GRG Remuneration Insight 24
by Denis Godfrey
30 September 2010
As many companies have recently reviewed their equity plans (plans involving the granting of shares, options and/or rights) it is timely to highlight the issues that have emerged and comment on the approaches being taken in the light of the new employee shares scheme (ESS) taxing and termination payment limit provisions. New legislation was passed late in 2009 and the tax regulations that finalised the changes to the ESS taxing provisions were introduced in early 2010. Thus, we have had time to digest these provisions and companies have developed new plans that will be introduced following shareholder approval at annual general meeting to be held late in 2010.
This GRG Remuneration Review focuses on three areas being:
- Non-executive Director Equity Plans,
- Delivery of Short Term Incentive (STI) Awards in Equity, and
- Executive Long Term Incentive (LTI) Plans.
In discussing these aspect we will not cover:
- tax exempt plans where up to $1,000 of ESS benefit may be provided tax free to employees earning less than $180,00 per annum, or
- salary sacrifice plans where up to $5,000 of ESS benefit may be provided per employee per annum on a tax deferred basis without vesting conditions (without real risk of forfeiture).
Overview of taxation consideration
The previous pre-condition for shares to qualify for tax deferral being that the company operates a general employee share scheme, continues to apply. Previously tax deferral was achieved by having a condition of the plan that the shares would be forfeited in the even of the participant committing fraud, defalcation of gross misconduct. This provision allowed participants maximum flexibility, within legislative limits (10 years or earlier termination of employment) to select the taxing point which was usually when the shares were sold. Under the new ESS taxing provisions such a condition is insufficient for shares to qualify for tax deferral and the new deferral conditions are far more restrictive. They require a real risk of forfeiture (period of service performance conditions) and can include a subsequent dealing restriction which must be communicated when the shares are acquired. The taxing point will be when the shares vest if there are no subsequent dealing restrictions or on cessation of dealing restrictions. Note that dealing restrictions without a vesting condition (real risk of forfeiture) do not enable tax deferral.
Due to uncertainty as to the taxation position of ESS benefits during most of the second half of 2009, companies that had remuneration sacrifice share acquisition plans suspended their operation with effect from 1 July 2009, the operative date for the new ESS taxing provisions. When the taxation position became clear companies decided to discontinue their remuneration sacrifice share plans because the new tax deferral requirement were too onerous and too rigid. Thus, remuneration sacrifice share plans seem to be disappearing from executive and non-executive director remuneration practices.
Although share rights offer some scope to replace remuneration sacrifice share plans they seem not to have been well received by Boards and appear unlikely to develop into a common market practice.
The most frequently used type of option has been market exercise price options (MEPOs) which have an exercise price equal to the share price at about the time the options are granted. MEPOs are unattractive under the new ESS taxing provisions for the reasons discussed below.
1. No vesting condition
If there are no vesting conditions (i.e. no risk of forfeiture) the participant will be taxed on the market value of the MEPOs at the date of grant and they will only be able to have that amount excluded from their taxable income if they subsequently lose the MEPOs and the cause of the loss is not a result of either a decision made by the participant (other than a decision to cease employment) or a rule of the plan which has the effect of protecting participants from a fall in the share price. This limitation on when the taxing of an assessed ESS benefits may be reversed, represents a major issue for companies due to the potential impact on participants.
To illustrate it is assumed that a 5 year option is granted with an exercise price of $2.00 when the market value of a share is $2.00. That option would have a market value of $0.223 (derived from taxation option valuation scale in the Regulations). Thus, if the participant had 1,000,000 options then the taxable value would be $232,000 and tax at 46.5% would be $107,880 (approximately $0.11 per option). A refund of that tax would not be available if the options were not exercised and lapsed at the end of their term. If the share price did not rise to at least $2.11 then the participant would have lost money by having received the options.
2. Vesting conditions
If there are vesting conditions (i.e. risk of forfeiture) but no dealing restrictions (if there were dealing restrictions then the taxing point would be deferred) then the participant will be taxed on the value of the options when they vest. To illustrate it is assumed that a 5 year option with an exercise price of $2.00 vests after 3 years when the share price is $1.95. That option would have a market value of $0.064 (derived from taxation option valuation scale in the Regulations). Thus, if the participant had 1,000,000 options then the taxable value would be $64,000 and tax at 46.5% would be $29,760 (approximately $0.03 per option). A refund of that tax would not be available if the options were not exercised and lapsed at the end of their term. If the share price did not rise to at least $2.03 then the participant would have lost money by having received the options.
Thus, MEPOs contain a down side that was not previously present with options and it severely reduces their attractiveness. Under the former ESS taxing provisions a refund of tax paid on ESS benefits could be obtained if options lapsed.
A premium exercise price option (PEPO) is an option with an exercise price which contains a premium to the market value of a share at the time the option is granted. If the option taxation value scale in the Regulations is applied to the valuation of an option then it is possible to set the exercise price with sufficient premium to achieve a nil option value for taxation purposes. The premium required varies with the term of the option as indicated by the following examples: 17.6% for a 1 year option, 33.3% for a 2 year option, 48.3% for 3 and 4 year options, 66.7% for 5 and 6 year options and 100.01 % for 7 year options.
If no vesting conditions apply to the options then their ESS taxing point will be the date of grant of the PEPOs. If the market value of a PEPO is nil, no tax is payable. Tax will only become payable when either the option is sold (not usually permitted under plan rules) or the share is sold following exercise of the PEPO. The sale will be taxed under the capital gains tax (CGT) provisions and may qualify for the 50% CGT concession if the share or option sold has been held for at least 12 months. NB: if a share is sold the period for which the option was held is not relevant. It should also be noted that the exercise of the option would not be a taxing point.
If vesting conditions are attached to PEPOs then they may give rise to a taxable value at the time of vesting and generate the same problems as can apply to MEPOs. Thus, using PEPOs without vesting conditions would generally be the best alternative.
Zero exercise price options (ZEPOs) are also known as share rights as they can give rise to an entitlement to a share without paying an exercise price. Typically they are granted free and therefore involve no cost to the recipient in acquiring shares.
When ZEPOs are taxed the value that is taxed is the value of a share. If no vesting conditions are attached then the grant of a ZEPO is equivalent to a cash payment of the same value. They would generally need to be sold immediately to fund tax on the benefit received. Thus, ZEPOs tend not to be granted without vesting conditions.
If vesting conditions are attached then tax is deferred until both the vesting conditions are satisfied and any dealing restrictions, attached at grant, have ceased.
NED equity and executive LTI plans
The following table summarises the relevance of the main equity types for use in relation to NED and executive remuneration.
Termination payment limit and termination vesting rules
Longstanding practice in executive LTI plans has been for vesting to trigger forfeiture or vesting of unvested equity units. This practice arose because the taxing point for unvested equity unity was triggered by the termination. Thus, to avoid placing executives in a position of being taxed on benefits that may not be realised, companies generally structured LTI plans so that unvested equity units either lapsed or vested on termination of employment. Therefore participants were only taxed on equity units that vested. The new ESS taxing provisions retain the previous taxing position.
A new complication has arisen for executive and managerial officers in that equity units that vest on termination of employment are now treated as part of termination payments and will be subject to the one year’s base salary limit unless shareholder approval has been obtained for a higher amount.
Indications are that some companies will seek shareholder approval for termination payments that exceed one year’s base salary and will approach shareholders each year as part of the process of making LTI grant to managerial and executive officers. However, such approvals need to be for:
- the money value of the proposed benefit; or
- if that value cannot be ascertained at the time of the disclosure – the manner in which that value is to be calculated and any matter, event or circumstance that will, or is likely to, affect the calculation of that value.
Given that LTI grants tend to be annual and the date of termination will generally not be known well in advance it follows that the company will not know either which grants will be unvested at the date of termination or their value. Accordingly, there are significant practical difficulties in obtaining durable shareholder approval in advance for a higher termination payment if unvested equity grants are to vest on termination of employment.
Some companies have decided to continue to treat termination of employment as a trigger for forfeiture of unvested equity units. This will be the most common case as it covers resignations and dismissals. However, those that are not forfeited will continue to run their course and will vest or not depending upon performance and the extent to which vesting conditions are satisfied. Adopting this approach has an advantage in that it produces equity in the treatment of participants who leave and those that remain with the company as the same vesting scale would apply to both. Also it should encourage longer term thinking and decision making up to the date of termination. However, it does carry a taxing problem as unvested equity units would be taxable at termination. An exception applies in the case of indeterminate rights which are not taxable at termination. They are taxed when they vest on their value at the date of termination which should generally be lower than the value when they vest. A short fall interest charge may apply.
While indeterminate rights are not the sole way of dealing with the termination payment and taxing problems they represent an alternative that is worthy of consideration. In this regard it should be noted that some forms of indeterminate rights could be viewed as derivatives and could involve the issue of a PDS. However, this problem is simply avoided.
Delivery of STI awards in equity
Prior to the commencement of the new ESS taxing provisions it had become common practice for STI awards to be delivered partly in the form of shares which were fully vested but needed to be held for a minimum period, typically 2 years. Tax on such shares was usually deferred until the earlier of: sale of the shares, elapse of 10 years or termination of employment. Under the new ESS taxing provisions such shares would be taxed at the date of grant which would present employees with a problem of needing to fund tax but not being able to sell the shares to raise cash to fund payment of the tax.
To continue to provide equity units to deliver part of STI awards on a tax deferred basis now requires a vesting condition i.e. real risk of forfeiture, to be applied to the shares. This will significantly affect the value and attractiveness of this approach for employees. Also the tax deferral will be limited to the point when both the vesting conditions have been satisfied and any dealing restrictions, attached to the shares at grant, no longer apply.
At a time when deferral of part of STI awards into shares would be seen as good practice from a corporate governance point of view, given the Productivity Commission recommendations, it is disappointing that the Government has decided to not change this aspect of the new ESS taxing provisions.
Deferral of part of STI awards is likely to continue but with the use of share rights rather than shares so as to avoid administrative problems associated with dealing with shares that do not vest.
The new ESS taxing provisions have significantly impacted the use of equity units as part of the remuneration of non-executive directors even though there remain some opportunities.
For executive LTI plans the tax deferral period is shorter and drafting of the termination of employment provisions of the plan rules has become more challenging.
In relation to delivery of STI awards in the form of equity units the new ESS taxing provisions have made this more complex than previously but this practice can be continued on a modified basis.