Upon Vesting or Exercise: a Taxing Choice

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The government has recently announced a review into the taxation of employee share options. To date, few details have been released in relation to the focus of the review. No doubt, given repeated industry criticism on the subject, the government will consider delaying the relevant taxing point from the date options vest to the date they are subsequently exercised.

It is widely suggested this change will breathe new life into start-up businesses and provide much needed impetus to innovation and talent development. Options are often used within such businesses instead of higher salaries, with the promise of a greater return if and when the company lists on the share market or is sold to another company.

Once options have vested (often on achievement of particular performance conditions), employees are typically taxed on the options’ then market value, prior to their actual exercise and conversion into shares. Particular industry representatives and more outspoken politicians have claimed this is akin to “paying tax on the winnings of the lotto ticket before you win the lotto”.

With respect, the above comments are misguided and unhelpful to the present debate. Just because the options have not been exercised and the employees have not been issued or transferred the underlying shares does not mean they have not derived the benefit of any appreciation in the share price at vesting. Almost all options that vest are exercisable immediately at the election of the employee.

Whether the options are exercised or not post vesting depends on the personal circumstances and investment preferences of the employee. As the Productivity Commission noted on page 345 of its 2009 Report “Executive Remuneration in Australia”, “the decision of whether to realise equity or how to finance any tax bill will be made on the basis of portfolio choice and does not alter the fact that the employee has received a benefit for their labour”.

Changing the relevant taxing point will change not just the amount of income tax payable but also the amount of any subsequent share price movement captured under the capital gains tax regime. As importantly, whether the vesting date or exercise date is chosen as the relevant taxing point, employees will be taxed by reference to this date. However, employees are in a position to time crystallisation of their capital gains tax position (when the underlying shares are sold). It could be argued that delaying the relevant taxing point to the exercise date reduces the flexibility offered to executives in managing this latter aspect of their remuneration and subjects a greater proportion of any share price accretion in the interim to income tax.

Perhaps the best way forward is to offer executives the option (pun intended) of electing to be taxed upon vesting or upon exercise. This may end up representing the optimal path to take going forward given the strongly held (and sometimes misguided) views of relevant stakeholders in the present debate.

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