Disappearing down the “blackhole” – ATO releases draft tax determination regarding the deductibility of ESS expenses

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On 23 February 2022, the Australian Taxation Office (ATO) issued Draft Determination TD 2022/D2 - Income tax: deductibility of expenses incurred in establishing and administering an 'employee share scheme' (TD 2022/D2) which considers the deductibility of expenditure incurred by employers to establish and administer employee share schemes (ESSs).

TD 2022/D2 applies in relation to expenses incurred by an employer in establishing and administering an ESS as part of its remuneration strategy, including establishing and administering an ‘employee share trust’.

In essence, the ATO’s views are that certain costs incurred by employers in relation to their ESS (such as establishment fees and amendment expenses) are not immediately deductible on the basis that they are on capital account, but may be deductible under the “blackhole” provisions contained in section 40-880 of the Income Tax Assessment Act 1997 (Cth) (1997 Act) over five years.

The ATO’s views in TD 2022/D2 appear to build upon the findings of the Full Federal Court in Clough v Commissioner of Taxation [2021] FCAFC 197, where costs incurred to cancel employee options and equity rights in the context of a takeover of a company were found to be on capital account.  However, it is arguable that the ATO’s views in TD 2022/D2 go beyond what the Court found in that decision, given that the decision looked at an instance where ESS-related payments were made in the context of a wider corporate transaction.

The ATO’s views in TD 2022/D2 also challenge how many would consider that the capital / revenue distinction operates in the context of employees and costs related to those employees.  Accordingly, TD 2022/D2 appears consistent with a trend from the ATO’s perspective to push where the “line” is to be “drawn” between capital and revenue, to increase the types of expenses which the ATO considers should be regarded as “capital”.

TD 2022/D2, and the ATO’s views regarding how the capital / revenue distinction applies in the context of employee equity plans, will no doubt be a surprise to many corporates who have such arrangements in place, and who may have treated such expenses as being fully deductible in the year in which they are incurred on the basis that they are an expense incurred in connection with the remuneration and incentivisation of their employees.  For such corporates, TD 2022/D2 may present some concerns especially because the ATO’s views in TD 2022/D2 are stated to have retrospective effect.

TD 2022/D2 also raises a number of issues of how other ESS-related expenses should be treated, such as contributions to and expenses incurred by ‘employee share trusts’, and how the ATO’s views in TD 2022/D2 can or should impact on the tax treatment of such amounts.

It should be emphasised that the draft determination is in draft only, and it is possible that the ATO could amend or withdraw the draft determination prior to finalisation.  To this end, the ATO has invited submissions on TD 2022/D2.  Submissions are due on 25 March 2022.

A link to TD 2022/D2 is available here.

Summary of ATO’s views

The ATO differentiates between three main types of expenses which may be incurred by employers in relation to their ESS:

  • “Establishment expenses”, which are incurred in setting up the ESS as part of the employer’s remuneration structure.
  • “Amendment expenses”, which are incurred in amending the ESS.
  • “Ongoing expenses”, which are incurred in administering and operating the ESS.

Establishment and amendment expenses

In the ATO’s view, the establishment and amendment expenses are capital or of a capital nature.  In quoting from seminal cases which consider the revenue / capital distinction (being Sun Newspapers, GP International Pipecoaters and Sharpcan), the ATO argues that:

  • An ESS sets up a strategy to remunerate employees to reward, motivate and retain staff while linking some of their personal remuneration to shareholder wealth creation.  In this respect, the ESS adds to the business structure of the employer company and is established to deliver benefits to its employees.
  • These expenses are one-off in nature and used in setting up or amending the ESS as part of the employer company’s remuneration structure.  The character of the advantage sought is the enduring benefit of having the ESS in its business structure to deliver ESS interests.
  • In comparing the business structure after the payment of establishment expenses with the expected structure but for the expense, an employee company would not have been able to offer its employees an ESS interest.

Therefore, the ATO would disallow a deduction under section 8-1 of the 1997 Act for the establishment and amendment expenses.  However, the ATO considers that these expenses would be deductible to the employer over five years under section 40-880.

Ongoing expenses

Conversely, the ATO considers that the ongoing expenses are regular and recurrent (i.e. not “one-off” in nature), and do not add to the business structure of the employer.  Therefore, ongoing expenses are deductible under section 8-1 of the 1997 Act.

Date of effect

We finally note that TD 2022/D2 is proposed to have retrospective effect.  This would require employers to amend prior-year tax returns if they have treated ESS-related expenses differently to the position detailed in the determination.  

Next steps

Please contact a member of the KWM Tax Team if you would like more details regarding the implications of TD 2022/D2, or if we can assist in preparing a submission in response to the draft determination.

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