The ultimate drafting of the plan requires consideration of commercial, human resource, accounting, legal and taxation issues.

The design of the plan can have material taxation implications for employees which can ultimately impact on the success of the underlying strategy.

We have set out below a high level overview of an employee option plan.

The grant of an option provides the employee with an opportunity to acquire a share at specified times by paying the exercise price.

There is a time limit by which this exercise price must be paid as set out in the Employee Share Option Plan Rules.

The Income Tax Assessment Act 1936 provides specific rules regarding the taxation implications of receiving share options.

Broadly speaking there are two alternatives available as follows:

1. Upfront Taxation

2. Deferred Taxation

Employees must make a choice between these methods of taxation when lodging the taxation return for the year in which the options are granted. In the absence of a choice being made, the deferred taxation alternative will apply.

There are pros and cons with each alternative which are highlighted below.

Upfront Taxation

Upfront Taxation involves returning the market value of the options granted as assessable income in the taxation return lodged for the year in which the options were granted. The market value of the options are taxed at the employees marginal rates of tax.

There are tables contained in the Income Tax Assessment Act which are used to compute the value. A key ingredient in the calculation is the market value of a share at the date the options are granted.

If the options are not exercised the amount of taxation paid upfront will be refunded by the Commissioner of Taxation.

With the upfront taxation election the exercise of the option and payment of the exercise price do not give rise to any taxation liability.

The benefit of upfront taxation is that the sale of either an option (prior to exercise) or a share (after exercise) is subject to the capital gains tax rules. It is noted that the sale of the option would generally require the approval of the company.

Where the option (if the option is cancelled) or the share (if a share is sold) is held for 12 months prior to sale a 50% capital gains tax discount will apply. This can reduce the effective tax rate on the capital gain to a maximum of 24.25%.

If an employee intends to exercise an option and then immediately sell the share the 12 month period will not be satisfied. If these circumstances have the potential to arise, some planning alternatives may be available and should be discussed with us.

In summary whilst some tax is paid upfront the immediate access to the capital gains tax regime and the 50% discount can reduce the ultimate tax bill on disposal of the shares.

Deferred Taxation

Under deferred taxation the grant of an option will not give rise to a taxation liability.

A taxing point will, however, arise at the earliest of the following times (referred to as the cessation time):

a) The time when an employee disposes of an option;

b) The time when employment ceases (note that if the options are not exercised and are lost no taxation liability will arise);

c) If the option is exercised and there is a restriction preventing the employee from disposing of the share acquired – the time when the restriction ceases;

d) If the option is exercised and there is no restriction – the time when the option is exercised;

e) Ten years from the date the option is granted.

Usually the taxing point (cessation time) will be the date of exercise.

The taxable amount at the cessation time is the market value of a share at that time less the exercise price.

This taxable amount is subject to the employees marginal rate of tax. Any subsequent taxation liabilities will arise under the capital gains tax rules.

There are two potential disadvantages with the Deferred Taxation alternative:

1. Any increment in the value of the shares above the exercise price up to the cessation time event is taxed at marginal rates of tax; and

2. As this liability may be significant employees may be forced to sell shares in order to fund the liability.

Where Upfront Taxation provides a significant taxation liability, however, Deferred Taxation may be preferred due to cash flow concerns even though the ultimate rate of tax paid on disposal of the shares may be higher.