Employee share schemes a challenge

Irrespective of the size of a business, one of the challenges for any business owner is to be able to attract and retain talented staff.

One means of doing so is an effective remuneration package that motivates staff in a way that aligns their performance with the owner’s business objectives. Not every individual is driven by monetary reward, but it is a key ingredient.

In its most basic form, a remuneration package will comprise payment of a salary or wage and potentially cash bonuses. It is often assumed that the next step is for key staff to be incentivised by having them take a stake in the business. However, there is a middle ground that should also be considered. It is relatively straight forward to design a remuneration target that takes into account the performance or value of the business. For example, ‘phantom equity’ involves remunerating an employee based on a set percentage multiplied by an increase in the value of the business. It is akin to providing shares in a business, without actually giving up ownership of the business.

If consideration is being given to providing employees with an ownership share, or such a scheme is already in place, it is important to be mindful of the tax treatment. Employees will naturally look to the employer to ensure they are fully informed regarding the implications. Unfortunately, the tax treatment of employee share schemes (ESSs) is currently under review by IRD.

The IRD’s concern is that there are inconsistencies between ESSs and more vanilla approaches to incentivising employees, such as cash bonuses (and phantom equity).

The IRD has a particular dislike of ‘conditional’ ESSs. Under such schemes, an employee’s continued ownership of shares may be subject to continued employment or performance targets being satisfied. One outcome of such a scheme is that any increase in value after the initial receipt of the share is typically a tax free capital gain.

IRD is of the view that until the shares are free from restrictions, their increase in value should be taxable. Its apparent rationale is that the share is only subject to conditions because the individual is an employee, and therefore any benefit due to an increase in value should be employment income. IRD’s point of comparison is to an ‘ordinary investor’ who might purchase shares on the NZX, who is free from restrictions and whose investment is at risk.

The IRD review commenced in May with the release of an officials’ issues paper setting out its view and that was followed in September with an update on its proposals. When designing a reward system, consideration should be given to IRD’s proposals and the uncertainty that currently exists. Depending on the final outcome, there is a risk that either the employer or employee will find it is the IRD that is being rewarded and not them.

If you would like advisement on any of the points raised in this article, please get in touch.

Published summer 2016

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