The new ESS rules will be contained in Division 83A of the Income Tax Assessment Act (ITAA) 1997 and will apply from 1 July 2009. 

Brief overview of the new ESS regime

The ESS rules only apply where the share or right is issued at a discount to its market value.

The default taxing point will be at the date of acquisition (i.e. taxed upfront). Tax deferral will only occur where there is a real risk of forfeiture.

Taxed upfront

The normal taxing point will be at acquisition (i.e. it is taxed upfront) and the discount must be included in an employee's assessable income for that income year.

A $1,000 tax exemption is available to an employee participating in an ESS who pays tax upfront, if they have an adjusted taxable income of $180,000 or less, and the employee and the scheme meet the following conditions:

• the employee must be employed by the company offering the scheme, or one of its subsidiaries; 
• the scheme must be offered in a non-discriminatory way to at least 75 per cent of Australian resident permanent employees with three or more years service; 
• the shares or rights provided must not be at real risk of forfeiture; 
• the ESS interests offered under the scheme must relate to ordinary shares; 
• the shares or rights must be required to be held by the employee for three years or until the employee ceases employment; and 
• the employee must not receive more than 5 per cent ownership of the company, or control more than 5 per cent of the voting rights in the company, as a result of participating in the scheme.

The new law provides for a refund of tax paid in relation to ESS interests in certain circumstances where:

• an amount of employee share scheme discount has been, or would be, included in the employee's assessable income;  
• the employee has either forfeited the ESS interest or, in the case of a right, the employee has lost the right without having disposed of or exercised it; and  
• the forfeiture or loss is not the result of:
• a choice made by the individual (except when that choice was to cease employment), and
• a condition of the scheme that has the direct effect of wholly or partly protecting the employee from a fall in the market value of the ESS interest. 

Deferred taxing point

The deferred taxing point for shares is the earliest of when: 

• there is no real risk that the employee will forfeit the share, or lose the share other than by disposing of it; and there are no genuine restrictions preventing disposal; or 
• when the employee ceases the employment in respect of which they acquired the share; or 
• seven years after the employee acquired the share.

Similar rules apply in respect of rights.

The term “real risk of forfeiture“ is not defined within the legislation, but the accompanying Explanatory Memorandum contains numerous examples of what Treasury considers to be “real risk of forfeiture”.

These examples are helpful, but we expect activity in this area over the next few years as additional clarity is sought.

It will be necessary to review the existing ESS plan rules to ensure that income tax is not paid on rights or shares that are under water at the taxing point.

Capital Gains Tax (CGT) treatment

For ESS interests that are taxed upfront, the interest is taken to have been acquired for its market value from the point at which the employee initially acquired the ESS interest.

For tax deferred ESS interests, the ESS interest is taken to have been reacquired for its market value immediately after the ESS deferred taxing point.

Please note the asset must be held for 12 months from the acquisition time in order to qualify the 50% CGT discount.