Share-based Incentive Schemes: Optimising The Benefits

As a result many schemes fail to optimize the potential benefits for both the company and its employees, whilst poorly conceived schemes can also prove to be unwieldy or unworkable.

Below we highlight some of the issues to be considered in implementing an effective share-based incentive scheme.

Designing an effective share-based incentive plan

In designing a framework for share-based incentives, it is important to consider the purpose and objectives of the scheme, which may vary across different categories of employee. For instance, you may wish to provide a scheme which incentivises the executive directors and senior management - those with most ability to influence the performance of the company - by providing significant share-based remuneration if company and individual performance objectives are met. At the same time, you may wish to issue a lesser number of shares to other staff in recognition of their contribution and generally to increase their attachment and motivation within the company. Accordingly, it is not uncommon for a company to implement two or three different schemes.

The structure of each scheme, including eligibility and vesting criteria, number of shares or options to be offered, restrictions on sale and other key terms will need to designed with these objectives in mind, whilst being acceptable to the market. Generally speaking, shareholders will want to ensure that the quantum of any share issues is closely aligned to the financial performance of the company and is not overly dilutive to their interests. In order to be workable, it is important that clear, objective criteria are established to determine whether company and individual performance objectives and other vesting conditions have been met.

In establishing a share-based incentive plan, it is also important to consider the taxation implications for both the company and its employees - not least with a view to accessing valuable ATO concessions - and the impact of the issue of shares or share-based instruments on the company's financial statements, particularly given the substantial changes in this area as a result of the introduction of Australian Equivalents of International Financial Reporting Standards ("AIFRS").

Taxation considerations

Under Division 13A of the Income Tax Assessment Act 1936, a share or option to acquire a share will generally be taxable in the hands of the employee where it is issued to the employee (or an associate) in connection with his or her employment at a discount to its market value. It is therefore important for employees to be informed of the tax implications of receiving free or discounted shares.

Any tax liability will arise in the year in which the employee receives the share or option, and is calculated on the market value of the share or option, less any consideration paid by the employee.

Employees may, however, be entitled to concessional tax treatment for shares or options acquired, provided that certain conditions are met. These concessions enable the employee to either defer taxing of the discount for up to ten years or qualify for up to $1,000 worth of free shares (or discount) tax-free.

Deferral plan

Employees may be able to defer the tax liability under a scheme where:

• 75% of all permanent employees - defined broadly as employees with at least three years' service - are entitled to participate in that or another share scheme; and
  
  
• The employee does not hold more than 5% of the legal or beneficial interests or voting rights of the company.
  
  
• Provided the above conditions are met, the tax event may be deferred until the earlier of:
  • When the employee disposes of the share;
    
  • When the employee’s employment ceases;
    
  • The later of:
    
    • the time any restrictions on disposing of the shares are lifted; and
      
    • the time any forfeiture conditions cease to have effect; and
    
    
  • Ten years after the shares or options were issued.
  
  

$1,000 exemption plan

Under current taxation rules, employees may be granted a discount of up to $1,000 per annum on the issue of shares or options on a tax-free basis. This exemption is commonly used in connection with the issue of free shares and is popular as a means of remunerating and incentivising less senior employees. In some cases, free shares are automatically granted on an annual basis, whilst in other cases the grant of shares may be a one-off event - such as at the time of the company’s IPO - or may only be made in years when the company achieves specified performance goals.

In order to qualify, the scheme must meet the following conditions, in addition to those outlined for the deferral plan:

• Employees must be restricted from disposing of their shares for a period of three years or (if earlier) until the date of cessation of employment; and
  
  
• There must be no conditions that could result in the employee forfeiting ownership of the shares.

As a general rule, the company is unable to claim a tax deduction in respect of shares issued to an employee.

However, there are two commonly used exceptions to this rule:

• A tax deduction of up to $1,000 per annum is allowed in respect of shares issued to each employee who participates in the $1,000 exemption plan (see above); and
  
  
• Where the company pays for the shares issued - typically where the company provides funding to a trust established to hold shares on behalf of employees.

The issue of shares and options to employees, where taxed in the hands of the employees, is specifically excluded from the definition of a "fringe benefit", and is therefore not subject to Fringe Benefits Tax (FBT). Furthermore, an employer is not required to withhold tax for PAYG purposes in relation to such issues of shares or options.

Recognising the cost

Under AIFRS - effective for reporting periods commencing on or after 1 January 2005 - companies are required to recognise the financial effect of issuing shares, options or other share-based instruments in their financial statements, on the basis that they represent a cost to the business as a component of the remuneration of directors and employees. This represents a significant departure from previously applicable accounting standards, which required certain disclosure within the notes to the financial statements in relation to shares and options issued (in accordance with the Corporations Act 2001), but did not require a cost to be recognised in the income statement.

Specifically, under AASB 2 Share-based payment, companies are required to recognise as a cost the estimated value of the instrument Share-companies are required to recognise as a cost the estimated value of the instruments issued and to record a corresponding increase in equity. In respect of shares, the cost will generally be the market value of the shares less any amount paid by the employee. In the case of options or other instruments, the value will need to be determined in accordance with an appropriate pricing model, such as the Black-Scholes formula. In either case, the cost is recognised over the vesting period, with changes in the value of the instrument in each accounting period being reflected in the financial statements for that period.

Given the potential for share-based incentive schemes to have a significant - and uncertain - impact on future earnings, it is essential that companies evaluate the likely range of outcomes and include an appropriate cost in any earnings forecasts or guidance released to the market. It remains to be seen whether these new accounting rules reduce the attractiveness and popularity of such schemes.

In conclusion–

• Don’t leave consideration of share-based incentive schemes to the last minute
  
  
• Keep vesting conditions and performance criteria objective, clear and aligned with company goals - the simpler the better
  
  
• Seek advice on what is likely to be acceptable to the market
  
  
• Where possible, ensure that relevant tax concessions are accessed
  
  
• If tax concessions are not available, ensure scheme enables employees to fund tax liabilities and consider issuing shares or options well in advance of IPO
  
  
• Establish and factor into earnings forecasts the likely impact of issuing shares and options
  
  
• And finally, bear in mind that, whilst employees may be strongly motivated by a rising share price, this can soon evaporate if shares and options held are “under water”.

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