ESS – The ‘start-up’ concession

This is the third and final article in our three-part series explaining a number of key aspects of the Australian employee share scheme (ESS) tax rules:

The first article discusses how you qualify to defer any tax otherwise payable on shares and options you acquire under an ESS, and when that deferral comes to an end;
Our second article explains how you work out the ‘discount’ (if any) that arises when you acquire an interest under an ESS, in other words, how much tax you may be up for; and
This article explains how to access the ‘start-up concession’ and the benefits that arise under it.

As discussed in our other articles, the general position when an interest is granted under an employee share scheme (i.e. an ESS interest) is that:

You (being the employee) will be taxed on any ‘discount‘ you receive at the time you acquire an ESS interest as though that ‘discount’ is ordinary income, unless you qualify to defer the taxing point to a time in the future under the ESS provisions; and
If you qualify to ‘defer’ the time at which you are taxed, then when the deferral comes to an end, the difference between the market value of the ESS interest at that time, and what you paid for the ESS interest when it was received, will be included as part of your ordinary income and you will have to pay tax on that amount, i.e. you will pay full marginal rates at that later time.

You will get a better tax outcome if the ESS qualifies for the ‘start-up concession’.

What is the benefit of qualifying for the start-up concession?

If you qualify for the start-up concession, then:

Any ‘discount’ the employee receives when they acquire the ESS interest will not be taxable to the employee at the time that the ESS interest is acquired or granted;
The employee will hold the ESS interest on capital account, and may therefore qualify for the 50% CGT discount on a later disposal of the ESS interest;
If the ESS interest is an option, and you sell the option, the CGT cost base of the option is any amount you paid to acquire and sell the option. If you exercise the option and then sell the resulting share, the amount you paid to exercise the option will be added to the cost base;
If you acquire a share by exercising an option, the date of acquisition of the share is taken to be the date the option was first acquired. This can assist you to qualify for the 50% CGT discount at the time that you sell the share that you acquired; and
If the ESS interest is a share, the CGT cost base of the share will be the market value of the share when you acquired it. This is very favourable because the employee effectively gets the initial discount to market value on the share at the time of grant tax-free.

How do you qualify for the start-up concessions?

To qualify for this concession, you need to satisfy the following general criteria:

The entity you are employed by must be an Australian company;
The ESS interest must relate to the issue of an ordinary class share or an option over an ordinary class share (with the point of emphasis being that the ESS interest relates in whichever manner to an ordinary class share);
The company that is issuing the ESS interest to you must not operate business as a share trader or investment company;
You must not be able to dispose of the ESS interest for a minimum of 3 years from the time you acquire it or until you cease your employment with the company. The 3-year period may be reduced if 100% of the company is sold to a third party before the 3 years elapses;
The employee, together with their associates, must not hold, or have the right to acquire, more than 10% of the shares in the company. This includes any shares the employee acquires or has a right to acquire under the ESS;
Where the ESS interest is a share and the company is more than 3 years old at the time the shares were acquired, at least 75% of the Australian resident permanent employees of the company who have completed at least 3 years of services must be (or must at some time have been) entitled to acquire ESS interests under the ESS;

In addition, you must satisfy the following criteria that only apply to the start-up concession:

The company must be a ‘start-up company’, which means that in the most recent income year before the ESS interest is issued under the ESS:
Neither the company, nor any subsidiary, was listed on a stock exchange;
The company, and any subsidiary, had been incorporated for less than 10 years; and
The company’s aggregated turnover did not exceed $50 million.
If the ESS interest is an option, the exercise price must be equal to or greater than the market value of the ordinary share that will be acquired; and
If the ESS interest is a share, the discount was 15% or less of its market value when acquired.

To qualify for this ‘start-up concession’, there is no need for the ESS interest to be an interest that is subject to any genuine risk of forfeiture (this is required in a number of other circumstances).

There is also no need for the scheme to be made broadly available to at least 75% of permanent employees unless the ESS interest is a share and the company is more than 3 years old.

It is not clear whether the company needs to specifically state that the scheme is intended to qualify for the start-up concession. However, this is a good idea so that you know the concession applies.

Valuing the ESS interests under the ‘safe harbour’ rules

In a binding legislative instrument (ESS 2015/1), the ATO has outlined two accepted methods of valuing shares and options when applying the ‘start-up concession’. If either of these methods are adopted to value the ESS interest, you will have certainty that the ATO will accept the valuation (which is why they are referred to as ‘safe harbour’ valuations).

The approved market valuation methods can be used to value shares and options to make sure that you satisfied the criteria set out above and are eligible for the ‘start-up concession’.

The first valuation method is based on a modified version of the ‘net tangible assets‘ of the company. The company must meet certain criteria for you to be able to apply this method, most notably that the company’s accounts have been prepared in a professional manner that complies with all applicable accounting standards.

The second valuation method is a ‘director’s valuation‘ based on a valuation performed by the CFO of the company, or another person with relevant knowledge, experience and training in undertaking a valuation. The ATO has specified a list of relevant factors that the person performing the valuation must take into account. Most of these are in line with what a valuer would ordinarily consider.

Call us on 1300 654 590 or email us to find out more about whether you are eligible for the ‘start-up concession’.

The information contained in this post is current at the date of editing – 3 July 2023.

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