In May 2017 the Government released an official’s issue paper proposing a deferral mechanism for taxation of employee share schemes (ESS) for startup companies. The aim of measures introduced in Taxation (Annual Rates for 2017-18, Investment and Employment Income, and Remedial Matters) Bill (The Bill) is to ensure that the taxation of ESS benefits is consistent with the taxation of cash remuneration, i.e. that the employees will be taxable on shares received in connection with ESS, once the employee becomes the economic owner. This is when all conditions relating to ownership are satisfied, referred to as Share Scheme Taxing Date.
The Government recognises that start-up companies face liquidity problems and that remuneration through ESS plays an important role in the retention of employees.
The issue with start-up companies is that it may be difficult for employees to sell shares which are not readily traded to cover the resulting income tax liability. Furthermore if there is no earnings history or realizable assets the valuation of such shares can be somewhat difficult. The Commissioner’s Statement CS 17/01 provides guidelines on determining the value of shares. Whilst various valuation methods are discussed it is not prescriptive. An independent third party valuation is preferred.
The proposed deferral regime for startup companies enables the company to elect to defer the recognition of ESS income until there is a “Liquidity Event”, when shares are more easily able to be valued, to fund the tax on income. The taxing point will be triggered if any of the following occur (i.e. IPO, sale of company’s assets followed by distribution to shareholders, cancellation of shares, ceasing to be a NZ tax resident). The employee would be taxed on the value of shares at this point less any amount paid for shares by the employee. The employer will be allowed a corresponding deduction at this point. Both Employee income and the employer deduction would be deferred. Any increase in value after an IPO has taken place would generally be tax free. If the employee sells his shares within 6 months after initial IPO, it is suggested that the sale price and not the listing price, or some weighted average of the two, be used to determine the employees tax liability. It is also proposed that recognition of income cannot be deferred by more than 7 years.
Whilst deferring the taxing point appears to be a good idea, the longer the taxing point is deferred the greater the resulting income tax liability, assuming that company’s shares increase in value with time. The issues paper also raises a question of how a “Startup Company” should be defined. The current thinking is that the annual turnover of a NZ startup company should not exceed $ 10 Mil.
In the case where a startup company applies for an R&D Loss cash out the cost of ESS will be included in R&D cash out calculation only once it becomes deductible for the company.