Edited version of private advice

Authorisation Number: 1052243793306

Date of advice: 24 April 2024

Ruling

Subject: PAYG withholding

Question

Are the payments made by the shareholders of the Company for the cancellation of options held by employees of the Company under the Employee Share Option Plan (the ESOP) subject to Pay as you go (PAYG) withholding under Part 2-5 of Schedule 1 to the Taxation Administration Act 1953 (TAA)?

Answer

No.

This ruling applies for the following period:

Income year ending 30 June 2024

Relevant facts and circumstances

1.    The Company was incorporated in 19XX as a private company.

2.    Until their recent sale, the shares in the Company had been held by the family of Mr C at all times. Since 20XX, the shareholding of the Company was as follows:

Table 1: Since 20XX, the shareholding of the Company was as follows:

3.    With a view to retirement, Mr C sought to maximise the sale value of the shares in the Company. To that end, in 20XX the Company adopted the ESOP in order to align the activities and behaviours of key employees to the goals and ambitions of the business. The ESOP was governed by the ESOP Plan Rules.

4.    The stated purpose of the ESOP was to:

(a)  attract, motivate and retain Participants;

(b)  provide an incentive to Participants to drive the Company's performance;

(c)   provide market competitive reward mechanisms;

(d)  provide Participants the opportunity to acquire an ownership interest in the Company; and

(e)  further align the financial interests of Participants with those of the Company's shareholders.

5.    The sole director of the Company at the time the ESOP was established was Mr C and absolute control of the ESOP, including selection of the employees, the setting of Exercise Conditions and Vesting Conditions, and the termination of the ESOP rested with him.

6.    Mr C, in his absolute discretion, invited employees of the Company determined to be eligible to participate in the ESOP.

7.    Upon signing and returning an Application Form annexed to the written invitation, the Employee (a Participant) was bound by the Plan Rules and the constitution of the Company, and was granted a specified number of options to acquire the same number of shares in the Company for no consideration, subject to the satisfaction of any Exercise Conditions or Vesting Conditions (Options).

8.    Broadly, the issued Options were to vest over a 3 year period from the time of issue. However, upon an earlier Exit Event, defined in the Plan Rules to include the date on which an agreement for the sale to a third party purchaser of all of the issued share capital of the Company is completed, the written invitation received by Participants stipulated that all Options would vest and may be exercised.

9.    All shares issued to a Participant as a result of the exercise by a Participant of an Option (Option Shares) were to rank equally in all respects with other Shares on issue in the Company.

10.  The ESOP was able to be terminated and wound up at the determination of the directors, although such a determination mustn't have prejudiced any existing rights of the Participants.

Sale of the Company and termination of the ESOP

11.  At or around the beginning of 20XX, Mr C (both on his own behalf and on behalf of the Family Trust) entered into a protracted negotiation with the Purchaser for the sale of the Company. The negotiations had many 'moving parts' to the deal and Mr C, together with his legal representative, decided not to incorporate the ESOP into the negotiations and, ultimately, to terminate the ESOP.

12.  No Options were exercised prior to the cancellation of the ESOP. Therefore no Option Shares were ever issued to Participants.

13.  Confirmation regarding the cancellation of the Options issued to Participants under the ESOP, and the subsequent termination of the ESOP was delivered to the Participants via letter by the Company in May 20XX.

14.  The ESOP was wound up in June 20XX and the entire share capital of the Company (owned by Mr C and the Family Trust) was sold to the Purchaser pursuant to a share sale agreement executed shortly thereafter.

Recognition Payments

15.  Given:

(a)  the pending execution of the share sale agreement in respect of the sale of all of the issued share capital of the Company (i.e. the occurrence of an Exit Event) and the notification in the invitation that the Options would vest and may be exercised upon the happening of an Exit Event;

(b)  the Exercise Conditions attached to the soon-to-be cancelled Options had been achieved; and

(c)   the decision to terminate the ESOP prior to the occurrence of the Exit Event had been made and the requirement (as provided for under the Plan Rules) that any existing Participant rights not be prejudiced by that decision,

the Company shareholders were conscious of potentially exposing themselves to claims for damages by the Participants in the event that their existing rights under the ESOP would not be satisfied as a consequence of the termination of the ESOP, and decided to make a payment to the Participants in lieu of them receiving any Option Shares.

16.  On the same date on which the Participants under the ESOP were informed of the ESOP termination by the Company, the Participants received a letter from a Company shareholder acknowledging and recording the arrangement reached by the Participants with the shareholders in recognition of their contribution to the Company and its subsidiaries (the Group). That is, subject to the sale of the entire share capital of the Company to a third party buyer having occurred by no later than 31 December 20XX:

(a)  the shareholders agreed to pay the Participant a stipulated amount "[i]n recognition of [their] performance and continued contribution to the growth in the value of the Group" (the Recognition Payment); and

(b)  the Participant acknowledged that "the Recognition Payment is being made for the purpose of encouraging [the Participant] to improve the performance of the Company and its return to the shareholders of the Company".

17.  The Recognition Payment to be made to each Participant was to be made from the sale proceeds under the share sale agreement and determined by the Company shareholders based on the amount the Participant would have been eligible to receive under the share sale agreement for the sale of their Option Shares (had their Options under the ESOP been exercised rather than cancelled and they were a party to the share sale agreement, as a seller).

18.  At the time of cancelling the ESOP it was perceived by the Company shareholders (and their representatives) that the continuation of the ESOP would cause a substantial reduction in the valuation of the Company shares and that the reduction would be far in excess of the sum of the Recognition Payments made by the Company shareholders to the Participants.

19.  The Recognition Payments payable to the Participants by the Company shareholders from the share sale proceeds payable to them by the Purchaser under the share sale agreement totalled approximately $x million in aggregate, and were paid directly from a solicitor trust account during the 20XX income year. The proportion of the Recognition Payments funded by each shareholder is in proportion to their respective shareholding.

Relevant legislative provisions

Taxation Administration Act 1953 Part 2-5 of Schedule 1

Taxation Administration Act 1953 subsection 10-5(1) of Schedule 1

Taxation Administration Act 1953 Division12 of Schedule 1

Reasons for decision

Summary

The Recognition Payments made by the Company shareholders to the ESOP Participants are not subject to PAYG withholding.

Detailed Reasoning

PAYG withholding is set out in Part 2-5 of Schedule 1 to the TAA. Under PAYG withholding, amounts are withheld from particular kinds of payments or transactions and then paid to the Commissioner (generally but not always) by the entity making the withholding payment.

A list of withholding payments is in subsection 10-5(1) of Schedule 1 to the TAA. None of the withholding payments listed in that provision, and set out in Division 12 of Schedule 1 to the TAA, apply to the Recognition Payments made by the Company shareholders to the Participants.

The Recognition Payments are therefore not subject to PAYG withholding.