This article examines whether an SMSF can acquire shares offered under an employee share scheme (‘ESS’).
What is an ESS?
Broadly, an ESS (also known as an employee share plan or employee share ownership plan) typically gives employees the opportunity to purchase shares in their employer.
Usually, employees are able to obtain more favourable terms or prices compared to other investors and there can be lower transaction costs.
Acquiring shares under an ESS may also be attractive from a tax viewpoint. A person entitled to acquire ESS shares may be eligible for special tax concessions, such as the ability to defer the taxing point.
It should be noted that ESS shares may be subject to restrictions on vesting and sale and, in some cases, ESS shares may be forfeited on the happening of certain events (ie, when employment ceases). Thus, a careful review should be undertaken on the conditions relating to any shares.
Can an SMSF trustee acquire ESS shares from an employee?
Under some ESS arrangements, the employee can elect to have an associate (eg, a spouse, family company, family trust or SMSF trustee) take up their share entitlement. Even though the associate may acquire the shares under the ESS directly from the employer, the legal transaction needs to be carefully analysed to ensure there are no superannuation contraventions.
The acquisition of shares under some ESS arrangements results in an employee foregoing his or her entitlement to ESS shares to allow an associate to take up the entitlement. Thus, from a legal viewpoint, if the employee’s SMSF acquires ESS shares, this may be considered an acquisition by the SMSF trustee from the employee. The employee is generally taxed in his or her personal tax return on any discount in respect of the initial grant of ESS entitlements.
However, under some ESSs, the SMSF trustee may be given a direct entitlement which does not result in an acquisition from a member or related party; whether on a direct or indirect legal analysis. A detailed review of the legal documents and the background facts needs to be undertaken to determine whether the acquisition contravenes superannuation law.
Acquiring assets from related parties
Since SMSFs have restrictions on acquiring assets from related parties, the SMSF trustee should ensure that they do not contravene s 66 of the Superannuation Industry (Supervision) Act 1993 (Cth) (‘SISA’). Section 66 broadly provides:
- … a trustee … of a … fund must not intentionally acquire an asset from a related party of the fund.
- Subsection (1) does not prohibit a trustee … acquiring an asset from a related party of the fund if:
- the asset is a listed security acquired at market value; or …
In respect of shares, there is an exception under s 66(2) that allows an SMSF trustee to acquire a ‘listed security’ from a related party, ie, a listed share on the ASX provided the acquisition is at ‘market value’. When an ESS share is offered at a discount, as discussed below, care is needed.
Further, s 66(2A)(c) broadly provides that SMSFs are not prohibited from acquiring assets from related parties if the acquisition will not result in the level of in-house assets of the fund exceeding the level of in-house assets permitted by Part 8 of the SISA (which is broadly a 5% limit of the fund’s total assets).
Under the SISA, a related party includes a member of the fund, a standard employer‑sponsor of the fund and a Part 8 associate of an entity of either the member or the standard employer‑sponsor. (An employer‑sponsor is an employer that contributes to an SMSF pursuant to an arrangement between an SMSF trustee and the employer.) Broadly, Part 8 associates include a company that is controlled, sufficiently influenced by or in which a majority voting interest is held by the member or their Part 8 associates.
Hence, an SMSF trustee should ensure they fall within one of the exceptions to s 66 where there is a direct or indirect acquisition of an ESS entitlement in respect of a member or related party.
Where the ESS share is listed, provided the acquisition is at market value, the share can be generally acquired by an employee’s SMSF without contravening s 66. However, where the shares are not listed, an employee’s SMSF may be precluded from acquiring an ESS entitlement that relates to the employee. As discussed, a careful analysis of the legal relationship is required to determine whether the arrangement is one in which there is a direct acquisition by the SMSF from the employee or a related party or it is one in which the SMSF acquires shares directly from the employer (which may, on a legal analysis, be an indirect acquisition from the employee or a related party).
If shares are acquired by an SMSF trustee at less than market value or for no consideration, the ATO will treat the discount as a personal contribution to the fund by the employee (ie, generally a non-concessional, in-specie contribution). The ATO’s website raises the following query:
If the scheme says the member can nominate their SMSF to receive shares or options and the trustee of the SMSF pays no consideration or less than the market value consideration for the shares or share options, the acquisitions by the SMSF result in super contributions if the contributions are made for the purpose of benefitting one or more particular members of the fund, or all of the members in general.
Further, the ATO, in TR 2010/1, state that where the capital of the fund increases and the purpose is to benefit a member or members then a contribution arises.
Thus, where an asset, such as ESS shares, is acquired by an SMSF trustee for no or for less than market value consideration, the discount to its market value is generally treated as a contribution. This may result in an SMSF trustee having acquired the ESS shares at market value once the value of the contribution is added to any other consideration paid to acquire the shares. This is important since an acquisition of an asset below market value can result in any dividends or capital gain derived from the asset being taxed as non-arm’s length income (‘NALI’), which is discussed below.
This ‘contribution’ rule has an important link to the rule in s 66 since a listed security, for instance, can only be acquired from a related party where the security is listed and where it is also acquired at market value. Since many ESS arrangements issue shares at below market value, and s 66 is only satisfied if the shares are acquired at market value, this requirement is satisfied by an employee accounting for the discount as a contribution to their SMSF.
Another important consideration is whether NALI can apply to any dividends or capital gains derived in respect of ESS shares by an SMSF. Broadly, NALI can apply where an SMSF trustee acquires the shares below market value, the SMSF trustee and the other party are not dealing at arm’s length or the SMSF trustee derives more ordinary income or statutory income compared to what might have reasonably been expected to derive had the parties been dealing with each other at arm’s length.
For example, if the SMSF trustee acquired shares in a private company at 10% of their market value, then all dividends and capital gains would be taxed at 47% even if the SMSF was in pension mode. This was broadly the facts in Darrelen Pty Ltd v Commissioner of Taxation  FCAFC 35 where the court found that private company shares issued to an SMSF trustee for around 10% of the value of the public company shares held by the private company would have its income taxed as NALI (under the former ‘special income’ provision in s 273 of the Income Tax Assessment Act 1936 (Cth) which is now in s 295-550 of the Income Tax Assessment Act 1997 (Cth)).
Furthermore, if the employee is working in say a small private company for less than his or her market value remuneration and the amount of dividends is greater than arm’s length (especially if the dividends are in lieu of the lower wages), the ATO could seek to tax the dividend and any capital gains on those shares as NALI. The ATO recently issued a taxpayer alert TA 2016/6 targeting such arrangements.
In particular, the ATO in TA 2016/6 is concerned about arrangements involving an employee or contractor who provides services to an employer or company where, rather than being properly remunerated, the employee or contractor receives a greater dividend from having a shareholding in the employer or principal. The ATO notes in TA 2016/6 that it may apply other anti-avoidance provisions in addition to applying NALI if it comes across this type of activity.
ESS arrangements help motivate and align the interests of employees with their employer’s profit motive. Research confirms companies with ESS arrangements generally outperform companies without one.
Some companies may even offer share and option arrangements on the basis of a greater return on equity provided the employee contributes ‘sufficient sweat labour’. However, SMSFs are at risk of NALI being applied if the employee’s remuneration is below market value.
The documentation relating to the ESS, the company’s constitution and any related documents such as shareholders agreement and disclosures need to be carefully reviewed. Typically, ESS terms includes restrictions in respect of the shares or options which are linked to the employee’s employment (eg, the shares must be disposed of if the employee’s employment is terminated or the employer may have a charge or lien in respect of the shares or options).
SMSF trustees that wish to acquire shares pursuant to an ESS arrangement should be aware of the potential opportunities and risks examined above. A key risk to manage is s 66 of the SISA, which can result in up to one year of imprisonment for anyone involved in the contravention (including an adviser). While we are not aware of anyone being imprisoned in respect of s 66, we are aware of other penalties that have been imposed.
Further, the market value of any contribution also has to be considered where there are any discount on ESS shares. This discount is generally assessable to the employee and treated by the ATO as a personal contribution to the SMSF.
There is also a risk of NALI being applied unless all dealings in relation to the employment relationship are on arm’s length terms. This is especially relevant for small private companies where ESSs are designed to motivate and encourage employees to work for less than arm’s length remuneration. Unless all dealings between the company and related parties are at arm’s length and each employee’s remuneration is at arm’s length, the ATO may seek to apply a 47% NALI tax to any dividends and capital gains derived by the SMSF trustee.
We recommend that SMSF trustees thinking of investing in ESS shares seek expert legal and tax advice. As discussed above, the detailed terms of the arrangement must be carefully examined to determine whether an employee’s SMSF can exercise any such entitlements.
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This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.
Note: DBA Lawyers hold SMSFCPD training at venues all around Australia and online. For more details or to register, visit www.dbanetwork.com.au or call 03 9092 9400.