IR issues multiple ESS papers

Inland Revenue (IR) has been busy over the past week, issuing two Interpretation Statements and one Commissioner’s Statement (CS) dedicated to various employee share scheme taxing issues.

The first is the Interpretation Statement (IS) 24/05, titled ‘Employer obligations for Employee Share Scheme benefits paid in cash.’

Usually, the benefit of an Employee Share Scheme (ESS) is provided for in shares, and to make things easier for the employee, the employer can elect (but is not required to) withhold and pay tax on the ESS benefit. Should this election occur, the employer must also deduct student loan repayments, but Accident Compensation Corporation (ACC) earners levy and KiwiSaver do not apply.

However, on occasion, an employee may receive cash instead of shares (a cash-settled ESS benefit), and the IS is targeted towards answering the following questions:

• Is the employer required to withhold tax (and student loan, if any) from the benefit (on the basis that a cash benefit is an ordinary extra pay), or does the employer have the choice to withhold as they do if the benefit is provided in shares?

• Does an employer have to withhold ACC earners’ levy or have KiwiSaver obligations?

To answer the first question, two further questions must be resolved first—is the scheme an ESS, and does the amount give rise to a benefit under an ESS? One thing to note here is so-called phantom share schemes—these are not an ESS, as the employee will never become a shareholder in the company, and consequently, any cash payments will simply be a bonus subject to usual PAYE rules.

However, if you do tick both the boxes, and consequently you do have a cash-settled ESS benefit, then the amount paid is an ‘extra pay’, subject to withholding at the applicable extra pay rate (a flat rate which is determined based on an annualised income calculation). The amount paid is also subject to ACC earners levy and student loan deductions, but not KiwiSaver deductions or employer contributions. There is also no withholding election available to the employer here (this only applies to share-settled benefits) – you cannot elect out in a scenario where withholding is already required.

IS 24/05 is a 41-page document that includes a useful flowchart on page 32 and several examples to illustrate its commentary.

A useful support document to IS 24/05, in my humble view, is IS 24/06, titled ‘PAYE – How an employer funds the tax cost on an Employee Share Scheme benefit.’

The IS aims to explain an employer’s withholding and reporting obligations related to PAYE, student loans and KiwiSaver if the employer wants to fund the cost of tax (and student loan, if applicable) on an employee share scheme benefit provided in shares.

Stop! It is important to note…

If you haven’t already done so, note that the obligation to pay the tax on an ESS benefit rests directly with the employee/shareholder employee and not with their employer. While an employer must now disclose to IR the value of an ESS provided to an employee (at the relevant time), the employer is not obligated to account for the tax payable on the ESS benefit to IR.

Now, either the employer and the employee can agree that the tax payable will be funded by way of a deduction from the employee’s net salary or via the sale of a portion of the shares on behalf of the employee, or the employer could agree to fund the tax cost (as a bonus for example). Under either arrangement, however, the rate of tax payable is determined by the ‘extra pay’ rules.

IS 24/06 explains the nature of the additional payment, an employer’s PAYE, student loan and KiwiSaver obligations, when an employer must gross up the additional payment (and how) and explains an employer’s obligations in reporting the additional payment. Finally, the 26-page IS contains various examples to illustrate the commentary.

To round everything off is the Commissioner’s Statement titled ‘Determining the ‘market value’ of shares that an employee receives under an employee share scheme.’ The document is referenced as CS 24/01 and replaces the earlier CS 17/01.

Under an ESS, employers are required to determine the value of any share benefit that an employee receives and to report this value in the relevant employment information for which the share benefit arises (note that this value is also relevant in determining expenditure or loss for employers in relation to an ESS).

CS 24/01 provides taxpayers with safe harbour valuation methods that the Commissioner will accept. However, it is not intended to provide a definitive and comprehensive set of valuation techniques, and companies may still apply other valuation methods that determine the market value of a share. If a company does use another valuation method, the valuation must reflect the market value of the shares on the share scheme taxing date.

The value of an ESS benefit is calculated using the formula: share value – consideration paid + consideration received – previous income. The first item in the formula is the market value of shares or related rights owned by an employee share scheme beneficiary on the Share Scheme Taxing Date (SSTD), if the SSTD is not triggered by a transfer or cancellation of the shares or related rights.

The 15-page CS discusses appropriate valuation methods for listed and unlisted shares – the latter probably most relevant to us all. With no published share price information, I suspect it’s the area which will raise the most questions. In this regard, the CS permits the use of one of the following:

Option A: an arm’s length value determined by an independent, suitably qualified valuer that conforms with commercially accepted practice;

Option B: a valuation involving the arm’s length issue or sale of the same class of shares to a non-associated third party in the 6 months prior to the SSTD (e.g., a previous capital raising or sale of a parcel of shares) where, if new shares are being issued to ESS beneficiaries, the valuation is adjusted for dilution of existing shares; or,

Option C: a valuation that an appropriate person in the company prepares using an appropriate method. The commentary provides explanations for each option and sets out the types of records that should be maintained in support of whichever valuation method is chosen.

This article from the 'A Week in Review' newsletter was originally published on Monday, August 5th 2024. If you have any questions or would like a second opinion on any national or international tax issues, please get in touch with me at [email protected].

If you want to receive these updates directly to your mail inbox, you can subscribe by clicking here.