Can listed companies continue to claim tax deductions for contributions to employee share trusts?

In brief

A recent draft tax ruling may make it more difficult for employers to claim tax deductions for contributions made to employee remuneration trusts. However, the ruling is expected to have limited practical application to listed companies making non-refundable contributions to traditional employee share trusts. Partner Sarah Bernhardt and Senior Associate Shaun Cartoon report.

Background

On 5 March 2014, the Australian Taxation Office (the ATO) issued a Draft Taxation Ruling TR 2014/D1 (the Ruling), which outlines the tax consequences for employers, trustees and employees who participate in ERT arrangements. One aspect of the Ruling (and the focus of this article) is the extent to which companies are eligible to obtain tax deductions for contributions made to the trustee of an ERT.

An 'ERT' is described very broadly in the Ruling as any arrangement where an employer establishes a resident trust, to which it makes contributions that may be used by the trustee to provide benefits to employees of the employer. Examples of such benefits include the distribution of cash and/or assets such as shares from the trust and the making of loans by the trustee.

The wide definition of an ERT means that the Ruling will potentially apply to all employee trust arrangements set up by companies to operate in conjunction with their employee share plans.

Traditional employee share trusts (not involving loan plans)

Publicly listed companies may offer their employees the opportunity to participate in various employee share plans that involve the employees being awarded shares in the company as part of their remuneration (eg under a long- or short-term incentive plan) or as a matching award (eg under a general share plan). The employer may choose to operate such plans in conjunction with an employee share trust.

In such arrangements, the employer would generally make contributions to the employee share trust to enable the trustee to subscribe for, or purchase shares in, the company to be delivered to employees who participate in the share plans and who are not required to pay consideration for the acquisition of those shares. Those shares might then be immediately allocated by the trustee to be held on behalf of specific employees. Alternatively, the shares might be held by the trustee on behalf of employees generally (ie held on a discretionary trust) pending allocation to specific employees under a share plan. Shares that are allocated by the trustee to be held on behalf of specific employees may be immediately transferred to those employees. Alternatively, the trustee may retain legal title in the shares after allocation to a specific employee (eg until vesting conditions are satisfied or until the employee requests a sale or transfer of the shares).

The issue to be discussed in this article is the extent to which listed companies are eligible to obtain a tax deduction for such non-refundable contributions (not including where loan arrangements are used).

Application of the Ruling to contributions to traditional employee share trusts

Broadly, a contribution made by an employer company to an employee share trust will generally be tax deductible if it is necessarily incurred in carrying on the employer's business for the purpose of gaining or producing assessable income (or is incurred in gaining or producing such income) and it is not private or domestic in nature or capital or of a capital nature.

The two factors that the Ruling indicates are important to establish deductibility for non-refundable contributions to a traditional employee share trust are:

• is the primary purpose of the contribution for it to be substantially diminished within a relatively short period to the direct provision of remuneration of employees?
• does the company secure a capital structure advantage from the contribution?

Is the contribution likely to be substantially diminished within a relatively short period of time?

The Commissioner states in the Ruling that he will accept a period of five years or less from when the contributions are made as being a relatively short period within which the trustee of an ERT must diminish its contributions for the direct provision of remuneration to employees. However, that period may be up to seven years if the contribution has been made to facilitate an employee having an interest in an employee share trust corresponding to a particular number of shares in the employer to which an ESS deferred taxing point applies.

'Diminish' essentially means that the contributions are applied by the trustee so as to become remuneration income (eg employee share scheme income) of the employees within the specified period of when the contributions are made. For example, the contributions might be applied by the trustee to purchase shares in the employer company which are to be held on a discretionary trust pending allocation to specific employees on the vesting of performance rights granted under a long-term incentive plan. In such a case, the Commissioner should accept that the contributions satisfy the nexus of being necessarily incurred in carrying on a business, provided it was intended at the time the contributions were made that the shares would be transferred to specific employees for no consideration within five (or, in some cases, seven) years of making the contributions.

It is not clear from the Ruling whether the Commissioner would consider that a contribution has been substantially diminished in providing remuneration within the specified period where the contribution has been used to purchase shares that have been allocated by the trustee to specific employees within that period, but where legal title in those shares has not been transferred to the employees during that period. This would not be unusual in practice where, for example, the shares are in a foreign listed company. In such circumstances, a careful examination of all relevant plan documentation would assist with assessing whether the relevant nexus was satisfied.

Does the company secure a capital structure advantage from the contribution?

The Ruling states that a contribution to an ERT will be capital (and therefore not deductible) to the extent that it is made for the purpose of securing a capital advantage by way of being ultimately and in substance applied by the trustee to acquire a direct interest in the employer (capital structure advantage). The capital structure advantage is described in the Ruling as the advantage that flows to the employer from enlarging its own equity structure. That is, the asset or advantage obtained is the alteration or transformation of profits to share capital as a result of the movement of value out of profits (or capitalised profits) to share capital that is structural and enduring.

It is difficult to see how an employer could have a purpose of obtaining a capital structure advantage from making contributions where those contributions are to be used by the trustee to purchase already existing shares (eg to purchase shares on the ASX). In that case, the purchase of the shares by the trustee should not result in any increase in the company's share capital account (as no new shares would be issued). If there is a difference between the cash purchase price of the shares and the accounting expense that the company is required to report, that difference may have to be 'reconciled' for accounting purposes through the company's balance sheet. However, such a reconciliation process should not impact on the company's share capital account and it would seem highly unlikely it would be a relevant factor in determining the company's purpose of making the non-refundable contributions to the employee share trust.

Where it is proposed that newly issued shares will be used, then it is possible that there could be some capital structure advantage received by the employer. However, in most cases involving listed companies, it seems unlikely that the employer would have made contributions to the employee share trust with a purpose of receiving that capital structural advantage, particularly where the number of shares issued under employee share plans only represents a very small percentage of the share capital on issue in the company. Instead, the motivating purpose of making such contributions is very likely to be remunerating and motivating the company's employees.

In the event that an employer making contributions to an employee share trust does have both a purpose of remunerating its employees and a purpose of obtaining a capital advantage, the employer will be required to apportion the contributions on a fair and reasonable basis. However, the Ruling creates a safe harbour for capital advantages that are 'very small or trifling', provided the arrangement satisfies certain conditions. That is, if the safe harbour applies, then the Commissioner will accept that no part of the contribution needs to be apportioned to the capital advantage. In relation to capital structure advantages, the safe harbour will only apply if the shares in the employer are intended to be transferred to the employees within a relatively short period of the contribution being made (within five or, in some cases, seven years), with the expectation that the employee will not immediately dispose of those shares.

We would expect that the safe harbour rule should be satisfied by a listed company that grants performance rights and, after vesting of those rights, makes contributions that are used by the trustee to subscribe for new shares in the company where legal title in those shares is immediately transferred to the employees to satisfy the vested rights. We would also expect the safe harbour rule to be satisfied where a listed company awards a short-term incentive in the form of a beneficial interest in shares subject to forfeiture for three years and makes contributions around the time of the award that are used by the trustee to subscribe for new shares in the company which are immediately allocated to specific employees, with the legal title in those shares being transferred to the employees on vesting of the award (ie within three years of when the award was made).

In both of the above examples, it is likely that the employees will be assessable under the employee share scheme tax provisions on the value of the shares around the time that legal title in the shares is transferred to the employees. The employees may therefore immediately sell sufficient of the shares transferred to them to meet this tax obligation. Unfortunately, the Ruling indicates that the safe harbour rule is limited to where the employer does not have an expectation that the shares will be immediately sold on transfer to the employees. We assume that, in formulating that requirement, the Commissioner may not have turned his mind to the possible need for the shares to be sold to pay tax under the employee share scheme tax provisions (given that the Ruling attempts to carve out circumstances in which benefits received from an ERT may be employee share scheme income – but then curiously deals with the extension of the five-year period to seven years in such cases). We are therefore hopeful that the safe harbour rule will be appropriately amended in the final version of the Ruling to recognise that a sale expectation arising out of the need to pay tax relating to those shares should make it more rather than less likely that the employer's purpose of making the contributions was remuneration. However, even if it is not, it is important to recognise that the requirements set out in the Ruling are only safe harbour requirements. That is, depending on the particular circumstances, a purpose of obtaining a capital structure advantage may still be considered very small or trifling (or non-existent) even where the explicit safe harbour requirements in the Ruling are not satisfied.

Conclusion

The Ruling is an attempt by the ATO to curtail the use of particular types of arrangements involving employee remuneration trusts. The good news for listed companies is that the Ruling is unlikely to impact on their ability to claim a tax deduction for contributions made to traditional employee share trusts in the circumstances we have identified above.