Edited version of private advice

Authorisation Number: 1051935597324

Date of advice: 23 December 2021

Ruling

Subject: Income tax - capital gains tax - employee share schemes

Question 1

Will the irretrievable cash contributions by Company X or any subsidiary member of Company X's income tax consolidated group, to the trustee of the employee share trust (Trustee) to fund the acquisition of Company X shares by the employee share trust (Trust) for the purposes of the Plan 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 2

Will a capital gain or capital loss that arises for the Trustee of the Trust at the time when either CGT Event E5 or E7 happens in relation to Company X shares held by the Trustee be disregarded under section 130-90 of the ITAA 1997, if the Participants 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

The scheme commenced on:

In a particular income year

Relevant facts and circumstances

Company X

Company X is an Australian incorporated company involved in a particular industry.

Company X is the head entity of Company X income tax consolidated group (Company X TCG) consisting of itself and wholly owned Australian subsidiaries.

Company X's remuneration policy aims to embody transparency, competitiveness and reasonableness, with the goal of retaining key talent in alignment with business and shareholder objectives.

As part of the overall remuneration strategy, in addition to fixed remuneration, Company X offers certain employee and executives, payments of shares upon the satisfaction of certain performance conditions. This is implemented through the Plan.

Company X and a number of wholly owned subsidiaries of the Company X TCG are employers of individuals that participate in the Plan (Employer Entities).

The Plan

The Plan was approved by Company X's shareholders on a certain date. The terms and conditions of the Plan are set out in the Company X Plan Rules (Plan Rules).

The terms on which Participants are invited to participate in the Plan are set out in the invitation letter (Invitation).

Under the Plan and Plan Rules:

a.    Eligible Participants are issued an invitation by the Board, to apply for a specified number of rights which vest according to performance criteria. The Invitation will outline the number of rights offered and the performance conditions.

b.    Once the Eligible Participant has received the invitation, they may accept the invitation in accordance with the instructions accompanying the invitation, unless the Board determines otherwise.

c.     Eligible Participants may nominate, by written notice to the Board, a nominee in whose favour the Participant wishes to renounce the invitation. The Board may, in its discretion, resolve not to allow a renunciation of an Invitation in favour of a nominee. A nominee can be an immediate family member of the Eligible Participant, a trustee of the Eligible Participant's family trust whose beneficiaries are limited to the Eligible Participant and/or immediate family members, or a company whose members only comprise of the Eligible Participant or immediate family members.

d.    The grant of rights is subject to receiving a signed and completed Application Form for rights.

e.    The rights will be issued to Participants for nil consideration.

f.      The rights will not vest and be exercisable unless the vesting conditions attaching to the right have been satisfied or a change of control event occurs. The Board may, in its absolute discretion, waive the vesting conditions upon death, total or permanent disability, retirement or redundancy of the Participant.

g.    A Participant may exercise any vested right at any time after the Board notifies them that the right has vested and before it lapses.

h.    Following the exercise of a vested right, the Participant will be entitled to shares in Company X (one ordinary share for every right unless the Invitation states otherwise).

i.      All shares issued under the Plan on the exercise of a right will rank equally with other shares which are on issue and a Participant will be entitled to dividends and to exercise voting rights attached to the shares.

j.      At the time these conditions are satisfied, within 10 business days of delivery of the required documentation (i.e., the certificate for rights and notice of exercise of rights), the Company will issue the Participant the shares as being fully paid.

k.     Rights can lapse in a number of ways, including:

                                  i.    by expiry of the right in accordance with its terms;

                                 ii.    the receipt of a notice from the Participant to the effect that they have elected to surrender the rights;

                                iii.    if the Board determines that the Participant has acted fraudulently, dishonestly or wilfully breached the Participant's duties; or

                               iv.    The rights could also lapse according to another provision of the Plan Rules or in accordance with the terms of an invitation.

l.      The Board may, at any time, establish a Trust for the sole purpose of acquiring and holding Shares in respect of rights which a Participant may exercise, or has exercised, and vested rights, including for the purpose of enforcing disposal restrictions and appointing a trustee of the Trust. Further the Trustee will hold shares for and on behalf of Participants as the beneficial owner.

m.   Participants are subject to transfer restrictions under the Plan Rules. The Board may, in its discretion, determine that a restriction period will apply to shares issued to a Participant (for up to a maximum of X years). A Participant may not deal with any Company X share acquired under the Plan until the end of the restriction period.

n.    The Board may, by written notice, deem any unvested, or vested but unexercised, rights of a Participant to have lapsed or do all such things necessary to cancel any shares issued on exercise of the Participant's rights if the Participant has:

                                  i.    acted fraudulently or dishonestly;

                                 ii.    engaged with gross negligence;

                                iii.    demonstrated serious and wilful misconduct;

                               iv.    caused a material adverse effect on the reputation of the Company;

                                 v.    their employment or office terminated due to serious or wilful misconduct or otherwise for cause without notice; or

                               vi.    becomes ineligible to hold their office due to Part 2D.6 of the Corporations Act (Rule 10.2).

Rights may be granted under the Plan to non-residents of Australia with the Board able to adopt additional rules and rights subject to additional or modified terms. Contributions to the Trust may be made to acquire Shares in relation to rights granted to non-resident Participants. The consideration of contributions made with respect to non-resident Participants (and any associated Australian tax implication for Company X) is outside the scope of this ruling.

Company X Employee Share Trust (Trust)

The Trust was established for the sole purpose of subscribing for, acquiring, holding and transferring shares for the benefit of Participants under the Plan.

The trustee of the Trust (Trustee) is an external trustee acting in an independent capacity on behalf of the beneficiaries of the Trust.

The Trust will be managed and administered so that it satisfies the definition of "employee share trust" for the purposes of subsection 130-85(4) of the ITAA 1997.

The Trust broadly operates as follows:

o.    Company X or a member of the Company X TCG will 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.

p.    Company X or a member of the Company X TCG is likely to contribute funds, by way of capital contribution to the Trust when written notice is provided by the Board to the Trustee. Such a notice can be issued from time to time, however, typically are issued when the rights vest to the Participant and are subsequently exercised by the Participant or when rights vest and are converted into vested rights.

q.    These funds will be used by the Trustee to acquire the shares in Company X either from other shareholders or via a subscription for new shares in Company X based on the notice provided by Company X.

r.     Allocated Shares acquired by the Trustee must be allocated to the relevant employees and held on their behalf as soon as reasonably practicable where required to do so, or permitted, by the relevant Plan Rules. Each Participant will be the beneficial owner of and absolutely entitled to their Allocated Shares.

s.     Unallocated Shares must be held by the Trustee on behalf of Participants and employees generally. The Trustee must deal with each Unallocated Share in the manner set out in a notice from the Board.

t.      If the Trustee is an associate of Company X, the Trustee must not exercise any voting rights in relation to Unallocated Shares. If the Trustee is not an associate of Company X, the Trustee may exercise voting rights in relation to Unallocated Shares, but only where the Trustee determined that voting in those circumstances is 'merely incidental' to obtaining, holding and providing shares to Participants.

u.    At any time after expiry of the restriction period (if any), the Trustee must transfer the relevant number of shares into the name of the relevant Participant or any third party nominated by the Participant (i.e. legal title) upon a withdrawal notice being lodged with and approved by the Board.

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

w.   The Trustee is not entitled to receive from the Trust any fees, charges, 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.

x.     In the event that the Trust is terminated, the Trustee must not pay any of the surplus assets to Company X and each of its subsidiaries.

Associated costs

Company X will incur various on-going administration costs associated with the services provided by the Trustee of the Trust in respect of the on-going administration and management of the Trust, such as:

y.     Employee plan record-keeping

z.     Production and dispatch of holding statements to employees

aa.  Provision of annual income tax return information for employees

bb.  Costs incurred in the acquisition of shares

cc.  Management of employee termination

dd.  Preparing the annual audit of the financial statements of the Trust

ee.  Preparing the annual income tax returns of the Trust

Company X has and will incur on-going administration costs associated with the company's accounting and legal advisors in relation to the Plan.

Company X will incur various costs in relation to the establishment and implementation of the Trust, including:

ff.    legal advice obtained in respect of the implications which may arise for both Company X and the Participants of the Plan in respect of the EST structure;

gg.  legal documents required in respect of the EST and the Plan;

hh.  legal advice obtained in respect of the drafting of changes required to the existing Plan in order to accommodate the EST structure; and

ii.     professional fees associated with the establishment of the EST including such costs associated with the creating and registration of the EST with various authorities.

Company X will also incur costs in managing its own tax affairs, including:

jj.     Tax advisor fees associated with the drafting and lodgment of the private binding ruling application with the ATO.

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 section 130-90

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

Income Tax Assessment Act 1997 section 83A-10

Income Tax Assessment Act 1997 section 104-85

Income Tax Assessment Act 1997 section 40-880

Reasons for decision

All references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless stated otherwise.

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 Income Tax Assessment Act 1936 (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 or any other member of the Company X TCG to the Trust forms part of the corpus of the Trust that will be applied for the sole purpose of acquiring, or subscribing for, 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 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 or any other member of the Company X TCG to the Trustee of the Trust to fund the acquisition or subscription of Company X shares are also not assessable income of the Trust pursuant to section 6-10 of the ITAA 1997.[3]

Question 2

CGT Event E5

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

Under subsection 104-75(1), 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]

Pursuant to the Trust Deed, a Participant is the beneficial owner of and absolutely entitled to their Allocated Shares. Allocated Shares is defined as a Trust Share that is credited to the Trust Share Account of a Participant. Once credited, the Participant (i.e. the beneficiary) will become absolutely entitled to the Allocated Shares (i.e. a CGT asset of the Trust) as against the Trustee, and thus, pursuant to subsection 104-75(1), CGT event E5 happens.

However, any capital gain or loss that the Trustee makes, if CGT event E5 happens, is disregarded if section 130-90 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 trustee *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 to satisfy its obligation under the Plan, and subsequently allocated to Participants 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:

a.    The Trust acquires shares in a company, namely the Company; and

b.    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 the Company in accordance with the 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).

The 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 Trust Deed satisfies the definition of an employee share trust in subsection 130-85(4) of the ITAA 1997.

As the rights granted under the Plan will be acquired by the employees at a discount, they are ESS interests to which subdivision 83A-B 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 Trust Deed at the time when CGT Event E5 happens in relation to Company X 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.[7]

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.[8]

Under the Trust Deed, after the expiry of the applicable disposal restriction period, the Trustee must transfer the legal title of the relevant shares into the name of the relevant employee (or any third party as directed by the relevant employee) upon a withdrawal notice being submitted to the Trustee. Upon such a transfer, CGT event E7 will occur pursuant to section 104-85 of the ITAA 1997.

However, any capital gain or loss that the Trustee makes, if CGT event E7 happens in relation to the Allocated Shares or the shares allocated upon the exercise of an option, 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 Company X 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).

[5] Subsection 104-75(3).

[6] Paragraph 41 of TR 2004/D25.

[7] Subsection 104-85(2).

[8] Subsection 104-85(3).