TAX TIP #15: | EMPLOYEE SHARE SCHEME | PHANTOM EQUITY

Facts

Company C is a mature business of more than 10 years in operations.

It wishes to motivate and reward its hardworking key employees.

However, it does not wish to issue shares to those key employees for various reasons including:

• the owner(s) do not necessarily wish for the key employees to become minority shareholders (which has certain implications); and/or

• the key employees do not have sufficient available funds to acquire the shares.

Question

How does Company C provide the key employees with equity without them becoming a minority shareholder and without requiring capital from them?

Answer

One of the methods is referred to as ‘Phantom Equity’.

1. The key employees are provided with a right, from the existing shareholder(s), to a payment from those existing shareholder(s) upon a vesting event.

2. The vesting event is usually an initial public offering (IPO), share sale (generally 100%) or business sale.

3. Upon the vesting event, the existing shareholder(s) have an obligation to extinguish the key employees’ right by making a payment to the key employees.

4. The reason it is ‘phantom’ is because the key employees hold nil shares in Company C, and never will hold shares, because the key employees are merely entitled to a payment from the existing shareholder(s).

5. The reason it is ‘equity’ is because the payment is equal to an amount that the key employees would receive ‘had the key employees held shares’.
   

Tax Tip

1. The granting of the Phantom Equity triggers CGT Event D1 (about creating contractual or other rights) for Company C.

2. Generally, the key employees will pay $nil for the Phantom Equity because there is no certainty the vesting event will occur.

3. As a result, the market value substitution rule must be considered, however, CGT Event D1 is especially excluded from the market value substitution rule (see section 116-30(3)(b) ITAA 1997).

4. Upon a vesting event, the payment received by the key employees have a dual character:

   • a capital amount received by the ending of the right – CGT Event C2 (about cancellation, surrender and similar endings); and

   • an amount received because they are a key employee (ordinary income).

5. The anti-overlap provision, contained in section 118-20 ITAA 1997, will mean the amount received is taxed as ordinary income rather than a capital gain and therefore the CGT 50% general discount will not apply.

6. Note, under an employee share scheme (ESS) that is in accord with subdivision 83A ITAA 1997, the amount received under the ESS is not ordinary income, even though it is an amount received because they are a key employee, because the ESS is in relation to, or in respect of, shares. However, under a Phantom Equity scheme, the amount received is not in relation to, or in respect of, shares because of its phantom nature being merely a payment by the existing shareholder(s).
   

Further note, there are alternatives to Phantom Equity schemes that provide better tax outcomes for the key employees.

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