Employee Share Scheme: assessability to an employer of the option exercise price paid by an employee

Will an amount paid by an employee to an employer as the exercise price of an option acquired under an employee share scheme (ESS), be included in the employer's assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes. The amount of the option exercise price paid by an employee to an employer will be included in the employer's assessable income under section 6-5 of the ITAA 1997 as the receipt of the payment is a product of the employer's business or is incidental to the conduct of the business.

An employee acquires rights (options) to acquire shares in the employer company under an ESS within the meaning of section 139C of the Income Tax Assessment Act 1936 (ITAA 1936).

The ESS, which is governed by plan rules, is part of the employer's overall remuneration strategy to motivate and reward employees.

The plan rules provide that the option exercise price is payable by the employee directly to the employer.

The employer has established an employee share trust (EST) to acquire and hold shares in the employer company, to meet future obligations arising from the exercise of options by employees.

The employer makes irretrievable cash contributions to the trustee of the EST to enable the trustee to acquire shares in the employer company either on market or by subscribing for new shares.

Under subsection 6-5(1) of the ITAA 1997, assessable income includes amounts that are income according to ordinary concepts.

A receipt that is part of the proceeds of a taxpayer's business, or a product of or incidental to the conduct of the business, is income of the taxpayer according to ordinary concepts even though the amount may not be regarded as a usual or normal receipt, as illustrated by the following cases.

In H.R. Sinclair Pty Limited v. Federal Commissioner of Taxation (1966) 114 CLR 537; (1966) 14 ATD 194; (1966) 10 AITR 3, the High Court determined that a refund of royalty payments made to a saw miller in respect of royalties paid in previous years was part of the proceeds of the taxpayer's business and properly formed part of the taxpayer's assessable income in the year of receipt.

In Automatic Totalisators Ltd v. Federal Commissioner of Taxation (1968) 119 CLR 666; (1968) 15 ATD 170; (1968) 10 AITR 763, the High Court found that a rebate of payroll tax paid to the taxpayer as a consequence of increased export sales in previous years was a trading receipt and assessable income of the taxpayer.

In FC of T v. Reynolds 81 ATC 4131; (1981) 11 ATR 629, the taxpayer was permitted by a lessor to sell a leased truck that he used in his log hauling business and to retain the surplus of the proceeds of sale over the payout figure for the lease. The Supreme Court of Tasmania determined that the surplus that the taxpayer retained was incidental to the taxpayer's conduct of his business and was therefore assessable income.

The ESS is part of the remuneration strategy of the employer and as such is an integral part of the employer's business. It follows that payments and receipts associated with the operation of the ESS are also part of that business.

Even though a share acquired by an employee on exercise of an option acquired under the ESS is not acquired under an employee share scheme within the meaning of section 139C of the ITAA 1936, the exercise of the option and subsequent acquisition of a share is carried out in accordance with the plan rules that govern the overall arrangement between the employer and employee.

Just as the contributions paid by the employer to the trustee of the EST to acquire shares are deductible under section 8-1 of the ITAA 1997 because they are considered an ongoing expense of conducting the employer's business, the receipt of payments by the employer in the form of an exercise price paid by an employee is also considered to be an incident of conducting the employer's business.

Both the payments to the trustee and the receipt of the exercise price for an option are integral parts of giving effect to the operation of the plan that governs the ESS.

The treatment of the receipt of the exercise price of an option as ordinary income of the employer is consistent with the treatment of a recipients' contribution, a recipient's payment or recipient's rent received by an employer in relation to the provision of fringe benefits.

Miscellaneous Tax Ruling MT 2050 provides that such amounts paid to an employer are assessable income of the employer for income tax purposes because they are: • part of the proceeds of the employer's business, or • a product of the business, or • incidental to the conduct of the business.

Therefore, the receipt by the employer of the option exercise price paid by the employee to acquire a share under the plan rules is properly regarded as either a product of the employer's business or incidental to the conduct of the business and is included in the employer's assessable income as income according to ordinary concepts under section 6-5 of the ITAA 1997.