Employee share schemes - proposed reforms to tax collection mechanism

Monday 20 April 2015

Authors: Jarrod Walker and Caleb Saunders

​Overv​​​iew

Benefits derived by employees under share (including share option) schemes are usually taxable income to the employees. The employees must declare the income in tax returns and pay tax on that income at their marginal tax rate. Benefits so derived are not taxed under the “pay as you earn” (PAYE) system, nor are they fringe benefits.

From a practical perspective this can raise compliance and cash flow issues for employees. An employee may not be aware of the obligation to file a tax return and/or may not have the cash to pay the tax. Selling some of the shares to fund the tax liability is not always an option as shares might be subject to “lock-up” arrangements restricting their sale, or there may be no ready market into which the shares can be sold. The employee may also become subject to the provisional tax system as a result of the income, creating additional compliance problems.

There is nothing new in this problem and employers have often sought to ease the compliance burden for their employees by looking at ways of treating gains under share schemes as PAYE income or a fringe benefit, thereby ensuring that tax is paid on time and relieving employees from the need to file tax returns. Based on current law however, there is no technically correct way of achieving that result.

The Inland Revenue has now issued a discussion paper on this topic, “Simplifying the collection of tax on employee share schemes”. The paper acknowledges the problems with the current collection mechanism for share scheme income and seeks submissions from interested parties on potential solutions.

Key questions posed

The Inland Revenue proposes taxation at source for this income, through either the PAYE or fringe benefit tax (FBT) systems or through a new withholding tax regime. The Inland Revenue poses two key questions in its paper:

  • What is the appropriate source taxation system, either the existing PAYE or FBT regimes, or a new withholding regime altogether?

  • If source taxation is adopted, should it be compulsory or optional (and, if it is compulsory, should employers be able to select which of the source taxation regimes they use)?

The Inland Revenue’s preference is not to introduce a new withholding system, as the existing PAYE and FBT regimes are already well developed and employers are familiar with them. If a preference is expressed between the existing PAYE and FBT systems, it is for PAYE, as the Inland Revenue notes that not all employers are required to operate an FBT system and PAYE reporting and payments are more frequent than for FBT.

Using the PAYE system

An obvious issue with using the PAYE system is that share scheme income is not cash, so there is nothing to “withhold” the tax payment from. That problem already exists in the tax system however, with respect to accommodation provided to employees. The value of accommodation provided to employees is taxable income subject to PAYE “withholding”, and is not a fringe benefit as one might expect. 

The Inland Revenue notes that employers making a payment through the PAYE system on account of share scheme taxation may require employees to reimburse them for that tax payment (for example by deduction from other, after tax, cash pay). Instead, the Inland Revenue notes that employers may choose to gross up the share scheme benefit by way of a cash payment on account of the tax liability. 

However, a gross up arrangement may not be plain sailing for all employers. A gross up obligation may represent an unwelcome cash drain for the employer (for instance, share schemes are often popular in start up businesses). Further, the amount of the gross up will often not be determinable at the outset of the scheme. In an option scheme, for instance, the gain will not be quantified until the option is exercised at some point down the track. Share price appreciation over the term of the scheme would be welcomed by employers and employees alike, but would lead to an increased gross up obligation to employers on account of employees’ tax liabilities.

An elective regime?

The Inland Revenue acknowledges that some employers may prefer to have the choice whether to use source taxation as a collection method or to leave employees to satisfy their own tax liabilities (as is currently the case). If choice is permitted (which does not appear to be favoured by the Inland Revenue), the Inland Revenue would prefer to see the choice resting with employers, not employees, and for employers to be required to notify the Inland Revenue as to which employees received benefits (and how much) under share schemes.

There are merits in an elective regime. This would presumably appeal to employers which are able to offer employees participation in a share scheme but do not want the cash flow burden of having to gross up for resulting tax liabilities.

The obligation on employers to notify the Inland Revenue of benefits derived by employees would need to be thought through. Depending on the details of the relevant share scheme, an employer may not know when an employee derives a benefit under the scheme and the amount of that benefit.

Other implications

The Inland Revenue notes that transitional measures may be required to deal with existing share schemes, on the basis that they will have been entered into without contemplation of potential employer liability to withhold PAYE or pay FBT on benefits derived by employees. The Inland Revenue notes “grandparenting” and a “phase-in” period as potential options.

It also comments on consequential implications of the proposed reforms such as employer deductions for share scheme costs, the treatment of share scheme benefits where the employee provides services in New Zealand and offshore and the treatment of share scheme benefits for social policy purposes. The Inland Revenue does not propose changes in these areas.

Making a submission

The Inland Revenue calls for submissions by 5 May 2015. A copy of the Inland Revenue’s discussion paper can be accessed here. If you would like to make a submission to the Inland Revenue or otherwise discuss the proposed reforms, please contact me or your usual adviser at Bell Gully.​​​


Disclaimer

This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.

For more information
  • Jarrod Walker

    Partner Auckland
Related areas of expertise
  • Tax