6 February General Manager Law Design Practice The Treasury Langton Crescent PARKES ACT 2600 Attention: Chris Leggett and Simone Abbot

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1 6 February 2015 General Manager Law Design Practice The Treasury Langton Crescent PARKES ACT 2600 Attention: Chris Leggett and Simone Abbot Dear Sir/Madam Improvements to the taxation of employee share schemes We refer to the exposure draft legislation and associated documents concerning the Government s proposal to improve the taxation of employee share schemes. Thank you for the opportunity to provide submissions on the proposed legislation. Greenwoods & Herbert Smith Freehills Pty Limited (Greenwoods) is a specialist tax practice and Australia's largest advisory firm practising exclusively in revenue laws. Greenwoods advises many listed and unlisted companies and private equity and venture capital funds in relation to the structure of employee equity incentives. We generally welcome the proposed changes and consider they are an improvement on the current provisions. However, we consider that there are some issues with the proposed legislation which could be improved. We have split our submission into 2 parts, addressing issues in relation to the start-up provisions and technical issues separately. We would be happy to discuss these issues with you in more detail if you require any further information. Yours sincerely Toby Eggleston Director Greenwoods & Herbert Smith Freehills toby.eggleston@greenwoods.com.au Toby Eggleston Director Greenwoods & Herbert Smith Freehills toby.eggleston@greenwoods.com.au Doc Collins Street Melbourne Vic 3000 Australia GPO Box 396 Melbourne Vic 3001 Australia Liability limited by a scheme approved under Professional Standards Legislation T F DX 240 Melbourne Greenwoods & Herbert Smith Freehills Pty Limited ABN

2 1 Start-up issues 1.1 Requirement that start-up option plans must satisfy broad availability requirement proposed section 83A-33(1)(c) Proposed s.83a-33(1)(c) requires that the start-up concessions only apply if, among other requirements, the requirement in s.83a-105(2) is satisfied. Section 83A-105(2) requires that at least 75% of the permanent employees of the employer who have completed at least 3 years of service, are, or at some earlier time have been, entitled to acquire ESS interests in the employer or the holding company of the employer. For employee share plans outside of the start-up concessions, s (1)(c)(i) only requires this provision to be satisfied if the ESS interest is a beneficial interest in a share. However, for employee share plans that seek to access the start-up concessions proposed s.83a-33(1)(c) does not appear to differentiate between whether the ESS interest in the start-up is a beneficial interest in a share or a right to acquire a share. There does not seem to be any policy reason why the broad availability requirement should apply to rights as well as shares. We recommend that proposed s.83a-33(1)(c) be modified to expressly provide that s.83a-105(2) will only be applicable to ESS interests that are beneficial interests in a share. 1.2 Grouping rules in proposed s.83a-33(3) & (4) We understand that the grouping rules in proposed s.83a-33(3) & (4) are integrity measures and are intended to ensure that the start-up concessions are only available to genuine start-ups and, for example cannot be accessed by a large corporate simply creating a new subsidiary or a new holding company. We agree that some form of integrity provision is necessary to avoid this outcome. However, we consider that the use of the grouping definitions incorporated into proposed s.83a-33(3) & (4) may result in genuine start-ups not qualifying because a Venture Capital Limited Partnership (VCLP) or Early Stage Venture Capital Limited Partnership (ESVCLP) holds a 40% or greater interest in the company. (a) Proposed s.83a-33(3) incorporated for less than 10 years Proposed s.83a-33(3) provides that none of the start-up, any subsidiary of the start-up, the holding company of the start-up, or any other subsidiary of the holding company have been incorporated for 10 years or longer. The concepts of holding company and subsidiary are determined by reference to the Corporations Act definitions. A holding company in relation to a body corporate, means a body corporate of which the first body corporate is a subsidiary. 1 A subsidiary is defined in section 46 of the Corporations Act to mean a body corporate (the first body) where another body corporate: Controls the composition of the board, including by having the power to appoint a majority of directors to the board 2 ; Is in a position to cast more than 50% of the votes at a general meeting; or Holds more than 50% of the issued share capital of the first body. 3 1 Section 9 of the Corporations Act 2 Section 47 of the Corporations Act page 2

3 As VCLPs and ESVCLPs are generally formed as incorporated limited partnerships 4 and they will therefore constitute a body corporate for the purposes of the Corporations Act. 5 Accordingly, if a VCLP or ESVCLP holds a greater than 50% interest in a start-up then the start-up will only meet the requirement in proposed s.83a-33(3) if the VCLP/ESVCLP and all of the entities in which it holds a greater than 50% interest (either directly or indirectly) have been incorporated for less than 10 years. (b) Proposed s.83a-33(4) aggregate turnover of less than $50m Proposed s.83a-33(4) requires the start-up to have an aggregated turnover of less than $50m in the income year preceding the grant. The concept of aggregated turnover is defined in Subdivision 328-C by reference to the turnover of the start-up and any connected entity or affiliate of the start-up. Section provides that an entity is connected with another entity if: (a) either entity controls the other entity in a way described in this section; or (b) both entities are controlled in a way described in this section by the same third entity Section (2) goes on to provide that an entity controls a company if it owns, or has the right to acquire, 40% of the voting interests in that company. Accordingly, if a VCLP or ESVCLP holds a 40% or greater interest in the start-up then the start-up will be connected with the VCLP/ESVCLP and any other company which the VCLP/ESVCLP holds a 40% or greater interest. Accordingly, the turnover of all of those entities will be included in the determining the aggregate turnover of the start-up. In our view, in the context of encouraging start-ups, a distinction should be made between a subsidiary (or new holding company) of a large corporate group accessing these concessions and an investee of a VCLP/ESVCLP. The Venture Capital Act was introduced to enable VCLPs and ESVCLPs to encourage foreign and domestic investment in early stage Australian companies that meet strict criteria, such as industry, size and location. While a VCLP or an ESVCLP may take a 40% plus interest in the investee, the investee is generally not related in any other way to the other investee entities of those funds. It seems incongruous that the legislation on the one hand should encourage investment by VCLPs/ESVCLPs and on the other provide a disincentive if a start-up has received material funding from such an entity. Maintaining the grouping rules in their current form would have the effect of imposing a further restriction on the possible investments of a VCLP and ESVCLP. Similarly, if the start-up company has a foreign venture capital fund formed as a limited partnership as a majority investor, similar inappropriate outcomes may arise. We recommend that proposed s83a-33(3) and (4) incorporate explicit carve-outs to exclude grouping entities that are independent investors including VCLPs/ESVCLPs and foreign venture capital funds and their other majority owned/controlled investees. Alternatively, the start-up definition could be modified so that to be a start-up a company could either meet the requirements in s.83a-33 or meet the criteria to be an eligible venture capital investment in s year sale restriction proposed section 83A-45(4) Proposed s.83a-45(4) requires that ESS interests issued by start-ups will only qualify for the concessions if the employee share scheme is operated on the basis that employees 3 The first body is also a subsidiary of another body corporate if the first body is a subsidiary of a subsidiary of the other body. 4 See for example, s.53 of the Partnership Act 1892 (NSW) 5 See definition of body corporate in s.9 of the Corporations Act page 3

4 are not permitted to dispose of their ESS interests, or shares acquired on exercise of those ESS interests, before the earlier of 3 years from grant and cessation of employment. This absolute restriction is not appropriate for equity issued to employees of start-ups. Most start-up companies will have, or will seek, to have investment from professional venture capital providers. Those investors will want to ensure that a sale cannot be frustrated by minority shareholders refusing to sell. This is particularly important as bidders may make their offer conditional on 100% acceptance or alternatively, so that the company can be listed under an IPO. Accordingly, all holders of shares and options in such companies will generally be required to be a party to a shareholders agreement where, among other things, all parties are required to sell their shares or options to a purchaser if a specified percentage of investors (usually 75%) wish to accept the offer. These drag along clauses are standard for these types of investments. If an investor cannot secure a clear path to an exit because the employee equity is not able to be dragged to comply with the restriction in proposed s.83a-45, we expect that those investors will not allow companies to issue employees with equity which accesses these concessions. In a similar fashion, many shareholders agreements will include a right entitling minority shareholders to participate in a sale by majority shareholders at the same time and at the same price for each share. The minority shareholder then "tags along" with the majority shareholder's sale. This protects the minority shareholder from not being able to sell when the majority investor exits, or at the same price as that investor. We consider that it is appropriate to allow employees to be able to sell under a tag along clause without losing the benefit of the start-up concession, so that the employee can get the full benefit of the ESS interests. Accordingly, we recommend that an exception be inserted into proposed s.83a-45 to allow ESS interests to be disposed of pursuant to either a whole of company sale or restructure to enable an IPO or under a tag along clause. 1.4 Interaction of start-up concessions and section 83A-105(1) It appears that there is a drafting anomaly between the interaction of the start-up concessions and s.83a-105(1). A typical start-up option plan will generally involve issuing options, with an exercise price equal to the market value of the underlying ordinary stock on the date of grant. The options generally have a 3 year vesting period, requiring a 12 month minimum employment condition after which 1/3rd of the options vest. The remaining options vest pro-rata over the following 24 months based on continued employment. While the options can be exercised on vesting, the shares are subject to sale restrictions. The start-up concessions are located in Subdivision 83A-B. Section 83A-105(1) provides that the deferral rules in Subdivision 83A-C apply, and Subdivision 83A-B does not apply, where among other things options are issued subject to a real risk of forfeiture, such as a 12 month continued employment condition. Therefore, there is a technical issue that if a start-up issues options with vesting conditions, the deferral rules in Subdivision 83A-C will apply to the options, rather than the start-up concessions in Subdivision 83A-B. We consider that this was not intended and is merely a drafting anomaly. We recommend that s.83a-105 clarify that 83A-C does not apply if the ESS interests meet the criteria to qualify for the start-up concessions in s.83a page 4

5 1.5 Acquisition date of shares acquired on exercise of options If the employee acquires qualifying options in the start-up and holds those options for at least 12 months then the employee would be entitled to the benefit of the CGT discount in the event that those options were cancelled or transferred. However, if the employee exercises the options and then sells the shares within 12 months of exercise the employee will not be entitled to the benefit of the CGT discount. Most start-up exits will involve a 100% acquisition of the equity, and rather than the employee paying the exercise price and then selling the shares, it is simpler for the company to cancel the options or the purchaser to acquire them. However, there may be circumstances where the employee has exercised the options and then an exit opportunity arises within 12 months of exercise. We consider that the employee should not be discouraged from exercising the options and therefore denied the ability to access the CGT discount in the event of a sale within 12 months. We recommend that the date of acquisition of shares acquired on exercise of a right in a qualifying start-up should be deemed to be the date of acquisition of the right, rather than exercise page 5

6 2 General technical issues 2.1 Meaning of exercise The proposed taxing points for rights in s.83a-120(7) requires that, amongst other things, you exercise the right. For performance rights, it is common practice for the plan documents to be drafted so that where the requisite performance hurdles have been satisfied, the participant automatically receives shares without having to take any action to formally exercise their rights. The ATO has previously ruled that, in the context of the employee share scheme provisions, exercising a right does not necessarily require an action or activity by the holder of the right. Most recently, in class ruling CR 2014/54, the ATO stated: The word 'exercise' as used in Division 83A is not a defined word, thus it should take its ordinary meaning having regard to its legislative context and the purpose or object of the statute. For the purposes of Division 83A, the concept of 'exercising a right' is not considered to necessarily require an action or activity by the beneficial owner of the right. It is enough that they become the beneficial owner of the share that was the subject of the right, without having to do anything, that is, it happens automatically or is instigated by the employer or another party. Therefore, a Participant is taken to have exercised the Rights when Securities are allocated on vesting of the Rights. We recommend that: the ED make it clear that you are taken to have exercised a right where the employee automatically becomes the owner of the shares; or the EM contain a similar statement to the extract above from CR 2014/ Employment requirement The definition of employee share scheme in s.83a-10(2) expressly contemplates prospective employment. However, current s.83a-35(3)/proposed s.83a-45(1) provides: This subsection applies to an *ESS interest in a company if, when you acquire the interest, you are employed by: (a) the company; or (b) a *subsidiary of the company. (emphasis added) That is, at the time you receive the ESS interest, you must be employed by the relevant company. Accordingly, the subsection does not appear to be satisfied if you will become employed after you receive the ESS interest. This employment requirement must be satisfied in order for employees to be eligible for: 1 the $1,000 assessable income reduction (proposed s.83a-35(1)(b)); 2 the proposed start-up concession (proposed s.83a-33(1)(b)); and 3 tax deferral (s.83a-105(1)(b)). Under changes made by ASIC to its class orders for employee incentive schemes, an eligible participant now includes a prospective participant 6, which is defined as being: in relation to an offer of an eligible product under an employee incentive scheme, means a person to whom the offer is made but who can only accept the offer if an arrangement has been entered into that will result in the person becoming covered by one of paragraphs (a) to (d) of column 3 of Table A [being a full time or part time employee; a non-executive director; a contractor or a casual employee]; 6 Listed bodies: Unlisted bodies: page 6

7 Given the employee share scheme provisions are intended to apply to prospective employment, there is no sound policy reason why the employee share scheme tax concessional provisions should not apply if a person receives the ESS interest prior to their employment commencing. We recommend that proposed s.83a-45(1) be modified so as to apply to both current and prospective employment, using similar language to the ASIC class orders % ownership limit Proposed s.83a-45(6) provides that for the purpose of applying the 10% ownership limit: For the purposes of subsection (4), you are taken to: (a) (b) shares. hold a beneficial interest in any *shares in the company that you can acquire under an *ESS interest that is a beneficial interest in a right to acquire a beneficial interest in such shares; and be in a position to cast votes as a result of holding that interest in those The requirement in s.83a-45(6)(a) is that you count shares that you can acquire under an ESS interest that is a right. It is not clear whether you count rights in respect of which you cannot at a particular time acquire an ESS interest, because the right has not yet vested. Accordingly, it should be clarified whether a right that has not yet vested, such that you cannot immediately acquire any shares, is counted when applying the 10% ownership limit. If unvested shares or rights are taken into account when owned or controlled by an employee (or associate), then the test should take into account all unvested rights and shares on issue when determining whether the 10% threshold is reached. 2.4 Refund We welcome the proposed amendments to 83A-310 to allow employees a refund of previously paid tax when they choose not to exercise a right before it lapses which would occur most commonly when the right is out of the money. The denial of refunds for forfeitures as a result of employee choice, other than choices to cease employment, was first introduced in 2009 as part of Division 83A. However, in our view Parliament did not appear to recognise that in combination with moving the taxing point from exercise of rights to vesting, this measure would have the effect of taxing employees on value they may never see. In summary, the Government has now recognised the inappropriateness of this outcome by proposing to revert to a refund for rights to be issued under the regime commencing 1 July The amendment should apply retrospectively to all ESS rights and options from 1 July 2015, regardless of when they were issued there is no sound policy reason why employees should not receive a refund of previously paid tax in respect of a benefit that ultimately has no value to the employee. 2.5 Valuation issues (c) Fringe benefits tax Item 29 of the ED amends s.83a-315 as follows: Whenever this Division (other than section 83A-20) uses the *market value of an *ESS interest, instead use the amount specified in the regulations for the purposes of this section in relation to the interest, if the regulations specify such an amount. We understand that one intended effect of this amendment is as follows: page 7

8 Where an option is acquired at its market value as calculated in accordance with the regulations (including where the option is treated as having a zero value under the regulations), the interest will now be taken to still have been issued at a discount for the purpose of s.83a-20. This means that Subdivision 83A-B will apply to the ESS interest, but no amount is included in the participant s assessable income. As such, the exclusion in paragraph (h) in the definition of fringe benefit in the Fringe Benefits Tax Assessment Act 1986 for ESS interests to which Subdivision 83A-B applies should now apply to an option that is acquired at its market value as calculated under the regulations. We recommend that this be set out in the EM, and that the amendment apply retrospectively given the amendment corrects a technical anomaly. (d) Section Section provides: In working out the market value of a *non-cash benefit, disregard anything that would prevent or restrict conversion of the benefit to money. A similar rule is contained in regulation 83A (2) in the Income Tax Assessment Regulations A number of private rulings indicate that the ATO have interpreted this provision such that vesting conditions and performance hurdles are not taken into account in determining market value (see for example edited PBR ). In our view, this interpretation is technically wrong vesting conditions and performance hurdles go to the amount of money that a taxpayer could convert an ESS interest into. Yet s only requires anything that could would prevent or restrict conversion of a benefit to money to be disregarded that is, conditions which go to the amount of money that could be realised is not a relevant factor. Further, from a policy perspective, it is inappropriate for employees to be taxed on an amount which bears no resemblance to the market value of the benefit actually received. Clearly performance hurdles, for example, are fundamental to determining market value of an ESS interest and should be taken into account. Accordingly, the ED should clarify the scope of s as being limited to disposal restrictions that apply to an ESS interest. For example, it should be made clear that whilst you are required to ignore disposal restrictions that apply to a share or a right; you are not required to ignore performance conditions that go to whether share or right will vest. 2.6 Value shifting The employee share scheme provisions require that the ESS interest be acquired by the employee at a discount, which can include having ESS interests issued by the company (s.83a-20). The value shifting provisions in Division 725 can apply where, amongst other things, shares or options in the company are issued at a discount (s , s ). The value shifting provisions can result in a deemed capital gain arising if there is a shift in value from existing equity interests, such as from issuing new shares at a discount. Division 725 generally only applies to a company where there is a controller and less than 300 shareholders this means that a start-up company is likely to be subject to Division 725. Given the purpose of the ED is to increase the number of entrepreneurial companies in Australia, and Division 83A ensures that the employee is taxed on the market value of the ESS interest (either upfront or on a deferred basis), it would be inappropriate for Division 725 to apply where ESS interests are issued at a discount to employees page 8

9 In order to provide certainty, we recommend that Division 725 contain an exclusion for equity interests that are acquired under an employee share scheme to which Subdivision 83A-B or 83A-C applies (ie, similar to the FBT exclusion) page 9