ATO ID 2007/217: Employee share scheme: whether payments by an employer company to a trustee to acquire shares to be later provided to employees result in the company deriving assessable income
Date of decision: 22 November 2007
Year of income: Year ended 30 June 2008 Year ended 30 June 2009 Year ended 30 June 2010 Year ended 30 June 2011 Year ended 30 June 2012
Business line: Public Groups and International

Issue
Where, in respect of rights granted to an employee under an employee share scheme, an employer makes contributions to the trustee of a trust, which are used by the trustee to obtain shares which are to be provided to the employee on the exercise of those rights, will the employer derive ordinary income assessable under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) at the time the contributions are made or at the time the shares are provided?

Decision
No. The contributions by the employer to the trustee of the trust will not result in the employer deriving ordinary income assessable under section 6-5 of the ITAA 1997 at the time the contributions are made or at the time the shares are provided.

Facts
An employer company has established an employee share acquisition scheme. Under the scheme employees acquire rights to acquire shares in the company. The rights are acquired for nil consideration and are subject to vesting conditions. On vesting, the rights become exercisable and employees are entitled to be provided with shares in the company. To provide shares to employees under the scheme, the employer company makes contributions to the trustee of a discretionary trust established for the purposes of the scheme (pre-funding arrangement). Under the terms of the trust deed, the trustee applies the funds to acquire shares in the employer company and holds the shares on trust in anticipation of the rights vesting. Dividend income from the shares held by the trustee is applied by the trustee to acquire further shares. The trustee is assessed on this income under section 99A of the Income Tax Assessment Act 1936 (ITAA 1936). The amount of the employer company's contributions under the pre-funding arrangement is calculated to meet its estimated future liability to provide shares under the scheme and takes into account the trustee's tax and administration costs. When an employee exercises a right in accordance with the scheme, the trustee transfers a share to the employee for nil consideration. It is expected that the total value of shares that will be distributed to employees on the exercise of rights will exceed the total amount of the payments made by the employer company under the pre-funding arrangement.

Reasons for decision
Summary: The pre-funding arrangement is comparable to a hedge against a future liability where the extent of the liability is uncertain. While it is expected that the share price at the vesting day will be higher than when the trustee acquired the share, any financial advantage that might flow to the employer company from the pre-funding arrangement is contingent on an increase in the price. It is not possible for the employer company to estimate the extent of any advantage it might gain under the pre-funding arrangement, as that is dependent on the extent to which rights vest and the share price at the time rights are exercised. At the time the payments are made, any gain to the employer company is contingent and unascertainable. It is not capable of being reflected in the company's accounts. These facts contrast with the facts in Federal Commissioner of Taxation v. Orica Ltd (1998) 194 CLR 500; (1998) 98 ATC 4494; (1998) 39 ATR 66 ( Orica ) and Commissioner of Taxation v. Unilever Australia Securities Ltd (1995) 56 FCR 152; (1995) 95 ATC 4117; (1995) 30 ATR 134 ( Unilever ). In those cases a taxpayer company contracted with a third party who promised to meet its future liabilities to redeem debentures issued by the company some years previously. The consideration provided by the company under the liability assumption agreement was approximately equal to the present value of the future liabilities and was less than the principal amount of the debentures. The liability assumption agreement did not result in the defeasance of the company's primary liability under the debentures at law but did, for practical purposes, relieve it of its future obligations. In each case the court held that the difference between the amount paid as consideration under the liability assumption agreement and the amount the company would have had to pay in the future to redeem the debentures was a gain to the company - a capital gain in the case of Orica and income under ordinary concepts in the case of Unilever . In Unilever the gain was held to come home to the company at the time the debentures were redeemed. In the case of Orica Ltd, the Federal Court subsequently held that the capital gain was deemed to come home to the taxpayer at the time the assumption agreement was made, by virtue of section 160U of the ITAA 1936 (see Orica Ltd & Anor v. Federal Commissioner of Taxation [2001] FCA 31; (2001) 2001 ATC 4039; (2001) 46 ATR 218). In Orica and Unilever the liability assumption agreement gave rise to a notional gain that was reflected in the company's accounts for the income year in which the company made the payment. There was no element of risk mitigation against an uncertain future liability, unlike the present case. In addition, the arrangements in Orica and Unilever were contractual and gave rise to contractual rights. In this case, the pre-funding arrangement was not contractual and involved payments to a trustee. For this reason the broader context has greater significance in determining the nature of the payments by the employer company. That context includes the various relationships and agreements that make up the plan and the commercial and intangible benefits that flow to the employer company from its nature as an employee incentive. The payments relate to these benefits, which are enjoyed by the employer company from the commencement of the scheme and are not dependent on the exercise of rights by employees. In the context of the plan as a whole, for income tax purposes, payments made under the pre-funding arrangement are regarded as being outgoings on revenue account that constitute a business expense of the employer company; they are not treated as payments towards the discharge of its future liability. For these reasons , the employer company's payments under the pre-funding arrangement do not result in the company deriving income under section 6-5 of the ITAA 1997, either at the time the payments are made or at the time the trustee discharges the company's liability to employees by providing shares.

Legislative references: Income Tax Assessment Act 1997 section 6-5 section 8-1
Case references: Federal Commissioner of Taxation v. Orica Ltd [1998] HCA 33 (1998) 194 CLR 500 (1998) 39 ATR 66 98 ATC 4494
Related ATO interpretative decisions: ATO ID 2005/181 | ATO ID 2002/1074
Subject references: Debt defeasance Employee share schemes & options