Over the last decade, we have seen an increasing number of clients benefit greatly from employee share schemes. These programs can be complex, particularly for those less familiar with financial matters. As such, they require careful financial planning and taxation liability management.
What are they and how do they work?
Employees may be granted shares or options by their employer, often referred to as Restricted Stock Units (RSUs). Shares are typically listed on an exchange and can be traded, while options (call options) provide the holder with the right, but not the obligation, to purchase shares at a specific price (the strike price) by a certain date (the expiration date).
Employees can receive shares or options in a few ways:
- Sign-on Incentive: Some employers offer free shares or options as a one-time incentive when an employee joins the company. These may come with conditions, such as staying with the company for a set period or meeting performance targets.
- Short-term and Long-term Incentives: As a short-term incentive, part of an employee’s bonus may be paid in shares. However, it’s more common for shares or options to be granted as long-term incentives. These plans reward employees for years of service and/or meeting individual or company performance goals over several years, typically ranging from three to five years.
- Share Purchase Plans: Employees may have the option to buy company shares at a discount, often using pre-tax salary through salary sacrifice arrangements. This makes purchasing shares more affordable and tax effective.
Vesting
Vesting refers to the point at which an employee gains full ownership and control over the shares or options granted. It’s typically used to reward years of service or performance. Vesting can be time-based, meaning shares begin vesting after a certain period e.g.; shares begin vesting after 12 months in monthly tranches. Alternatively, vesting may be tied to performance milestones. Employees cannot sell their shares or exercise options until they have fully vested.
If you leave the employer before your shares have vested, you typically forfeit those shares. However, in the case of redundancy, the employer may choose to vest some or all of the unvested shares. Leaving your employer is no longer a taxing point – that changed in 2022.
Practical management of employee shares
Employee shares are issuer-sponsored, meaning they are managed by the company’s share registry, such as Computershare, Link Market Services, or BoardRoom, rather than through a stockbroker.
To trade these shares, you can either do so directly through the share registry – most offer the option to sell shares – or transfer your vested shares to a stockbroker like Betashares Direct, which doesn’t charge brokerage fees (for ASX shares only).
Taxation matters
Employees should confirm with their employer whether their employee share scheme is “tax-deferred” or “taxed-upfront”.
This classification usually depends on whether the shares or options come with a real risk of forfeiture, such as not meeting performance criteria, or restrictions on selling them. If the shares or options do not vest immediately, the scheme is likely to be tax-deferred. In that case, the taxing point is deferred until the shares vest, rather than when they are first allocated.
When shares vest, the market value of those shares at vesting date (less any amount you paid for them) is included in your taxable income for that financial year. However, if you sell the shares within 30 days of vesting, the ATO treats the sale proceeds as your taxable amount instead of using the market value on vesting day.
Typically, options are not taxed when they vest. Instead, the taxing point usually occurs when you exercise the options. That is, when you buy the shares at the exercise price. At that point, the difference between the exercise price and the market value of the shares is included in your taxable income.
If you keep the shares after they vest, the usual capital gains tax (CGT) rules apply. The market value on the vesting date becomes your cost base. If you hold the shares for more than 12 months after vesting and make a capital gain, you should be eligible for the 50% CGT discount.
If the scheme does not include any restrictions or risk of forfeiture, then it’s typically a taxed-upfront plan. In this case, the taxing point is the date the shares or options are issued. If the plan is offered company-wide, meets certain ATO eligibility criteria, and your adjusted taxable income is below $180,000, you can reduce that taxable amount by $1,000.
Employee Share Purchase Plans (ESPPs) allow employees to buy shares in their employer’s company, often at a discount, using pre-tax salary through salary sacrifice. If the plan complies with specific ATO rules, you can salary sacrifice up to $5,000 per year without triggering fringe benefits tax (FBT). This effectively allows you to invest in shares using pre-tax income.
Should you hold or sell?
You don’t need to decide what to do with your employee shares until they vest, because until that point, you cannot sell them even if you wanted to.
Once they do vest, there are two main considerations when deciding whether to hold or sell.
The first is concentration risk. If you hold on to your employee shares, a growing proportion of your wealth becomes tied to a single company and a single industry – the same one you rely on for your salary. That’s a lot of eggs in one basket. If something happens to the company or the sector, both your income and your wealth are exposed. That’s not a prudent long-term strategy.
The second is your view on expected future returns – what level of dividends and future share price growth can you realistically expect? It’s essential to stay objective here. Don’t drink the Kool-Aid. Instead, look at the numbers: valuation multiples relative to the broader market and peers, analyst recommendations, and the company’s financial health and industry outlook.
Our default position is to be conservative: unless we believe the stock is materially undervalued or we have a high conviction about future upside, we will usually recommend divesting.
That said, it’s never easy to sell a stock that’s delivered strong historical returns. A growth stock might look expensive today, but people understandably hesitate to sell in case it keeps rising. It’s important to stay rational and not get caught up in the hype.
Also, this doesn’t have to be an all-or-nothing decision. You might decide to hold a portion long-term and sell the rest. Or, if you are unsure, you could commit to selling a set amount each month or quarter to smooth out timing risk.
Of course, if you don’t sell all your stock, you will need to consider how to fund the tax liability associated with vesting.
The key is to have a clear plan, so you don’t accidentally end up with a large, concentrated exposure to one stock.
Foreign exchange could be another consideration
When dealing with employee shares listed on an international stock exchange, you will need to consider the impact of foreign currency exchange rates. Predicting short-term currency movements is almost impossible due to numerous domestic and international influencing factors.
Therefore, typically, my recommended approach is to compare the current exchange rate with its long-term average. If the rate is favourable, a more aggressive divestment strategy is best. Conversely, if the exchange rate is unfavourable, gradual divestment in smaller, regular tranches is often the prudent approach.
If you hold them, be tactical regarding tax
If you decide to retain the shares and they are unrestricted, it’s worth considering whether to transfer them off-market to another person or entity. Since the market value at the time of transfer becomes the cost base, this usually does not trigger any significant tax consequences.
For example, if your spouse has a much lower taxable income, it may be more tax-effective for them to hold the shares. For instance, in some cases, we transfer employee shares into a family trust alongside other investments to provide greater taxation flexibility.
Also, if the share price drops significantly within 30 days of vesting, transferring the shares to another person or entity can reduce the tax impact, since you will be taxed based on the lower market value at the time of transfer, rather than the higher value on the vesting date.
Should you participate in Employee Share Purchase Plans (ESPPs)?
If you can buy shares through an Employee Share Purchase Plan (ESPP) via salary sacrifice, at a discount, the key question typically is whether there are any restrictions on selling the shares once they are issued.
If there are no restrictions, then it’s likely you will benefit from participating. For example, if you salary sacrifice $5,000 and your marginal tax rate is 39%, you save $1,950 in tax. Let’s say you also receive a 10% discount on the shares, meaning you acquire $5,550 worth of shares. You will pay tax on the $550 discount at your marginal rate, so $215. That still leaves you $335 better off after tax. So, in total, you will be $2,285 better off ($1,950 tax saving + $335 net discount benefit).
However, if the ESPP is tax-deferred because the shares don’t vest immediately, then you need to consider the risk that the share price may fall between the issue date and vesting date. Using the same numbers, the share price would need to fall by more than your marginal tax rate (i.e. 39%) before you would be worse off overall. So, it’s important to consider how likely that is based on the stock’s volatility and market conditions.
Do they affect your borrowing capacity?
If you choose to participate in an ESPP voluntarily, as described above, it generally will not negatively impact your borrowing capacity, since you can opt out at any time.
If your short or long-term incentive includes shares or options, some lenders may take this into account when assessing your borrowing capacity. It’s not necessarily part of standard credit policy, but some parts of the bank, such as Private Banking, may include a portion of the vested share value as income. For example, they might count 80% of the lower of the past two years’ value.
That aside, the real benefit of these entitlements is the capital they can generate once sold (after allowing for tax). The sale proceeds can be used to repay non-deductible debt or reinvest, both of which can significantly boost your long-term investment capacity.
Personalised financial and tax advice is needed
Of course, every share plan is different, and so is everyone’s personal situation. That’s why it’s important not to rely solely on the general information above. Personalised financial and tax advice is essential to ensure you are making the right decisions for your circumstances.
