Edited version of private advice

Authorisation Number: 1051810964667

Date of advice: 1 March 2021

Ruling

Subject: Employee share schemes - minimum holding period

Question 1

Will the Commissioner allow the minimum holding period for ESS interests to be reduced in accordance with sub-paragraph 83A-45(5)(a)(ii) of the Income Tax Assessment Act 1997 for the purposes of determining the Company's reporting obligations under Division 392 of Schedule 1 to the Taxation Administration Act 1953?

Answer

Yes. The Commissioner will allow the minimum holding period in section 83A-45(4) of the Income Tax Assessment Act 1997 to be the period starting when the options were acquired, and ending when the options were either:

•         vested, and exercised for shares or

•         vested, bought back and cancelled

shortly before a Transaction where the Buyer completed a 100% acquisition of the Company's shares.

Question 2

Will the optionholders, with unvested options, other than Founder Options, be required to include any amounts in their assessable income under Division 83A of the Income Tax Assessment Act 1997 in any income year from 1 July 20XX to 30 June 20XX, for the purposes of determining the Company's reporting obligations under Division 392 of Schedule 1 to the Taxation Administration Act 1953?

Answer

No. Optionholders holding Class A Options, Class B Options, Exempt Options, or Former Employee Options will not be required to include any amounts in their assessable income under Division 83A of the Income Tax Assessment Act 1997 in any income year from 1 July 20XX to 30 June 20XX.

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

The scheme commences on:

July 20XX

Relevant facts and circumstances

The Company established an Employee Share Option Plan (ESOP) during July 20XX.

The ESOP Rules provide that an optionholder must not dispose of his or her legal or beneficial interest in an option or option share (other than under an arrangement meeting the requirements of section 83A-130) until:

•         3 years after the option was issued

•         such earlier time as the Commissioner allows under 83A-45(5)

•         when the optionholder's employment ceases.

The Company operated the ESOP in accordance with the Rules from establishment until September 20XX. During this period, no options were disposed or transferred after they were issued.

The company granted options under the ESOP, falling into the following categories:

•         grants of options in August 20XX to current employees (Exempt Options) and former employees (Former Employee Options)

•         grants of options between January 20XX to June 20XX to current employees (Class A Options)

•         grants of options in early July 20XX to current employees (Class B Options)

•         grants of options in early July 20XX to employees holding over 10% of the shares in the Company (Founder Options)

In April 20XX, the Company's Board entered an initial, non-binding letter of intent (ILOI) with the Buyer, which proposed that the Buyer would acquire 100% of the Company's shares for cash, subject to conditions.

Shortly after signing the ILOI, the Buyer significantly reduced their valuation of the Company, and imposed post-completion performance conditions. The Company's shareholders indicated that they would not sell for the reduced valuation on the proposed post-completion performance conditions.

In May 20XX, the parties entered a revised letter of intent (RLOI) which proposed a sale on the reduced valuation without any post-completion performance conditions (the Transaction). The RLOI provided for comprehensive conditions precedent, including Foreign Investment Review Board approval, Buyer due diligence investigations, Buyer Board approval, retention of all employees, and that no material adverse changes occurred in the Company's business, operations, financial condition or prospects.

In June 20XX, the Buyer said it would not approve the Transaction unless part of the consideration was subject to the Company achieving certain post-Completion performance targets (Earn Out Conditions). Several Company shareholders indicated that they would not sell their shares if part of the consideration was subject to the Earn Out Conditions. The shareholders continued to negotiate until September 20XX, when all shareholders agreed in principle to the Earn Out Conditions.

In June 20XX, the Company's largest client (Key Client) threatened to terminate an agreement with the Company if the Company did not agree to reduced pricing. The Company resolved this disagreement with the Key Client, and disclosed the matter to the Buyer in July 20XX.

Up until September 20XX:

•         the Buyer continued to request due diligence information from the Company

•         the Company continued to consider alternate funding strategies, including raising debt or equity funding from existing shareholders

•         the Company considered that the chances of completing the Transaction to be low, because the Buyer might abandon negotiations for various reasons including:

-        disagreement by some Company shareholders about the Earn Out Conditions

-        disagreement with the Key Client

-        uncertainty around the effects of COVID-19 on the Company's business or its client's businesses.

In September 20XX, the Company informed its current employees of the proposed Transaction, and the opportunity to exercise their options, or have their options bought back at Fair Market Value, on Completion of the Transaction. In September 20XX, subject to Completion of the Transaction, all current employees elected to exercise their options.

The Company's shareholders entered a binding, conditional share purchase deed for all the company's shares in October 20XX.

The Transaction was completed in December 20XX (Completion). The Company's Board elected to exercise a discretion under the ESOP Rules to:

•         vest, buy back and cancel the Former Employee Options, and

•         allow all remaining options to vest, be exercised into shares, and be sold to the Buyer on Completion.

Apart from the:

•         holding period requirement in subsection 83A-45(4) for Class A Options and Class B Options, and

•         the 10% limit on shareholding and voting power in subsection 83A-45(6) for Founder Options

all options made under the ESOP would otherwise meet all eligibility requirements for the start-up conditions in section 83A-33 and 83A-45 of the Income Tax Assessment Act 1997.

Relevant legislative provisions

Division 392 of Schedule 1 to the Taxation Administration Act 1953

Section 83A-45 of the Income Tax Assessment Act 1997

Subsection 83A-45(4) of the Income Tax Assessment Act 1997

Subsection 83A-45(5) of the Income Tax Assessment Act 1997

Paragraph 83A-45(5)a of the Income Tax Assessment Act 1997

Subparagraph 83A-45(5)a(ii) of the Income Tax Assessment Act 1997

Reasons for decision

Legislative references are to the Income Tax Assessment Act 1997 unless otherwise stated.

Question 1

Will the Commissioner allow the minimum holding period for ESS interests to be reduced in accordance with sub-paragraph 83A-45(5)(a)(ii), for the purposes of determining the Company's reporting obligations under Division 392 of Schedule 1 of the Taxation Administration Act 1953 (TAA)?

Summary

Yes. The Commissioner will allow the minimum holding period in section 83A-45(4) to be the period starting when the options were acquired, and ending when the options were either:

•         vested, and exercised for shares or

•         vested, bought back and cancelled

shortly before a Transaction where the Buyer completed a 100% acquisition of the Company's shares.

Detailed reasoning

Broadly, Division 392 of Schedule 1 to the TAA imposes reporting obligations on a company that provides ESS interests to individuals, where subdivision 83A-B applies in determining the tax consequences.

Section 83A-25 includes an amount in an employee's assessable income, equal to the discount on an ESS interest they receive under an employee share scheme (ESS). However, this amount can be reduced to the extent that ESS interests meet conditions, broadly targeted at start up companies, set out in sections 83A-33 and 83A-45 (the start up concessions).

One condition is that the ESS is operated so that every acquirer of an ESS interest under the ESS scheme is not permitted to dispose of that ESS interest (or a share acquired as a result of the ESS interest) during a 'minimum holding period': 83A-45(4).

The ESS interest's 'minimum holding period' is defined in subsection 83A-45(5) as the period starting when the interest is acquired under the ESS, and ending at the earlier of:

a)    3 years later, or such earlier time as the Commissioner allows if the Commissioner is satisfied that:

                      i.        the operators of the scheme intended for subsection (4) to apply to the interest during the 3 years after that acquisition of the interest; and

                     ii.        at the earlier time that the Commissioner allows, all membership interests in the relevant company were disposed of under a particular scheme; and

b)    when the acquirer of the interest ceases being employed by the relevant employer.

The ESOP Rules prohibit option holders from disposing their options during the minimum holding period. The ESOP rules were enforced until Completion.

Exempt Options, Former Employee Options, and Founder Options

The Exempt Options were issued in August 20XX, which is more than 3 years before Completion (December 20XX). The Former Employee Options were issued to individuals who have ceased being employed by the Company, so paragraph 83A-45(5)(b) applies. The minimum holding period has been satisfied for both option classes, so the Commissioner does not need to allow a later time under paragraph 83A-45(5)(a).

The Founder Options are not eligible for the start up concessions because the Founders held more than 10% of the shares in the Company, so the minimum holding period is not relevant.

Class A Options and Class B Options

The Company issued the Class A Options from January 20XX to June 20XX, and the Class B Options in early July 20XX. All Class A Options and Class B Options were issued to individuals who were still employed by the Company at Completion (December 20XX). All these options were issued less than 3 years before Completion. Therefore, the minimum holding period under subsection (4) will only be satisfied for the Class A and Class B Options if the Commissioner allows the period to end at the earlier time under paragraph 83A-45(5)a.

The acquisition of all shares in the Company by the Buyer at Completion in December 20XX will be the relevant disposal under a scheme for the purposes of subparagraph 83A-45(5)(a)(ii).

The Company issued the last Class A Options (in July 20XX) about ten months before entering the ILOI with the Buyer (in April 20XX), and about seventeen months before Completion (in December 20XX). There is nothing to suggest that the Company had contemplated a 100% share sale before entering the ILOI. Therefore, the Commissioner is satisfied that the scheme operators intended the prohibition on disposal would apply during the 3 years after the Class A Options were issued.

The Company issued the Class B Options in early July 20XX. This was after the Company had entered the ILOI and RLOI with the Buyer, but about five months before Completion. The Company considered that the chances of completing the Transaction were low: the parties were still negotiating, some shareholders had indicated they were unwilling to agree to the Earn Out Conditions, and there was concern that the Buyer may withdraw because of the Company's disagreement with the Key Client and/or the impact of COVID-19 on the business. This uncertainty continued until September 20XX (two months after the Class B Options were issued) when the shareholders agreed in-principle to the Earn Out Conditions.

While the Company would have realised the Transaction was a possibility, there were legitimate commercial reasons for the taxpayer to doubt whether the Transaction would proceed when the Class B Options were issued, based on previous negotiations with the Buyer. Therefore, the Commissioner is satisfied that the scheme operators intended the prohibition on disposal would apply during the 3 years after the Class Options were issued in early July 20XX.

For both the Class A Options and the Class B Options, the Commissioner will allow the minimum holding period in section 83A-45(4) to be the period starting when the options were acquired, and ending when the options were vested and exercised for shares shortly before Completion.

Question 2

Will the optionholders with unvested options, other than Founder Options, be required to include any amounts in their assessable income under Division 83A in any income year from 1 July 20XX to 30 June 20XX, for the purposes of determining the Company's reporting obligations under Division 392 of Schedule 1 to the TAA?

Summary

No. Optionholders holding Class A Options, Class B Options, Exempt Options, or Former Employee Options will not be required to include any amounts in their assessable income under Division 83A in any income year from 1 July 20XX to 30 June 20XX.

Detailed reasoning

As discussed in Question 1, when an individual receives an ESS interest under an ESS, the amount of the discount is included in an employee's assessable income under section 83A-25. However, that amount can be reduced for ESS interests meeting the start up concessions

Conditions for the start up concessions are contained in sections 83A-33, section 83A-45, and subsection 83A-105(2). Broadly, these conditions require that:

•         the company:

-        is not listed on a stock exchange

-        has been incorporated for less than 10 years

-        has aggregated turnover not exceeding $50 million

-        is an Australian resident

-        is not predominantly a share trading or similar business

•         the individual is employed by the company when it acquired the interest

•         the ESS operates to enforce the 'minimum holding period' discussed in Question 1

•         the acquirer, immediately after it acquires the interest, does not hold more than 10% of either:

-        shares in the company, or

-        votes that could be cast at a general meeting of the company

•         for ESS interests that are shares, at least 75% of permanent employees with 3 years' service may participate in the ESS

Apart from the:

•         minimum holding period rule in subsection 83A-33(4), and

•         the 10% rule in subsection 83A-33(6),

options issued under the ESOP otherwise meet all eligibility requirements for the start-up conditions in section 83A-33 and 83A-45.

The minimum holding period condition is satisfied for the reasons explained in Question 1. Since the start up concessions will be available, the relevant optionholders do not need to include any amount of their discount in their assessable income for the income years in which they acquired their options.

The Founder Options do not meet the 10% rule in subsection 83A-33(6), and so are not eligible for the start up concessions. Note that these optionholders may need to include the amount of their discount in their assessable income in the 20XX income year.