Employee share ownership in an innovative economy (2)

In the second of three articles seeking to stimulate thought and debate on the role of employee share ownership in the innovative economy, Mark Todd examines the employee share ownership environment in New Zealand.

Innovation and entrepreneurship are widely recognised as qualities that New Zealand must foster to achieve a prosperous future. If a few relatively minor law changes are made, employee share schemes can play an enhanced role in the transition to a knowledge-based economy.

Unlike many of our competitors, New Zealand does not have an environment that seeks to encourage employee share ownership through tax incentives. We only have one type of tax favoured arrangement, known as "section DF7" schemes after the section in the Tax Act which governs them. However, DF7 Schemes have little or no application to start-up companies because the maximum an employee can be required to pay for shares is $2,340 in any 3 year period. This will seldom (if ever) provide the level of incentive that is required to attract, retain and motivate the highly sought after individuals capable of making a key contribution to a start-up company.

New Zealand companies make relatively wide use of share option schemes and their derivatives. Such schemes provide employees with the right (but not the obligation) to purchase shares in the future at a price set at the outset. These schemes are ideally suited to start-up companies because they provide employees with the benefit of share price increases without exposure to losses if the company does not succeed.

However, the tax treatment of employee share options in New Zealand is relatively unfavourable. While no tax is payable when the option is granted, any gains achieved when the option is "exercised" are fully taxable. By way of example, if the employee has an option to purchase a share for $1 and exercises this right when the share is worth $10 the $9 gain will be taxable.

This significantly reduces the benefit available to the employee under this scheme and makes the employment package less attractive. It also imposes a tax burden at a point in time when the employee has not in fact realised the gain by selling the shares. This in turn creates an incentive to sell the shares to pay the tax and diminishes the effect of the scheme in providing ongoing employee share participation.

This tax position can be contrasted with a number of other OECD countries that provide a wide range of tax incentives to encourage employee share participation. Tax incentives are provided in the UK, US and Ireland but perhaps the most interesting example is the recently established Singaporean Entrepreneurial Employee Stock Option Scheme.

Singapore is, of course, a major participant in the knowledge-based economy in our region. It competes vigorously for the resources required by such an economy including the necessary human resources. The Singaporean Scheme has been established with this in mind and has the following features:

  • An employee can enjoy a tax exemption for 50% of up to S$10 million of stock option gains arising over a period of 10 years, if certain criteria are met.

  • In the first place, the company must qualify. To do this it must carry out business activities in Singapore and must have (at the time the options are granted) gross assets not exceeding S$100 million.

  • Employees also have to qualify. To qualify an employee must work at least 30 hours per week for the relevant company and must own less than 25% of the shares in the company.

  • The options must contain certain specified terms and conditions, but these are not onerous.

  • The tax incentives are structured so that the longer an employee serves, the greater the tax advantage that is provided. This encourages long-term contribution.

If our competitors are taking actions of this sort, we must consider doing so as well. The final article in this series will outline the key impediments in New Zealand and suggest some changes that may assist us to be competitive in the innovative global economy.

Mark Todd is a partner in the Auckland office of Bell Gully. In conjunction with Morel & Co, an investment bank specialising in technology companies, he has established a group interested in the development of employee share ownership in New Zealand.