What is a 'real risk of forfeiture' or a 'genuine restriction on disposal' under the new employee sh

Articles Written by Andy Milidoni (Partner), Jane Trethewey

Introduction

The new employee share scheme (ESS) provisions, contained in Division 83A of the Income Tax Assessment Act 1997 (Cth) (1997 Act), apply from 1 July 2009.

The concepts of 'real risk of forfeiture' and 'genuine restriction on disposal' are central to the new provisions. The presence or absence of a real risk of forfeiture will determine (unless the scheme is a qualifying salary sacrifice arrangement) whether deferred or up-front taxation applies under the new rules. A genuine restriction on disposal, while not of itself sufficient for deferred taxation to apply, is relevant in determining when a deferred taxing point occurs (if deferred taxation does apply) and can have the effect of extending the period of deferral after the real risk of forfeiture has ceased to apply.

These concepts are not defined in the provisions but there is guidance in the Explanatory Memorandum (EM) to the Tax Laws Amendment (2009 Budget Measures No. 2) Bill 2009 (Cth) that introduced the provisions and the Commissioner of Taxation (Commissioner) has also issued some guidance.

This article discusses these concepts and how they might be applied by the Commissioner, as well as some practical points to bear in mind.

Real risk of forfeiture

General

Under the new ESS provisions, whether deferred or up-front taxation applies will depend on whether or not there is, under the conditions of the scheme, a 'real risk' that the employee will forfeit or lose the ESS interest (other than by disposing of it) or, alternatively, whether the ESS interest is acquired under a qualifying 'salary sacrifice' arrangement.1 In the absence of such a real risk of forfeiture or qualifying salary sacrifice scheme, up-front taxation will apply - that is, the employee will be subject to tax at the time of acquiring the ESS interest, rather than at the 'ESS deferred taxing point', where deferred taxation applies).

The concept of 'real risk of forfeiture' is therefore a central design feature of the new provisions, designed to further the Government's aim of reducing the incidence of what it perceived to be tax avoidance associated with the elections available under the old provisions in former Division 13A of Part III of the Income Tax Assessment Act 1936 (Cth).2

The EM says that deferral is the appropriate treatment where there is a real risk that the economic benefits of shares or rights may never be realised because the ESS interests may be forfeited, as having employee remuneration at risk in this manner is consistent with the purpose of concessionally taxing employee share schemes, namely to align the interests of employees and employers.3

What is a 'real' risk?

The legislation does not define what constitutes a 'real' risk. Guidance is provided in the EM and some guidance has also been provided by the Commissioner.4

As noted above, the real risk of forfeiture test is intended to provide for deferral of tax when there is a real alignment of interests between the employee and employer, through the employee's benefits being at risk. The EM says it is a principles-based test which is intended to deny deferral where schemes contrive to present a nominal risk of forfeiture without complying with the intent of the law.5

In ATO ID 2010/61, the Commissioner refers to the following dictionary definition of 'real':6

… actually existing as a thing or occurring in fact … genuine; rightly co called; not artificial or merely apparent.

A risk will be a real risk rather than a contrived risk if a reasonable person would:

(a) regard it as something more than a mere possibility (rather than as a risk that is highly unlikely or nothing more than a rare possibility or eventuality);7 and
(b) consider there to be a genuine connection between the forfeiture condition and aligning the interests of the employer and employee.8

The risk does not have to be significant or substantial for it to be a real risk.9

The time frame of the risk will also be relevant. If the risk of forfeiture is over a short period of time and gives access to a relatively long period of deferral, the risk may not be considered to be a real risk.10

The Commissioner says that all of the facts and circumstances of the scheme and the individual circumstances of the employee need to be examined. What may be a real risk for one employee may not be a real risk for another.

The risk must not be within the control of the employee. As Examples 1.19 and 1.20 in the EM illustrate, if the grant of ESS interests is dependent on an act of the employee, this will not represent a real risk of forfeiture. In Example 1.19, the plan required the employee to make regular contributions to the plan and the employee stopped making those contributions - the EM says this is not a real risk of forfeiture. In Example 1.20, the plan required that the employee did not sell prior ESS interests - again, the EM says this is not a 'real' risk.

Condition of the scheme

The real risk of forfeiture must be 'under the conditions of the scheme'.

While the ESS provisions are silent on what constitutes the 'conditions of a scheme', the context indicates that the conditions need to be in written form and form part of the scheme.

Such conditions could be contained in either:

(a) the plan rules for the scheme. The plan rules may provide for the conditions specifically or otherwise allow for conditions to be imposed in respect of individual offers made to employees to whom participation in the scheme is offered; and/or
(b) the offer document given to employees inviting them to participate in the scheme.

For a scheme to be a deferred tax scheme, the plan rules and offer documents will need to be appropriately drafted to meet these requirements.

The conditions also need to be imposed when the employee acquires the interest (that is, at the date of grant of the ESS interest to the employee). A condition representing a real risk of forfeiture that is imposed after the grant date will be disregarded for deferral purposes.

Categories of real risks

Broadly speaking, there are 2 categories of conditions that may give rise to a real risk of forfeiture. These are:

(a) performance hurdles; or
(b) service conditions (i.e. minimum term of employment to be served).

Such conditions are designed to motivate and provide incentives to employees (in the case of performance hurdles) and achieve retention and maintain loyalty (in the case of service conditions).

Such conditions should represent real risks if they are 'meaningful'. However, whether they are in fact meaningful will require an examination of all facts and circumstances of the scheme.

Conditions that are not 'real risks'

A risk will not be a real risk if it is a contrived risk. Such a condition is not more than a mere possibility and is not one in which there is a genuine connection between the forfeiture condition and aligning the interests of the employee and employer. Rather, such a condition will be regarded as being imposed only for the purpose of accessing tax-deferred treatment.

The Commissioner has indicated that some of the factors which might suggest that a condition is contrived include:11

(a) a short minimum term of employment combined with a long disposal restriction period; or
(b) giving the plan operator an overriding discretion to vest ESS interests where performance hurdles are not met, and the operator routinely exercises that discretion.

The Commissioner also says there will not be a real risk of forfeiture where a scheme merely includes conditions such as the following:

(a) a condition which restricts an employee from disposing of their ESS interest for a period of time;
(b) a condition which allows an employee to request that an ESS interest be forfeited; or
(c) a condition which provides for an employee to forfeit their ESS interest if they are dismissed for fraud or gross misconduct.12

Minimum service period

'Safe harbour' rules

The Commissioner has set out certain safe harbour rules for minimum term of employment conditions that he will generally consider constitute a 'real' risk of forfeiture. He says that such a condition is capable of being a condition which imposes a real risk of forfeiture if either:

(a) the minimum employment term is at least 12 months; or
(b) the minimum employment terms is at least 6 months and the deferral period is no more than three (3) years.

Where a condition is outside these parameters, the Commissioner says all the facts and circumstances will need to be examined to determine whether a real risk is involved.13

Choice

Where an employee can make a choice which would lead to the employer withdrawing the ESS interest, this will not be considered to be a condition which imposes a real risk of forfeiture.

Good leaver provisions

The existence of 'good leaver' provisions (as an exception to the minimum service period condition) will not necessarily negate a real risk of forfeiture. The Commissioner says good leaver provisions will not negate a real risk of forfeiture where it can be demonstrated that the employer does not routinely allow for departing employees to retain their ESS interests irrespective of the reasons for ceasing employment. Good leaver provisions that apply where the employee ceases employment for reasons beyond their control, such as death, invalidity or redundancy, will not negate a real risk of forfeiture.

Retirement

A scheme may provide that the employee may retain their ESS interests if they retire (i.e. they cease employment to retire permanently from the workforce, usually having reached a certain age, such as 55) during the forfeiture period. Whether this negates a real risk of forfeiture at the time of grant will depend on the intention and individual circumstances of the employee at that time.

For example, if an ESS interest is granted on the basis that it will be forfeited if a minimum term of employment is not served, subject to a retirement exception, and the employee retires within the forfeiture period, whether the condition represented a real risk of forfeiture will depend on the intention and individual circumstances of that employee at the time of grant of the ESS interest. If it can be demonstrated that the employee had no intention of retiring at the time of grant, there would be a real risk of forfeiture and deferred taxation will apply. If, however, the employee was aware of their imminent retirement and knew that good leaver provisions could be relied on to ensure that their ESS interests would not be forfeited, then this would not be a real risk of forfeiture and upfront taxation will apply.

In Example 1.11 in the EM, the employee is granted rights to receive 7,000 shares in the employer company in 3 years' time, unless he ceases employment before that time, except if he ceases employment to retire, provided he is above a certain age and retires to leave the workforce. At the time of grant, the employee was within 6 months of retirement - the EM says the employee did not have a real risk of losing his shares as he knew that the good leaver provision would protect him from forfeiture.

The Forfeiture Fact Sheet contains an example in which the employee is granted rights to receive shares in her employer but will lose them if she ceases employment within the next 2 years, subject to good leaver conditions, which allowed employees 55 years and older who cease employment within the forfeiture period to retain their shares if the employer is satisfied that they are retiring permanently. The employee is 55 years old when she is granted the rights but has no intention of retiring during the forfeiture period - the Commissioner says that she does have a real risk of forfeiture.

Dismissal

As noted above, a condition which provides that an employee will forfeit their ESS interests if dismissed for fraud or gross misconduct over a certain period of time is unlikely to represent a real risk of forfeiture.

Performance conditions

Performance conditions can either:

(a) be imposed on individual employees and be specific to those employees - for example, individual key performance indicators may have been formulated for each employee; or
(b) relate to the achievement of certain targets by the company as a whole (company wide conditions) - such as share price or total shareholder return (TSR) targets, project completion, the award of new work to the company (e.g. bidding for work by a tender process) etc.

Performance conditions must be meaningful to be regarded as a 'real' risk of forfeiture. They will be meaningful if they can be objectively assessed and their achievement is determined in a transparent and objective way. Some examples of company wide conditions are discussed below.

Market share

A condition may require that the company's market share must increase over a period of time. In Example 1.14 in the EM, the employee has a right to receive 1,000 shares in the employer company if the company's market share has increased by 10% in 12 months' time. The company's market share had been steady over the previous 12 months. The EM says the condition does represent a real risk of forfeiture in that case.

Share price

A condition that the company's share price must be maintained over a period of time may or may not give rise to a real risk of forfeiture, depending on the facts and circumstances of the case.

Examples 1.16 and 1.17 in the EM involve such a condition, both requiring that the company's share price has maintained its value in 24 months' time. In Example 1.16 the value of the company's share price had decreased by 50% in the 12 months preceding the grant of the right and the company was facing financial hardship - in that case, the EM says there is a real risk of forfeiture.

In Example 1.17, on the other hand, the condition was the same but the company's share price had increased by 20% per annum for the past 6 years and continued good performance was forecast - in that case, the EM says there is not a real risk of forfeiture.

A condition that the company's share price must increase by a certain amount over a period of time may constitute a real risk of forfeiture.

Example 1.15 in the EM involves a condition that the company's share price has increased by 10% in 2 years' time. The company's share price had performed broadly in line with the sector index over the past 5 years but had outperformed the consumer price index by an average of 2% - the EM says there is a real risk of forfeiture in that case.

Total shareholder return

A condition may provide that the company's TSR must be in a particular percentile compared to the TSR of a peer group. The Forfeiture Fact Sheet includes an example involving a condition that the company's TSR be in the top 5% compared to the TSR of companies in a specified peer group. The company had a history of regularly achieving a high TSR relative to its peer group - the Commissioner says it is nevertheless a real risk of forfeiture in these circumstances.

Sales targets

The Forfeiture Fact Sheet includes an example of a condition requiring that the company's current year sales are equal to or greater than the previous year's sales. The company had increased sales by 10% in each of the past 5 years and recently took over a major competitor - the Commissioner says this is not a real risk of forfeiture.

Minimum service and performance conditions

Where the scheme has both minimum service period and performance conditions, it will not be necessary to rely on the performance condition if the service condition is sufficient (see 2.6 above).

What if only a portion is subject to real risk?

Where only a portion of the employee's ESS interests under the scheme are at real risk of forfeiture (e.g. if only a portion are subject to performance hurdles or will be forfeited on cessation of employment within the forfeiture period), only the portion that is at real risk will be eligible for deferral.

In Example 1.18 in the EM, the employee was given rights to receive 1,000 shares in one year's time if the company's market share increased in that period or 500 if it did not - the EM says that 500 of the rights are subject to a real risk of forfeiture and 500 are not.

The Forfeiture Fact Sheet contains an example of an employee who is granted rights, under which he will receive 1,000 shares in the employer company in 3 years' time if the company's TSR over the period is in the top 50% of the specified peer group and 600 shares if it is not - in that example, only 400 of the rights are at real risk of forfeiture.

Genuine restriction on disposal

General

If deferral applies (whether because there is a real risk of forfeiture or it is a qualifying salary sacrifice scheme), the ESS deferred taxing point for the relevant ESS interests is determined (in the absence of an earlier cessation of employment and it is before the end of 7 years from the date of grant) by both:

(a) when the ESS interests are no longer subject to a real risk of forfeiture; and
(b) when there are no longer any genuine restrictions on:

(i) disposal of the ESS interest (if the ESS interest is a beneficial interest in a share); or
(ii) exercise of the ESS interest or disposal of the shares acquired on its exercise (if the ESS interest is a beneficial interest in a right).

Thus, while a condition imposing a genuine risk of disposal is not sufficient for deferred taxation to apply, it can have the effect of extending the period of deferral after the forfeiture conditions have ceased to apply.

Condition of the scheme

A restriction is only relevant for determining the ESS deferred taxing point if, at the time the employee acquired the ESS interest, the scheme genuinely restricted the employee from disposing of it or exercising it, as the case may be.14 The Commissioner says that this means that the genuine restrictions must form part of the conditions of the scheme when the person acquires the ESS interest.15

Where an employee acquires an ESS interest which is a right and the restrictions relate to the disposal of the share obtained from an exercise of the right, the restrictions must be in place at the time the right is acquired (rather than when the shares are acquired on exercise). The Commissioner says the condition may be contained in one or all of the following documents:

(a) the plan rules;
(b) the offer document;
(c) other governing documents of the scheme (such as the trust deed if an employee share trust is being used);
(d) documented company policies that the employee is required to comply with (although it may be desirable to expressly incorporate these policies into the plan rules or offer document);
(e) the employee's employment contract (again, it may be desirable to incorporate any relevant terms into the plan rules or the offer document).

What is a 'genuine' restriction?

The ESS provisions also do not define what constitutes a 'genuine' restriction and, again, there is guidance in the EM and some guidance has also been provided by the Commissioner.16

As noted above, a genuine restriction on disposal is relevant in determining the ESS deferred taxing point and can extend the deferral period. The EM says that the deferral period is limited by the ESS deferred taxing points to ensure fairness, continue to align the interests of the employer and the employee and preserve the integrity of the tax system by preventing unlimited deferral on employment remuneration.17 As such, the same sort of considerations that are relevant to a 'real risk of forfeiture' will also be relevant in determining whether a restriction is 'genuine' or has been included merely to prolong the deferral period.

14 Section 83A-120(4)(c) and s 83A-120(7)(b) and (d) 15 ATO Fact Sheet: Deferred taxing points: genuine disposal restrictions (last updated 16 June 2010) (Genuine Restriction Fact Sheet) 16 In the Genuine Restriction Fact Sheet 17 Paragraph 1.191 of the EM.

Kinds of disposal restrictions

Restrictions can be of the following kind:

(a) time restrictions enforced by a holding lock or the shares being held in trust;
(b) statutory restrictions such as those contained in the insider trading laws in the Corporations Act 2001 (Cth);
(c) contractual restrictions, whether contained in the offer document, employment contract or company policies with which the employee is required to comply, where a breach of those restrictions leads to serious and enforced consequences. An example of this would be a company's share trading policy, where that policy is enforced and there are serious consequences for a breach.18

Company policies that require employees (e.g. executives) to maintain a minimum shareholding in the company are unlikely to be sufficient to amount to disposal restrictions, although it may depend on the particular circumstances and whether and how they are enforced.

A provision simply requiring employees to seek permission from a manager before selling any shares will not be a genuine restriction.19

A price condition on exercise of a right or option (e.g. a condition that the option cannot be exercised unless and until the share price exceeds the strike price of the option) can be a genuine restriction on exercise that will defer the ESS taxing point until the price condition is satisfied (in the absence of earlier cessation of employment or ending of the 7 year period), even if the option has otherwise vested. This is notwithstanding that it would not attract the operation of the 'refund' rule if the ESS interest is lost as a result of the condition not being satisfied before the rights expire.20

This is confirmed by Example 1.31 in the EM. In that example, the employee is granted non-transferable options in the employer on payment of an exercise price, which at the time of grant is equal to the market price of the shares. The options will be forfeited if the employee ceases employment within 3 years from grant, which constitutes a real risk of forfeiture. The options become exercisable at the end of 3 years but are not exercisable unless the market price is at least equal to the exercise price and they lapse 6 years from grant. The employee is still employed at the end of 7 years but the options have lapsed without ever having become exercisable in years 3 to 6 because the share price remained lower than the exercise price throughout that time. The EM says an ESS taxing point has not arisen and no amount is included in the employee's assessable income under Division 83A. This indicates that the price condition does constitute a genuine restriction on exercise that extends the deferral period beyond the vesting date (which is at the end of year 3 in the example). It also indicates that expiry itself does not give rise to an ESS taxing point, nor can there be a taxing point after the right has expired.

A genuine restriction can also arise where the employee is offered a choice to be restricted from selling their shares for a period, which choice must be made at or before the time when the employee acquires the interest and be irrevocable.

This is confirmed by Example 1.29 in the EM, in which the employee receives shares in the employer under the employee share scheme, which provides that the shares will be forfeited if she ceases employment in the next 3 years and also offers the employee a choice to be restricted from selling her shares for a 3, 4 or 5-year period, which she must choose when she enters the scheme and her choice will be final. The employee chooses the 4-year period - the EM says that her taxing point will occur in 4 years or at cessation of employment.

When are disposal restrictions lifted?

A restriction will be lifted when the employee is first able to take action to realise the ESS interest and not when the employee in fact takes that action.

Where periodic trading windows apply, the Commissioner regards the restrictions as being lifted at the beginning of the first trading window following the lifting of forfeiture conditions (notwithstanding that the trading window may close and further restriction periods commence if the employee did not dispose of the interest during that first trading window). Likewise, where there are blackout windows when shares cannot be traded, there is no restriction outside the blackout window.

Some practical points to note

Under the new ESS provisions, whether up-front or 'deferred taxation will apply is no longer a matter of employee choice but rather will depend on the features of the scheme (as well as certain circumstances specific to individual employees). Design of schemes is therefore critical. In particular:

  • If up-front taxation is desired - it will generally be necessary to ensure that there is no real risk of forfeiture under the scheme.
  • If deferred taxation is desired - it will be necessary to ensure that either:
    • there is a real risk of forfeiture under the scheme; or
    • the scheme meets the requirements for a qualifying salary sacrifice scheme.

Any forfeiture condition:

  • must be a condition of the scheme at the time of grant; and
  • needs to be carefully drafted and administered to ensure that the risk is 'real' - for example, particular care needs to be taken in relation to 'good leaver' provisions, employer discretions and other exceptions.

In the case of a deferred tax scheme (whether a salary sacrifice or real risk of forfeiture scheme), disposal restrictions can extend the period of deferral but only if they:

  • are genuine; and
  • form part of the conditions of the scheme at the time of grant; and

Disposal restrictions therefore need to be appropriately drafted and administered to ensure these requirements are met.

Consideration should be given to providing the employee with an option to choose a further period of restriction (up to 7 years from the date of grant) once the ESS interest has vested. Any such choice would need to be irrevocable and made by the employee (and in place as a condition of the scheme in relation to that employee) by the time the interest is granted to them.

Given that the deferred taxing point for rights or options that are subject to deferred taxation is now generally when the rights vest rather than when they are exercised, consideration should be given (among other things) to extending the period of deferral by providing:

  • genuine restrictions on exercise - for example, that they can only be exercised at the end of a particular period of time; or
  • genuine restrictions on disposal of the shares acquired on exercise; or
  • in the case of options with an exercise price, providing a genuine restriction on exercise until the share price exceeds the strike price, (in each case, for up to 7 years after the date of grant).

Where deferred taxation applies because of conditions that impose a real risk of forfeiture, consideration should be given to providing for pro-rata vesting on cessation of employment (which is still a deferred taxing point). That is, the scheme could provide that only a proportion of the ESS interests will be forfeited upon cessation of employment and the remainder will vest and not be subject to any restrictions. This would enable the former employee to realise the vested interests in order to fund the tax liability arising in respect of the ESS interests upon cessation of employment.

This is particularly important given that the 'refund' rule that prevents Division 83A from applying where the ESS interest is lost or forfeited no longer applies where the loss or forfeiture is a result of a choice made by the individual (other than a choice to cease employment) or a condition that has the effect of protecting the individual against a fall in market value.


Section 83A-105(3) and (4), respectively. Qualifying salary sacrifice arrangements are limited to ESS interests with a total market value of $5,000 or less per employee per employment relationship per year.
2 Paragraphs 1.14 to 1.16 of the EM
3 Paragraphs 1.51-1.52 of the EM
4 ATO Fact Sheets: ESS - guide for employers (last updated 22 June 2010) and Real risk of forfeiture (last updated 16 June 2010) and ATO ID 2010/61
5 Paragraph 1.158 of the EM.
6 The Australian Oxford Dictionary, 1999, Oxford Press
7 Paragraph 1.156 of the EM.
8 Paragraph 1.158 of the EM.
9 ATO Fact Sheet, ESS - guide for employers.
10 Refer to ATO ID 2010/61.
11 ATO Fact Sheet: Real risk of forfeiture (last updated 16 June 2010) (Forfeiture Fact Sheet)
12 ibid
13 ibid
14 Section 83A-120(4)(c) and s 83A-120(7)(b) and (d)
15 ATO Fact Sheet: Deferred taxing points: genuine disposal restrictions (last updated 16 June 2010) (Genuine Restriction Fact Sheet)
16 In the Genuine Restriction Fact Sheet
17 Paragraph 1.191 of the EM.
18 In Example 1.26 in the EM, the company has a share trading policy preventing employees from trading shares in the company for 3 weeks prior to release of the company's annual and half-yearly financial reports but the policy is not enforced - the EM says this is not a genuine restriction. In Example 1.27, by contrast, the company has a similar share trading policy but the policy also provides that employees found to be in breach of it will have their employment terminated, which is strictly enforced - in that case, the EM says there is a genuine restriction.
19 See Example 1.28 in the EM.
20 The so-called 'refund' rule in s 83A-310 treats Division 83A as never having applied in relation to an ESS interest where the interest is forfeited or lost in certain circumstances, thus entitling the employee to a refund of tax if they have already been assessed under Division 83A in respect of the interest. However, this rule does not apply where the forfeiture or loss is not the result of: (a) a choice made by the individual (other than a choice to cease employment); or (b) a condition of the scheme that has the direct effect of protecting (wholly or partly) the individual against a fall in the market value of the interest.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).

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