1. Introduction
For several decades, the Australian private equity industry has utilised management equity schemes to create greater alignment between the private equity sponsor and management of their portfolio companies, by providing management with the opportunity to participate in ownership of the portfolio companies.
Management equity schemes have delivered:
- participants significant tax benefits (compared to receiving cash bonuses), particularly for high growth businesses and turnarounds, through a 50% discount on capital gains tax (CGT) for individuals on assets held for at least 12 months (50% CGT Discount)1; and
- portfolio companies (and the private equity sponsors) with long-term loyalty from management who are incentivised to remain with the company (at least) until a liquidity event when their incentives are crystalised.
Management equity schemes currently also serve to reduce the cash burden on portfolio companies by:
- management accepting lower salaries in return for holding equity; and/or
- portfolio companies not having to pay bonuses annually to retain management (or having to pay only smaller bonuses).
From 1 July 2027, the Federal Government intends to replace the 50% CGT Discount with a return to a consumer price index (CPI) indexed cost-base treatment, broadly replicating the pre-1999 rules. These changes will materially reduce the tax benefit and attractiveness for participants of management equity schemes, particularly where the participant's cost base is low and indexation may be of little or no benefit. This will influence the structuring of management equity schemes utilised going forward, particularly from 1 July 2027.
Management equity schemes take several forms. The potential impacts of the budget changes on several of the more popular types of schemes are explored below.
2. Loan funded share plans
Loan funded share plans involve management subscribing for a separate class of shares in the portfolio company at market value, funded by a limited recourse loan from the company or a related body corporate. Subject to meeting certain requirements, the loan can generally be interest-free.
What do the budget changes mean for loan funded share plans?
Gains on the disposal of shares may be taxed on capital account under the CGT rules. Under the proposed changes capital gains accruing after 1 July 2027 will be subject to the indexation system rather than the 50% CGT Discount. Capital gains (allowing for indexation) that accrue after 1 July 2027 will generally be included in assessable income and taxed at rates of up to 47%.
Loan funded share plans will continue to be used where issuing shares at market value provides a cost base for indexation, for example in growth equity and mature companies. While the indexation model will likely impose a greater tax burden on participants, they will still have the opportunity to benefit from the companies' growth with little to no personal downside risk (with loans generally being limited recourse to the loan funded shares).
However, for companies the shares in which have a low or nil market value at the time of grant, such as start-ups and turnarounds, indexation will provide limited (if any) CGT relief as there will be effectively no cost base to index. While the Government is currently engaging in consultation to design a 50% CGT discount for early-stage investors (including employee share scheme participants) of innovative start-up businesses, the concession is likely to be narrowly targeted and limited in scope.
In those circumstances, phantom equity schemes may be more beneficial for the company and participants, for the reasons discussed below.
3. Employee share options
Employee share options may be structured as:
- options or performance rights, which fall under the income tax employee share scheme (ESS) rules (ESS options);
- purchased options – options acquired for the current market value of the underlying share and where the future exercise price is nominal; or
- premium priced options – options acquired for market value, typically nil or a nominal amount, because the future exercise price is set at such a premium to the current market value of the underlying share price that the market value of the option (as determined under the income tax regulations) is nil or nominal.
What do the budget changes mean for employee share options?
Subject to certain exceptions (eg, for companies which meet the "start-up" concession), gains under ESS options have always been taxed at ordinary income tax rates of up to 47%. The commercial value of ESS options has been the ability to generally structure them so as to defer the taxing point for the holder until a future liquidity event. ESS options should not be impacted by the proposed changes in the budget.
Purchased options could be preferred over premium priced options, because participants will pay full market value, establishing their cost base for indexation. However, there are downsides to purchased options. First, there is some uncertainty under the law as currently drafted as to whether the indexed cost base of an option can be "rolled-over" into the shares acquired on exercise. Additionally, purchased options cannot generally be funded through an interest-free loan from the company (or a related body corporate), as fringe benefits tax (FBT) is likely to apply unless interest equal to the FBT benchmark rate is charged on the loan.
Premium priced options, however, will provide minimal cost base for indexation, resulting in nearly all capital gains that accrue after 1 July 2027 being assessable income and taxed up to 47%. As such, it is unlikely they will be used.
Premium priced options have been used by some private equity sponsors as a method of having participants pay for their securities from their own funds, so they have some 'skin in the game'. This could still be achieved with purchased options, by having participants pay part of the acquisition price from their own funds, with the balance being loan-funded (subject to the FBT constraints mentioned above).
4. Phantom equity schemes
Phantom equity schemes (or share appreciation rights) mirror a standard cash bonus plan, however, payments are linked to the underlying performance of a share in the company. They are settled as a cash payment equal to the uplift (if any) between a notional exercise price and share price on a liquidity event. Management has “synthetic equity” only and no shares are issued.
One of the reasons phantom equity schemes have been less popular in Australia, compared to share or options plans, is that participants of phantom equity schemes are subject to income tax on cash settled entitlements and the company must withhold and remit amounts to the ATO accordingly (i.e. entitlements are treated as payments of salary – taxed at up to 47%).
What do the budget changes mean for phantom equity schemes?
After 1 July 2027, the tax on gains from shares and options with minimal cost base upon issue (i.e. capital gains taxed at up to 47%) will be very similar (if not the same) as the tax on cash payments received under phantom equity schemes (i.e. also taxed at up to 47%).
Phantom equity schemes, however, can present a benefit to the company that share and option plans do not, as the company could receive a tax deduction for the cash payments made to management under the phantom equity scheme. Given this, phantom equity schemes may become more attractive.
One limitation that may make phantom equity schemes less attractive is that there is no ability to roll-over phantom equity on a liquidity event given the phantom equity scheme will be 100% cash settled. Management can be required to re-invest part of the cash proceeds to obtain equity (depending on the plan terms), but this will need to be on an after-tax basis. This reinvestment would require withholding and remission to the ATO.
5. The future of management equity
A number of submissions have been made to the Senate Standing Committee on Economics in connection with the proposed changes, including by the Australian Investment Council (AIC), highlighting the negative impacts of removing the 50% CGT Discount and moving to an inflation-adjusted model, including the potential loss of talent (and capital) to other jurisdictions with significantly more beneficial CGT rates for participants.
As mentioned, the Federal Government has proposed preserving the 50% CGT Discount for innovative start-ups. However, as noted by the AIC in its submission, this fails to recognise the risk-taking that private equity sponsors, founders and management take when developing, growing or turning-around a business in any other sector. In each case, they risk capital and/or defer income to create successful Australian businesses. Hopefully, the Federal Government will reconsider the need to preserve the existing CGT treatment for (amongst others) management equity across the spectrum of businesses in Australia.
Even if the Federal Government persists with the removal of the 50% CGT Discount with a very narrow exception for innovative start-up companies, management equity will continue to be utilised by the private equity industry in Australia. However, structures that provide management with a cost base (where possible) will be preferred. Where that is not possible, phantom equity should be more carefully considered than in the past, given the potential for a tax deduction for the company.
- The 50% CGT Discount was introduced in 1999, in a move away from an indexation method to address concerns raised in the Ralph Committee Tax Review in 1998/1999 that the indexation method (amongst other things) was not incentivising investment and was out of line with other countries. The Australian Investment Council's submissions to the Senate Standing Committee on Economics in connection with the proposed changes (AIC Submission) illustrates (at Appendix A of the submission) why the Ralph Committee's concerns remain highly relevant today, with Australia capital gains taxes for management and founders to be significantly higher following the changes than in 6 comparable jurisdictions: USA, UK, Canada, New Zealand, Singapore and Israel.
