The Australian Taxation Office (ATO) finalised Taxation Determination 2019/13 Income tax: what is an "employee share trust" (EST Tax Determination) on 6 December 2019, following a consultation period in respect of the draft determination TD 2019/D8 (Draft Determination).
The EST Tax Determination takes a narrower view of the permissible activities of an employee share trust than may be reflected in market practice.
It is recommended that companies review the activities of their employee share trusts in order to identify whether they are consistent with the new ATO guidance.
The EST Tax Determination outlines the ATO's views on the interpretation of the "sole activities" test set out under subsection 130-85(4) of the Income Tax Assessment Act 1997 (ITAA 97). The EST Tax Determination replaces the ATO's previous guidance on the "sole activities" test that was contained in former ATO Interpretive Decision 2010/108 (Withdrawn ID), which was withdrawn on 18 September 2019.
The ATO's view is that the "sole activities" test must be construed narrowly, as it acts as an integrity measure in respect of the employee share trust concessions.
The EST Tax Determination contains examples of activities that it considers will cause an employee share trust to fail the sole activities test (discussed below). The following of these examples are indicative of the ATO's narrow view of permissible activities:
- making a distribution of income or capital to any employee or other beneficiary of the trust, other than amounts related to allocated shares;
- dividend waiver arrangements.
On a positive note, the EST Tax Determination confirms that it is the activities of the trust that are paramount in considering whether the "sole activities" test is satisfied. A trust will not fail the test simply because the trust deed contains discretions or powers which, if exercised, would result in an activity that is not "merely incidental" to the trusts employee share scheme purposes.
The EST Tax Determination confirms the ATO's position that, once a trust loses its status as an employee share trust, it will not be able to regain that status – that is, it has permanently failed the "sole activities" test and will forever be excluded from the tax concessions available to employee share trusts.
Scope of activities that are "merely incidental"
The "sole activities" test for determining whether a trust is an "employee share trust" requires that the sole activities of the trust are:
- obtaining shares or rights in a company; and
- ensuring that employee share scheme interests in the company that are beneficial interests in those shares or rights are provided under the employee share scheme to employees, or to associates of employees, of the company or a subsidiary; and
- other activities that are merely incidental to the activities mentioned in paragraphs (a) and (b).
The EST Tax Determination sets out activities which the ATO considers can be properly characterised as "merely incidental". Some key inclusions and exclusions to note are as follows:
Included as being "merely incidental"
- Borrowing money for the purpose of acquiring shares or rights in the employer company, where no security is provided over the trust assets and the interest payable on such a loan is no more than arm's length commercial rates.
- The transfer of shares to participating employees, or the sale of shares on behalf of such employees and the transfer to the employee of the net proceeds of the sale of those shares, when required under the rules of the employee share scheme.
- Receiving and immediately distributing shares under a demerger or actions in order to participate in a takeover or restructure covered by section 83A-130.
- Using dividends for unallocated shares and interest from bank accounts to pay necessary and incidental costs of administering the trust, as well as pay interest on loans provided for the acquisition of shares or rights in the employer company.
The EST Tax Determination expands on the examples of activities in the Withdrawn ID that are accepted by the ATO as "merely incidental" for the purposes of paragraph (c) of the test.
In particular, the Withdrawn ID acknowledged that "… receiving and immediately distributing shares under a demerger" was merely incidental. The EST Tax Determination expands on this permitted activity to also include "actions in order to participate in a takeover or restructure covered by section 83A-130".
It was hoped that the EST Tax Determination would also clarify that actions taken in common corporate transactions, such as a rights issue or other capital raising transactions, are also merely incidental. Unfortunately, the EST Tax Determination does not resolve this uncertainty. Rather, while the EST Tax Determination states that taking no action in respect of a rights issue will not cause a breach of subsection 130-85(4), they suggest that taking a positive action in respect of a rights issue may cause a breach "where that activity is not considered to be merely incidental to obtaining, holding and providing shares in the employer company to participating employees."
Some comfort can be found in the compendium to the EST Tax Determination, which states that it is expected that participation in a rights issue would satisfy section 130-85(4) in the majority of cases, "however an example of where it would not be satisfied is where the activity was undertaken to further some other purpose".
Excluded from being "merely incidental"
The ATO's list of examples of activities that are not "merely incidental" is now as follows:
- Borrowing money for a purpose other than purchasing shares or rights in the employer company or with security provided over any of the trust assets for the loan, or where the interest payable on the loan is more than arm's length commercial rates.
- Distribution of income or accrued capital from unallocated shares to any beneficiaries of the trust.
- Waiving or relinquishing of dividends or other entitlements on unallocated shares.
- Investing in assets other than shares or rights to shares in the employer company.
- Distributing mainly cash payments to employees rather than shares or employee share scheme interests.
- Providing financial assistance, such as providing a loan to an employee to purchase shares or interests 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 employee share scheme.
- 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.
A trust will not fail the "sole activities" test just because the trust deed has broader powers
The EST Tax Determination provides that, in applying the "sole activities" test the ATO will have regard to activities actually undertaken by the trustee, as opposed to only having regard to powers within the trust documents. That is, even where the trustee has powers which fall outside the "sole activities" test, the trust will not be excluded from the definition of employee share trust unless or until those powers are used by the trustee. Similarly, the fact that a power is provided for in the trust deed does not prevent that activity from being found to be outside the scope of the "sole activities" test.
Enforcement and compliance activity: trusts have until 1 January 2020 to ensure that they satisfy the test
The ATO has indicated that it will not apply compliance resources to investigate employee share trusts for periods prior to 1 January 2020. This includes that the Commissioner will not investigate whether activities undertaken by the trustee prior to 1 January 2020 affect the trust being considered an employee share trust going forward, provided that the "sole activities" test is satisfied on and from that date.
Updates from the Draft Ruling
The Draft Ruling left open for interpretation the ATO's approach to employee share trusts that administered multiple employee share schemes, and failed the "sole activities" test in relation to one of those schemes. The EST Tax Determination confirms the Commissioner's view that, where an employee share trust fails the "sole activities" test for one of its employee share schemes, it loses its concessional status in relation to all employee share schemes for which it is the trust.
By contrast, the EST Tax Determination also confirms that the ATO will only have regard to a trustees activities with regard to a particular trust in determining whether it is an employee share trust – that is, activity by a trustee in relation to one trust which violates the "sole activities" test will not contaminate any other employee share trusts for which the same trustee is appointed.
It is recommended that companies undertake a review of their existing or proposed employee share trust arrangements in order to identify whether the actual activities and trust documentation is consistent with the ATO's view of the "sole activities" test in the EST Tax Determination.
Please contact a member of the KWM tax team if you would like more details regarding the EST Tax Determination or assistance in reviewing your employee share trust arrangements.
A copy of the EST Tax Determination can be found here.