at the time when either CGT Event E5 or E7 happens in relation to the ESS interests be disregarded under section 130-90 of the ITAA 1997, if the employees acquire the shares for the same or less than the cost base of the shares in the hands of the Trustee?

Answer

Yes

Question 2B

Will a capital gain or capital loss that arises for the Trustee of the Trust established pursuant to the Amended Trust Deed at the time when either CGT Event E5 or E7 happens in relation to the ESS interests be disregarded under section 130-90 of the ITAA 1997, if the employees acquire the shares for the same or less than the cost base of the shares in the hands of the Trustee?

Answer

Yes

This ruling applies for the following periods:

Income tax years ended 30 June 20XX to 30 June 20XX

Relevant facts and circumstances

Company X is the head company of an income tax consolidated group.

Company X carries on a business which produces assessable income.

Company X established an Employee Incentive Plan (Plan) as part of its remuneration strategy. Incentives may be in the form of performance rights or options, which represent rights to acquire shares in Company X (Awards), shares in Company X (Plan Shares) and shares in Company X that may be treated as tax exempt (Tax Exempt Shares).

Under the Plan:

a)    Eligible employees (Participants) may receive a grant of Awards, Plan Shares or Tax Exempt Shares;

b)    Invitation letters sent to the Participants will outline:

(i)            The grant date applicable to the Awards, Plan Shares or Tax Exempt Shares;

(ii)           Details of any Vesting Conditions;

(iii)          The method and form of applying for, accepting, or rejecting a grant of the Award, Plan Shares or Tax Exempt Shares as applicable;

(iv)          The number of Awards, Plan Shares or Tax Exempt Shares the Participant is eligible to apply for;

(v)           The amount payable (if any) for the grant of each Award, Plan Share or Tax Exempt Share or how such amount is calculated;

(vi)          The manner in which the Awards, Plan Shares or Tax Exempts will be settled upon vesting; and

(vii)        Any other supplementary terms and conditions considered relevant by the Board.

c)    The Plan allows Company X to use an employee share trust to facilitate the allocation of shares to a Participant.

d)    Where there is a Change of Control event prior to the vesting of Awards, Plan Shares or the Tax Exempt Shares, the Board may determine the treatment of the Participant's Awards, Plan Shares and Tax Exempt Shares in its absolute discretion. The Board also has absolute discretion to determine the treatment of the Participant's vested but unexercised Awards, where they remain unexercised on the third business day prior to the Change of Control event.

e)    All shares issued under the Plan will rank pari passu in all respects with the shares of the same class from the date of issue.

f)     Participants must not sell, assign, transfer or grant a security interest over or otherwise deal with their Awards unless Company X in its absolute discretion provides approval to do so.

g)    Where a Participant ceases employment, then:

i) Vested Awards and Plan Shares will be retained; and

ii) Unvested Awards will be forfeited and Plan Shares will be compulsorily divested on a date determined by the Board, unless the Board provides express written consent that the Awards or Plan Shares may be retained.

h)    Where a Participant, prior to vesting of the Awards or Plan Shares, acts fraudulently or dishonestly, or commits a material breach of his or her obligations, the Board may deal with or take any actions, in relation to Awards, Plan Shares, shares resulting from the exercise of Awards or cash settlement so as to ensure no unfair benefit is obtained by the Participant.

i)      Tax Exempt Shares face no risk of forfeiture and are not subject to leaver provisions.

j)      Participants must not dispose of, or grant any security interest over, their Tax Exempt Shares or Plan Shares until the disposal restrictions no longer apply.

k)    Company X may make arrangements and do all things necessary to prevent the Participant from disposing of their Tax Exempt Shares, Plan Shares or shares resulting from Awards.

l)      From the date of issue, the Tax Exempt and Plan Shares will entitle the Participant to bonus issues and to participate in rights issues.

Company X will only make cash contributions in relation to Australian tax-resident employees.

The shares and awards to be granted under the Plan will be acquired at a discount by the employees of Company X.

Company X established the Employee Share Trust (Trust) for the purposes of acquiring, holding and transferring shares in connection with the Plan for the benefit of the Participants pursuant to an original Employee Share Trust Deed (Original Trust Deed).

The trustee of the Trust (Trustee) is neither a subsidiary nor a related body corporate of Company X.

Broadly, the Trust operates as follows:

a)    Company X must provide the Trustee with the funds required for the purchase of shares in accordance with the Plan and all funds provided to the Trustee will constitute accretions to the corpus of the Trust and will not be repayable by the Trustee.

b)    These funds are used by the Trustee to acquire shares in Company X either on-market or via subscription for new shares in Company X based on written instructions from Company X.

c)    Where the Plan Rules stipulate that the shares are to be held by the Trustee on behalf of Participants, the Trustee will hold shares in Company X as shares in respect of a Participant(s) (i.e. on an allocated basis), although the Participants will be the beneficial owner of and absolutely entitled to their Allocated Shares.

d)    Where the Plan Rules include that the shares may be held by the Trustee on behalf of Participants or employees, the Trustee will hold the shares as unallocated shares for Participants generally.

e)    The Trust is precluded from exercising voting rights in relation to the unallocated shares.

f)     After a disposal restriction period lapses, the Trustee must transfer the relevant number of shares into the name of the relevant employee or any third party as directed by the relevant employee (i.e. legal title) upon a withdrawal notice being submitted to the Trustee.

g)    The Trustee can sell shares on behalf of a Participant where permitted to do so by the Participant.

h)    The Trustee may make investments and subscribe for, sell or otherwise dispose of privileges.

i)      The Trustee is not entitled to receive from the Trust any fees, commission or other remuneration for operating or administering the Trust. However, Company X must pay or reimburse to the Trustee from Company X's own resources any such fees, commission or other remuneration incurred by the Trustee, as Company X and the Trustee agree from time to time.

j)      In the event that the Trust is terminated, the Trustee must not pay any of the Surplus Assets to Company X or its subsidiaries.

Company X subsequently made amendments to the Original Trust Deed and executed an Amended Trust Deed (Amended Trust Deed).

Under the Amended Trust Deed, the Trustee may make only ancillary investments and the Trustee is no longer able to subscribe for, sell or otherwise dispose of privileges. Ancillary investments encompass only investing in shares in Company X and retaining excessive cash in the bank account and nothing further.

Company X has confirmed that the Trustee had not, to that date, undertaken any investments or dealt with any privileges except for the acquisition of shares in Company X and holding those shares on behalf of the Participants.

Company X intends to make cash contributions to the Trust up to 6 months in advance of shares being allocated or awards vesting or being exercised.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 section 104-75

Income Tax Assessment Act 1997 subsection 130-90

Income Tax Assessment Act 1997 subsection 130-85(4)

Income Tax Assessment Act 1997 subsection 83A-10

Income Tax Assessment Act 1997 section 104-85

Reasons for decision

Question 1

Assessable income includes both ordinary income and statutory income according to sections 6-5 and 6-10 of the ITAA 1997. Ordinary income is income according to ordinary concepts. Statutory income is income that is not ordinary income but is included in assessable income because of a specific provision of the ITAA 1997 or ITAA 1936.

As Chief Justice Jordan noted in Scott v Commissioner of Taxation (1935) 35 SR (NSW) 215 (Scott):

.. what forms of receipts are comprehended within it, and what principles are to be applied to ascertain how much of those receipts ought to be treated as income must be determined in accordance with the ordinary concepts and usages of mankind, except in so far as the statute states or indicates an intention that receipts which are not income in ordinary parlance are to be treated as income, or that special rules are to be applied for arriving at the taxable amount of receipts.[1]

Ordinary income

Section 6-5 provides that a taxpayer's assessable income includes income according to ordinary concepts. The expression "income according to ordinary concepts" is not a defined term. However, case law has identified certain factors which may assist in determining whether a receipt is properly characterised as income according to ordinary concepts.

As a general rule, amounts received as a result of carrying on a business should represent ordinary income. However, receipts of a capital nature do not constitute income according to ordinary concepts, whether or not incurred in carrying on a business.

In GP International Pipecoaters v. Federal Commissioner of Taxation (1990) 170 CLR 124; (1990) 64 ALJR 392; (1990) 93 ALR 193; (1990) 21 ATR 1; 90 ATC 4413; [1990] HCA 25 (Pipecoaters), the High Court of Australia found that:

To determine whether a receipt is of an income or of a capital character, various factors may be relevant. Sometimes, the character of receipt will be revealed most clearly by their periodicity, regularity or recurrence; sometimes, by the character of a right or thing disposed of in exchange for the receipt; sometimes, by the scope of the transaction, venture or business in or by reason of which money is received and by the recipient's purpose in engaging in the transaction, venture or business.

The contributions made by Company X to the Trust forms part of the corpus of the Trust that will be applied for the sole purpose of acquiring shares for the benefit of the Participants under the Plan. The cash contributions received by the Trustee are therefore of a capital character.

It is irrelevant that, from Company X's perspective, the cash contribution may be deductible under section 8-1 of the ITAA 1997 because whether a receipt is income or capital depends on its objective character in the hands of the recipient, rather than the payer. This is made clear in Pipecoaters, where the High Court held that:

...although the amount expended on the construction of the plant was a capital expenditure, it does not follow that the taxpayer's receipt of the establishment costs was a receipt of capital.[2]

From the Trustee's perspective, the irretrievable cash contributions made by Company X are capital in nature and therefore not assessable to the Trust under section 6-5 of the ITAA 1997.

Statutory income

Section 10-5 of the ITAA 1997 provides a list of provisions of assessable income for section 6-10 purposes. None of the provisions apply to a cash contribution made by an employer to a trust established under an employee share scheme (ESS).

Therefore, the irretrievable cash contributions made by Company X to the Trustee of the Trust to fund the acquisition of shares in Company X (by subscription or on-market) are also not assessable income of the Trust pursuant to section 6-10 of the ITAA 1997.[3]

Question 2A

CGT Event E5

Pursuant to section 102-20 of the ITAA 1997, an entity can make a capital gain or loss if, and only if, a CGT event happens.

Under subsection 104-75(1) of the ITAA 1997, CGT event E5 happens if a beneficiary becomes absolutely entitled to a CGT asset of a trust (except a unit trust or a trust to which Division 128 of the ITAA 1997 applies) as against the trustee. The time of the event is when the beneficiary becomes absolutely entitled to the asset.[4]

If CGT event E5 happens, the trustee may make a capital gain if the market value of the asset, at the time of the event, is more than its cost base. The trustee makes a capital loss if that market value is less than the asset's reduced cost base.[5]

In the present case, the Trust is neither a unit trust nor a deceased estate to which Division 128 of the ITAA 1997 applies.

Draft Taxation Ruling TR 2004/D25 Income tax: capital gains: meaning of the words 'absolutely entitled to a CGT asset as against the trustee of a trust' as used in Parts 3-1 and 3-3 of the Income Tax Assessment Act 1997 (TR 2004/D25) explains the principles set out in the leading English trust law case of Saunders v. Vautier (1841) 49 ER 282 in relation to 'absolutely entitled' as follows:

... if a sole beneficiary's interest in the trust property is vested and indefeasible and they are of age then they can put an end to the trust by directing the trustees to transfer the trust property to them or at their direction, even though the trust deed contains a contrary intention. The basis of the principle is that a beneficiary is entitled now to that which will be theirs eventually anyway.[6]

However, any capital gain or loss that the Trustee makes, if CGT event E5 happens, is disregarded if section 130-90 of the ITAA 1997 applies. Section 130-90 provides as follows:

(1A) Disregard any *capital gain or *capital loss made by an *employee share trust to the extent that it results from a *CGT event, if:

(a)             immediately before the event happens, an *ESS interest is a *CGT asset of the trust; and

(b)             either of the following subparagraphs applies:

(i)            the event is CGT event E5, and the event happens because a beneficiary, of the trust becomes absolutely entitled to the ESS interest as against the trustee;

(ii)           the event is CGT event E7, and the event happens because the tustee *disposes of the ESS interest to a beneficiary of the trust; and

(c) Subdivision 83A-B or 83A-C (about employee share schemes) applies to the ESS interest.

(1) Disregard any *capital gain or *capital loss made by an *employee share trust, or a beneficiary of the trust, to the extent that it results from a *CGT event, if:

(a) the CGT event is CGT event E5 or E7; and

(b) the CGT event happens in relation to a *share; and

(c) the beneficiary had acquired a beneficial interest in the share by exercising a right; and

(d) the beneficiary's beneficial interest in the right was an *ESS interest to which Subdivision 83A-B or 83A-C (about employee share schemes) applied.

(2) Subsection (1A) or (1) does not apply if the beneficiary acquired the beneficial interest in the *shares for more than its *cost base in the hands of the *employee share trust at the time the *CGT event happens.

To qualify for the exemption in section 130-90, there must be an 'employee share trust' and an 'ESS interest'.

Subsection 130-85(4) of the ITAA 1997 defines an employee share trust as a trust whose sole activities are:

(a) obtaining shares or rights in a company; and

(b) ensuring that ESS interests in the company that are beneficial interests in those shares or rights are provided under the employee share scheme to employees, or to associates of employees, of:

(i) the company; or

(ii) a subsidiary of the company; and

(c) other activities that are merely incidental to the activities mentioned in paragraphs (a) and (b).

An ESS interest in a company is defined in subsection 83A-10(1) as either a beneficial interest in a share in the company, or a beneficial interest in a right to acquire a beneficial interest in a share in the company. Shares that are purchased by the Trustee, and subsequently granted to employees of Company X pursuant to the Plan, are ESS interests for the purposes of section 83A-10(1).

An 'employee share scheme' is defined in subsection 83A-10(2) of the ITAA 1997 as a scheme under which ESS interests in a company are provided to employees, or associates of employees (including past or prospective employees) in relation to the employee's employment. Company X's ESS constitutes an 'employee share scheme' because it is a scheme under which ESS interests in Company X are provided to the employees of Company X in relation to their employment with Company X.

Therefore, paragraphs 130-85(4)(a) and (b) of the definition of an employee share trust are satisfied because:

·         The Trust acquires shares in a company; and

·         The Trust ensures that ESS interests as defined in subsection 83A-10(1) are provided under an employee share scheme by allocating those shares to the employees of Company X in accordance with the Original Trust Deed and the Plan.

Paragraph 130-85(4)(c) of the definition of an employee share trust provides that a trustee can engage in activities that are merely incidental to those described in paragraphs 130-85(4)(a) and (b) of the ITAA 1997. The Commissioner's views on the types of activities that are merely incidental and not merely incidental are set out in Taxation Determination TD 2019/13: Income tax: what is an 'employee share trust'? (TD 2019/13).

According to paragraph 13 of TD 2019/13, 'investing in assets other than shares or rights to shares in the employer company' is not an activity that is 'merely incidental' as it is not a natural incident or consequence of administering an ESS.[7] Neither is the provision of 'additional benefits to participants and/or employees, over and above the delivery of the ESS interests or resulting shares and any dividend equivalent payment that accrues directly from the employee's ESS interest'.

The Original Trust Deed grants the Trustee the power to make investments (without limitation) and subscribe for, sell or otherwise dispose of privileges (privileges is undefined and therefore may amount to additional benefits that may be provided to the Participants).

However, whilst the relevant trust documents may include powers and/or duties that are broad reaching, the mere existence of those powers or duties in the trust document does not, of itself, mean that the trustee has breached the requirements to be an employee share trust. In examining whether the requirements of subsection 130-85(4) are met, it is necessary to examine the actual activities that the trustee has undertaken.[8]

Company X has confirmed that the Trustee had not, to that date, undertaken any investments or dealt with any privileges except for the acquisition of shares in Company X and holding those shares on behalf of the Participants. Therefore, while the Original Trust Deed contains powers and/or duties that are not merely incidental, the Commissioner is satisfied that the Trust established pursuant to the Original Trust Deed does satisfy the definition of an employee share trust on the basis that the Trustee has not in fact breached the requirements to be an employee share trust in subsection 130-85(4) of the ITAA 1997.

As the ESS interests granted under the Plan will be acquired by the employees at a discount, they are ESS interests to which subdivision 83A-B or 83A-C of the ITAA 1997 applies.

As such, a capital gain or capital loss that arises for the Trustee of the Trust established pursuant to the Original Trust Deed at the time when CGT Event E5 happens in relation to shares held by the Trustee will be disregarded under section 130-90 of the ITAA 1997, if the employees acquire the shares for the same or less than the cost base of the shares in the hands of the Trustee.

CGT Event E7

Under section 104-85 of the ITAA 1997, CGT event E7 happens if the trustee of a trust (except a unit trust or a trust to which Division 128 applies) disposes of a CGT asset of the trust to a beneficiary in satisfaction of the beneficiary's interest, or part of it, in the trust capital. The timing of the event is when the disposal occurs.[9]

If CGT event E7 happens, the trustee may make a capital gain if the market value of the asset, at the time of the disposal, is more than its cost base. The trustee makes a capital loss if that market value is less than the asset's reduced cost base.[10]

However, any capital gain or loss that the Trustee makes, if CGT event E7 happens will be disregarded under section 130-90 of the ITAA 1997 if the Trust is an employee share trust and the shares are an ESS interest. As discussed above, these two conditions are met in the present circumstances.

Consequently, section 130-90 of the ITAA 1997 will apply to disregard a capital gain or capital loss that arises for the Trustee at the time CGT Event E7 happens in relation to shares held by the Trustee, if the employees acquire the shares for the same or less than the cost base of the shares in the hands of the Trustee.

Question 2B

CGT Event E5

Under the Amended Trust Deed, the Trustee may make only ancillary investments and the Trustee is no longer able to subscribe for, sell or otherwise dispose of privileges. Ancillary investments encompass only investing in shares in Company X and retaining excessive cash in the bank account and nothing further.

The Amended Trust Deed contains only powers and/or duties that are merely incidental, as required by subsection 130-85(4)(c) of the ITAA 1997. Therefore, the Trust established pursuant to the Amended Trust Deed satisfies the definition of an employee share trust in subsection 130-85(4) of the ITAA 1997.

Accordingly, a capital gain or capital loss that arises for the Trustee of the Trust established pursuant to the Amended Trust Deed at the time when CGT Event E5 happens in relation to shares held by the Trustee will be disregarded under section 130-90 of the ITAA 1997, if the employees acquire the shares for the same or less than the cost base of the shares in the hands of the Trustee.

CGT Event E7

As discussed above under Question 2A, any capital gain or loss that the Trustee makes, if CGT event E7 happens will be disregarded under section 130-90 of the ITAA 1997 if the Trust is an employee share trust and the shares are an ESS interest. These two conditions are met in respect of the Trust established under the Amended Trust Deed.

Consequently, section 130-90 of the ITAA 1997 will apply to disregard a capital gain or capital loss that arises for the Trustee at the time CGT Event E7 happens in relation to shares held by the Trustee, if the employees acquire the shares for the same or less than the cost base of the shares in the hands of the Trustee.

[1] Scott at 220.

[2] Pipecoaters at 4420.

[3] This view is consistent with ATO ID 2002/965 Income Tax - Trustee not assessable on employer contributions made to it under the employer's employee share scheme, whichfound that: 'The funds provided to the Trustee are used in accordance with the Trust Deed and Plan Rules for the sole purpose of and under the employee share scheme. The contributions constitute capital receipts to the Trustee, and are not assessable under sections 6-5 or 6-10 of the ITAA 1997'.

[4] Subsection 104-75(2) of the ITAA 1997.

[5] Subsection 104-75 (3) of the ITAA 1997.

[6] Paragraph 41 of TR 2004/D25.

[7] See also paragraph 11 of TD 2019/13.

[8] Paragraph 6 of TD 2019/13.

[9] Subsection 104-85(2) of the ITAA 1997.

[10] Subsection 104-85(3) of the ITAA 1997.