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

Where under an employee share scheme an employee is granted a right to acquire a share from an employee share trust which requires the employee to pay an amount (the exercise price) to the employer, will the amount paid by the employee to the employer be included in the employer's assessable income under section 6-5 of the Income Tax Assessment 1997 (ITAA 1997)?

Yes. The exercise price paid by the employee to the 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 employer's business.

An employer establishes an employee share scheme (ESS) which is operated through an employee share trust. The ESS is part of the employer's overall remuneration strategy to motivate and reward employees.

Under the ESS an employee is granted rights to acquire shares in the employer company. The rights are granted at a discount and in relation to the employee's employment.

The rights may be exercised after three years on payment of an amount (exercise price) by the employee to the employer.

After the rights are granted but before the rights are exercised, the employer contributes money to the employee share trust to fund the acquisition of shares that the trustee will provide to the employee on exercise of the rights. The trustee acquires the shares either on market or through subscription for shares in the employer company.

When subscribing for shares in the employer, the trustee pays the full subscription price and the employer accounts for the subscription as an addition to share capital.

On exercise of the rights, the employee pays the exercise price to the employer.

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

Whether a particular receipt has the character of the derivation of income depends upon its quality in the hands of the recipient: Scott v. Federal Commissioner of Taxation (1966) 117 CLR 514; (1966) 14 ATD 286; (1966) 10 AITR 367, GP International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124; (1990) 21 ATR 1; 90 ATC 4413.

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 HR Sinclair Ltd v. Federal Commissioner of Taxation (1966) 114 CLR 537; (1966) 14 ATD 194, 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 (1981) 11 ATR 629; 81 ATC 4131, 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 conduct of the employer's business.

In accordance with the ESS, the trustee either acquires the shares on market or it subscribes for the issue of shares using the funds provided by the employer. If the trustee subscribes for the issue of shares, it pays the full subscription price for the shares and the company receives a contribution of share capital from the trustee. The subscription price received by the company from the trustee is a capital receipt of the company.

Whether the trustee acquires shares on market, or by subscription, the payment of the exercise price by the employee to the employer is not a payment for the issue of a share in the capital of the company, but rather a payment, under the terms of the ESS, for the delivery of a share from the trustee of the employee share trust.

The exercise price is a receipt of the company derived in the course of operating the ESS as an integral part of its business operations.

The payment of the exercise price by an employee to the employer is a contribution towards or consideration for the provision of a benefit that is an incidence of employment. The payment of the exercise price reduces the benefit provided to the employee, and more importantly, the cost to the employer of providing that benefit.

Therefore, the receipt by the employer of the exercise price paid by the employee to acquire a share under the ESS is properly regarded as either a product of, or incidental to, the conduct of the employer's business and is included in the employer's assessable income as income according to ordinary concepts under section 6-5 of the ITAA 1997 Note : whether the receipt of an exercise price under an ESS is ordinary income of the employer depends upon a close consideration of the facts and circumstances relevant to the particular ESS. The ESS in this ATO ID can be contrasted with an ESS where the employer grants options to an employee to acquire shares in the employer and, under the terms of the ESS, the employer will satisfy the options by the issue of new shares to the employee on payment of the exercise price. In such a case, the exercise price paid by the employee to the employer is consideration for the issue of shares from the employer to the employee and is a contribution to the share capital of the company. Accordingly, the exercise price is a capital receipt.