On 18 September 2019, the ATO issued a new draft tax determination TD 2019/D8: Income tax: ‘what is an ’employee share trust’? (Draft Determination) and withdrew the existing ATO Interpretive Decision 2010/108 (Withdrawn ID). Employee Share Trusts (ESTs) have been under the ATO’s microscope in recent years and the Draft Determination is the culmination of the ATO’s thinking in relation to ESTs.
The Draft Determination provides guidance in relation to the criteria that must be met by an EST in order for the EST, its beneficiaries and the employer company to qualify for certain capital gains tax (CGT) and fringe benefits tax concessions. In particular, it provides the Commissioner’s view as to when a trustee’s activities will not meet the ‘sole activities’ test or otherwise fall within the ‘merely incidental’ safe harbour.
In light of the Draft Determination, companies and trustees should review their EST trust deeds and activities, pending finalisation of the Draft Determination.
Other ESTs will not be ‘contaminated’
The Draft Determination confirms that if a company is the trustee of multiple ESTs and one of those ESTs fails the sole activities test in section 130-85(4) of the Income Tax Assessment Act 1997 (Cth) (ITAA), the other ESTs will not be ‘contaminated’ by the offending EST merely because they share a common trustee entity.
The trustee’s activities are paramount
In a private ruling context, the ATO has been subjecting EST trust deeds to high levels of scrutiny and, in practice, has generally only been willing to issue private rulings if any broad powers or duties contained in a trust deed are either removed altogether or appropriately limited. The Draft Determination, however, takes a more practical approach. Broad powers and duties in a trust deed will not prevent the trust from being an EST if, in substance, the trustee’s activities have been consistent with that of an EST.
However, this approach will not make it any easier to apply for private rulings, as the ATO has caveated that “…the correctness of the ruling may depend on whether or not the trustee will act on the relevant clauses in the trust documents, as the scheme will include the existence of the powers and duties in the trust documents. In these circumstances, the Commissioner will make an appropriate assumption (or assumptions) or decline to rule. If the Commissioner decides to make an assumption, given the powers and duties are specifically included in the trust documents, the most appropriate assumption will generally be that the power will be exercised or the duty undertaken.” In other words, a successful ruling is unlikely if the trust deed contains such broad powers and duties; notwithstanding that the ATO accepts, outside of a ruling context, that the trust can be an EST where the activities that the trustee has undertaken fall within section 130-85(4) of the ITAA.
Clarity in relation to ‘merely incidental’ activities
The Draft Determination also provides an updated list of examples of activities that the Commissioner considers are ‘merely incidental’ to the EST’s employee share trust activities and therefore fall within the ambit of section 130-85(4)(c)of the ITAA.
For example, the Withdrawn ID included as a permitted activity falling within the ‘merely incidental’ safe harbour “…receiving and immediately distributing shares under a demerger.” The updated list of ‘merely incidental’ activities in the Draft Determination extends that permitted activity to now include “…actions in order to participate in a takeover or restructure covered by section 83A-130…” The inclusion of this expanded activity should provide comfort that the trustee is able to facilitate corporate transactions in a demerger, takeover or restructure context without jeopardising the status of the trust as an EST.
A further example relates to dividend equivalent payments, on which the Withdrawn ID was silent. The Draft Determination now includes in the list of permitted activities falling within the ‘merely incidental’ safe harbour “…paying a dividend equivalent payment to a participating employee under the rules of the ESS…”
However, there appears to be some potential inconsistencies between the Draft Determination and TD 2017/26: Income tax: employee share schemes – when a dividend equivalent payment is assessable to an employee as remuneration. Example 1 in the Draft Determination (which refers to Megan, a participant, becoming entitled to receive dividend equivalent amounts from the EST upon the vesting of her performance rights) is silent on whether the dividend equivalent amounts that she receives are assessable to her; but in light of TD 2017/26, the ATO’s view is that such amounts would be treated as assessable, notwithstanding that such payments are sourced from amounts in the EST that have already been taxed in the EST at the top rate. The position should be clarified in the final determination.
Transition period for dividend waivers to be ‘switched off’
Dividend waivers are not permitted (see below), but the ATO has expressed that it will not apply compliance resources to investigate if any action has been taken in respect of such a clause or dividends waived, or the potential tax consequence, for periods prior to 1 January 2020. Therefore, dividend waivers should be ‘switched off’ before 1 January 2020 (if not already).
The ATO has taken a narrow interpretation of the ‘merely incidental’ activities safe harbour, where it states at paragraph 10 of the Draft Determination, “If the activities undertaken by the trustee are not a natural incident or consequence of obtaining, holding and providing shares or rights under an ESS, or if the activity is undertaken for or follows from some other purpose, such activities are not merely incidental.”
The ATO’s list of activities that are not ‘merely incidental’ now include, but are not limited to, activities that involve:
- Providing financial assistance, such as providing a loan to an employee to purchase shares or interests in the employer company;
- Payment of income or accrued capital from unallocated shares to any beneficiaries (or to employees who do not hold a beneficial interest in the employer company under the trust);
- Waiving or relinquishing certain entitlements, such as waiving the right to be paid or credited dividends pursuant to a dividend waiver clause contained in the governing trust documents;
- Exercising a general discretion to make distributions of income or capital to pay a class of participating employees or other beneficiaries of the trust amounts unrelated to their ESS interests or entitlements under the ESS rules;
- Investing in assets other than shares or rights to shares in the employer company;
- Engaging in trading activities in relation to shares in the employer company, other than purchasing and selling shares to satisfy obligations under the ESS;
- Distributing mainly cash payments to participating employees rather than shares or ESS interests under the ESS; and
- Providing additional benefits to participants and/or employees, over and above the delivery of the ESS interests or resulting shares and any dividend equivalent payment that accrues directly from the employee’s ESS interest.
Is EST status forever lost?
One slip up, and the trust is not an EST! At paragraph 13 of the Draft Determination, the ATO states, “Once the trust fails to meet the requirements of an employee share trust in subsection 130-85(4), it will no longer be an employee share trust for the duration of the ESS. That is, the trust cannot regain its status as an employee share trust for that ESS.”
Linking the status of the trust as an EST to a particular ESS is questionable, because in practice, companies do not generally establish separate ESTs for each of their separate ESSs that they operate. Typically, one EST is established for a company and is used to satisfy awards granted under multiple ESSs. If the operation of one ESS fails the sole activities test, is the trust contaminated in relation to the operation of the other ESSs?
ESTs do not typically identify and pool separate shares to separate ESSs (but instead, hold shares in the trust generally on either an allocated or unallocated basis). Can the same trust be an EST for one ESS and not an EST for another ESS? The Draft Determination would seem to suggest that is possible. Further, when the ATO refers to “that ESS” do they mean any awards (past, present and future) granted under the ESS, or instead, does “that ESS” refer to a particular grant under an ESS, such that the issue can potentially be cured for future grants under the same ESS? The ATO’s interpretation should be clarified in the final determination.
Another example is where the trustee breaches the sole activities test by exercising a broad power in the trust deed impermissibly, but not in relation to the operation of any particular ESS; for example, exercising a power to make a general capital distribution to a beneficiary of the trust. The outcome under the Draft Determination would seem to be that the entire trust is no longer an EST in relation to any ESS that the company has or might in the future operate. The ATO’s view resembles an absolute test approach, in which once the trust fails the sole activities test, it can never be an EST. Trust deeds generally permit a trustee to roll shares held in the trust to another EST, but the disposal of the shares to a new trustee would potentially trigger an (unintended) CGT liability. Given what is at stake (and how easily EST status can apparently be lost), it is possible that the days of ‘do it yourself’ employee share trusts may well come to an end.
Trustee to consider CGT and cost base where the trust is no longer an EST
Currently, the trustee of an EST does not generally need to concern itself with the cost base of shares that it acquires in the EST because any capital gains that arise on the allocation of such shares to participants under the ESS are generally disregarded (unless a company operates a share rights plan with an exercise price payable by the participant – in which case, the CGT exemption for the trustee only applies if the exercise price paid is not more than the cost base of the shares in the hands of the trustee).
However, if we move to a world where a trust becomes ineligible to be an EST for a particular ESS, and as a result, the EST CGT tax concessions are no longer available, the trustee will need to be cognisant of when CGT events occur and the cost base of the shares that it acquires in the EST. To mitigate any potential CGT liability if the trust is not an EST for a particular ESS, it would be important for the trust deed to give the trustee the flexibility to allocate specific shares to a participant in satisfaction of an award under an ESS.
Impact of the Draft Determination
Companies should be reviewing and auditing the activities of their ESTs, together with the underlying trust deed, to ensure compliance with the Draft Determination.
Please contact a member of our team to assist with the review of your EST trust deed.
This article was written by Shaun Cartoon, Partner and Stephanie, Kolaczkos, Solicitor.