Employee Share Ownership in Australia: The Advantages and Disadvantages of ESOPs
AEOA ESOP Policy
This page provides abridged details of the AEOA's policy objectives in relation to expanding Employee Ownership in Australia.
The AEOA recommends that public policy should be formulated so as to promote employee share plans for the following purposes:
- to better align the interests of employees and employers;
- to develop national savings;
- to facilitate the development of sunrise enterprises; and
- to facilitate employee buyouts and succession planning.
Why Employee Ownership Works
For the best study on how employee ownership works successfully, see the UK report "Shared Company".
For the most comprehensive survey of the evidence in support of employee ownership, see the excellent report "ESOPs: 30 Years of Research and Experience" .
ESOP uses
The AEOA supports the view that ESOPs can be used for several purposes.
- Ownership objectives: They can be used to transfer ownership of part, or of the whole of a company to the employees. ESOPs can be used by employees to increase the existing capital of a company. This way employees secure a stake in a business in return for their contribution to its capital expansion.
- Remuneration objectives: ESOPs can be used as a remuneration and employee-incentive vehicle. In this case, shares in the employer’s company are used as a performance-related supplement to existing salary and wages and as a means of enabling employees to share in the long term growth of a business.
- Workplace change objectives: Shares delivered through an ESOP can also be used to ‘change the culture’ of a company. Employee share ownership may help to reduced perceived ‘class barriers’ in the work place.
Each of the three major purposes of employee ownership can co-exist or apply in varying proportions.
See also the "ESO and Workplace Reform" Discussion Forum for more information
The Motives for Implementing Employee Share Ownership
Overall the motives for implementing employee ownership plans can be grouped into six main categories.
• Employee share ownership plans may be implemented in the hope of improving organisational performance.
• There may be direct financial advantages, either through tax advantages or as a source of capital or both.
• The plan can serve as an important employee benefit or as a vehicle to provide retirement income.
• Employee owned companies can be used to preserve employment (through buyouts of firms in distress), or to create employment (through new starts).
• They may be used as a vehicle to transfer ownership if the current owner is interested in selling up.
• There may be philosophical or ideological reasons.
There is an enormous variation in the types of employee-owned enterprises. For convenience, they have been classified into three general categories, according to the degree of ownership.
1. Partially employee owned: those firms which have some employee share ownership but do not meet the criteria set out in 2 and 3 below.
2. Majority employee owned: those firms where the majority of the voting shares are owned by the employees and a majority of the employees participate in the employee share plan.
3. Complete employee ownership: those firms where the employees hold all the voting shares in the enterprise.
See also "Going Ahead with Your ESOP" Discussion Forum for more information
The Advantages and Disadvantages of Employee Ownership
Companies might set up an employee share plan to:
• motivate employees to become more productive
• align employees' interests with those of shareholders
• recruit or retain key employees
• compensate for lower salaries and relieve pressure on cash flow
• remunerate employees in a tax-efficient way
• increase loyalty and reduce staff turnover
• raise working capital
• realise owners' investment
The disadvantages of setting up an employee share plan might be:
• The effect on morale and retention if the share price falls - particularly for share option schemes.
• Administration costs - short-term costs of drawing up and getting a scheme approved, plus long-term costs of managing the scheme and keeping records.
• Dilution of share ownership - as more shares are issued each share you own becomes a smaller percentage of the company - you could lose control of the business.
• Risks of arousing unrealistic expectations among employees of the financial rewards.
• If employees eventually wish to sell their shares in an unlisted company (one without shares on a public stock exchange), you may need to run an internal market for the shares, perhaps through setting up an employee benefit trust.
Positive Change from Employee Share Plans.
Companies and employees respond positively to ESOPs. Some of the areas where ESOP companies have observed positive change include:
• Increased productivity through the sharing of responsibility.
• Improved communications with employees, now part-owners in the enterprise.
• Improvements in the overall work environment.
• Increased reward opportunities for employees.
• Changes in work and culture so that consultation and co-operation become the way things are done.
• An additional source of low-cost funding.
• The creation of buyers for the owner/managers who wish to retire from their business.
• Key staff are attracted and remain with the organisation.
See also the "Research Into Employee Ownership" Discussion Forum for more information
Potential Benefits to Employers and Employees
The potential benefits to employers and employees from implementing employee share ownership are summarised below:
THE EMPLOYER
Benefits may include:
• A new source of low cost funds to grow the business;
• Directors becoming accountable to ‘employees as owners’
• Improved productivity and performance;
• A workforce which is better informed of the enterprise’s activities and able to share in an owner’s perspective;
• A more motivated and committed workforce: better general morale;
• A more service-oriented and client-focused workforce;
• Less industrial unrest and conflict;
• Improved flow of creative, innovative ideas and mutually beneficial changes to the way the enterprise does things;
• Reduced employee downtime costs ( a healthier workplace, fewer sick days, lower absenteeism, etc.).
THE EMPLOYEE
Benefits may include:
• Increased financial rewards, linked to individual and organisational performance;
• A long-term savings plan with minimal investment;
• An increased sense of ‘ownership’ of the enterprise;
• Improved awareness about the ‘big picture’ decisions; directions and corporate plans of the enterprise;
• Management more accountable to employees and concerned with their views;
• Opportunity to influence decisions about products and process;
• Improved communications between management and employees.
For more information on these matters, see the "ESOP Guidelines" and "Employee Involvement" pages. For ESOP examples in private companies, see our "Private Company ESOPs" page.
Principles of Employee Ownership
In order to develop a sound, strategically conceived policy on employee ownership, the following general principles ought to be kept in mind:
- It should be practically possible for the majority of employees to benefit from some form of equity participation arrangement.
- Diverse forms of equity participation are required to enable the majority of employees, especially private sector employees, to secure a stake in their employer's enterprise.
- Employees should be able to use Employee Share Ownership Plans (ESOPs), where feasible, to buy out their employer, or to participate in buy-outs (or buy-ins) in concert with other investors.
- Employees of foreign companies should have the opportunity to share in, and increase, Australian ownership of these firms by means of appropriately designed employee equity plans.
- Employee-owners should have the same rights as other owners. Like them, where applicable, employee owners (where ordinary shares are used) should be able to vote their shares, receive dividends, and be free of any artificial restriction upon the length of time they can hold shares in their employer's company.
- The use of ESOPs as a mechanism for funding the formation of new productive capital, particularly in unlisted companies, should be encouraged.
- All privatisations should be premised upon employees obtaining through ESOPs, or ESOP-like structures, a significant stake in the new enterprise.
- ESOPs should be promoted as a key element in national savings policy, providing a new level of medium-term savings in addition to longer term superannuation, and capable of meeting different objectives through being tied directly to productive investment.
- In order to realise the full savings potential of ESOPs (and, over the longer term, to increase Treasury tax receipts):
- All contributions to savings instruments, and the subsequent returns thereon, should be taxed progressively when the savings are withdrawn and at that point only.
- Employees should be able to roll over all, or part of, the savings accrued in one ESOP into that of their immediately subsequent employer without the savings being subject to tax at the point of termination.
- Tax should only be imposed on realised gains and even then should be divided into: (i) The gain at time of acquisition, which should be taxed as income. (ii) Any subsequent capital gain should be taxed under CGT.
- Major Government economic, taxation, and business regulatory decisions should be subject to an "ownership impact" assessment to determine whether they conform to the above principles and whether they promote a wider and more diversified ownership of our wealth-producing assets.
Current State of Legislation
Division 83A of the Income Tax Assessment Act (December, 2009) provides for:
- A definition of a qualifying employee share plan (i.e. one which complies with the legislation) includes any plan which offers at least 75 per cent of permanent employees of 3 years standing an ordinary share, or right thereto, in the employer's company;
- A tax-exempt plan under which employees can receive up to $1,000 worth of shares per year income tax exempt if the employee earns an adjusted taxable income of $180,000 or less;
- A tax-deferred plan under which employees can defer tax liabilities for up to 7 years based on tax deferred benefits of (i) $5000 per annum in salary sacrifice, and (ii) any further share benefits subject to "real" risks of forfeiture or "genuine" restrictions on disposal;
- Up to a maximum 5% of the firm's voting shares per individual employee;
- A 7-year tax deferral on share options;
- An exemption for option plans from the 75 per cent rule.
(For a more complete explanation of Division 83A, see the "The Current State of Legislation" provided courtesy of Owen Thomas and Associates - see advertisement this page).
Employers and employees are also subject (as of December, 2009) to a TFN-based reporting system to ensure that all tax obligations arising from participation in an employee share plan are fully reported.
General tax law also allows full tax-deductibility for employer contributions to an ESOP.
It will be noted that this legislation falls far short of the Principles of Employee Ownership set out above.
For our reform manifesto presented to the political parties contesting the 2007 Federal elections, see "Sharing in Growth". For what needs to be done on ESOP law reform, see "Future Directions". For more information on ESOP tax provisions, see the Australian government web-sites on our "Links" page.
Obstacles to Employee Ownership
Immediate Obstacles
Whatever its authors might have intended by it, the legislative regime for employee ownership actually sets major stumbling blocks in the way of expanded share ownership. Nor did the "reforms" enacted in December, 2009 (Division 83A of the ITAA) do anything to remove these obstacles. They are:
1. Employee share ownership is biased in favour of listed companies at the expense of unlisted and especially small companies.
This means that only the 13 percent of employees who work for listed companies have favourable opportunities to become employee owners. The major factors which contribute to this bias are:
a. A limit on employees earning, via an Employee Share Ownership Plan (ESOP), more than 5 per cent of the voting shares in their employer's company. This means that most small companies often cannot implement "succession planning" arrangements where the retiring employer uses an ESOP to sell the company to his employees.
b. Restricting ESOPs to ordinary shares in the employer's company. This means that those companies which cannot issue an ordinary share - for example, a wholly-owned domestic subsidiary of a foreign company or a small firm whose owners do not wish to relinquish control before retirement - can do nothing to help their employees become part-owners of the business.
c. Onerous prospectus requirements. These are especially burdensome for unlisted companies and, above all, for small companies. By themselves they represent a major obstacle in the way of issuing shares to employees.
2. A two-tiered system of share ownership: one for traditional shareholders who can hold their equity in perpetuity; and one for employee-owners who - for all practical purposes - cannot hold shares received under a Division 83A tax deferred plan for more than 7 years.
Normally employees who participate in a tax deferred plan will have to sell their shares at seven years to meet Division 83A tax liabilities. This arrangement defeats one of the main objectives of employee ownership which is to promote long-term commitment to the company where employees work.
This is especially relevant to unlisted and small companies for whom an ESOP could serve as the principle method for financing expansion of the business.
Longer-term Obstacles
3. Failure to link foreign investment policy to the promotion of employee ownership.
4. Lack of low-interest money for leveraging ESOPs to finance business expansion.
Removing Obstacles to Employee Ownership
Medium term objectives
Expanding the ESOP Frontier
1. To raise, in the case of small companies, the Division 83A limit on employees holding more than 5% of voting shares.
This measure would provide a major impetus to the use of ESOPs as a succession planning mechanism in the small business sector. The 5% limit means that in small firms where less than 20 employees are willing to participate in a plan, an ESOP structure cannot be used to purchase the company from the retiring owners.
2. To lift the Division 83A prohibition against ESOPs using equities other than ordinary shares and to allow for the use of other equity types - such as redeemable preference shares - useful to small business.
This measure would greatly facilitate the implementation of ESOPs in small businesses where there are severe disadvantages for owners in making employees ordinary shareholders in circumstances other than implementation of a succession plan.
3. To lift prospectus requirements in those cases where complete 'downside risk protection' on the value of the shares is provided.
This measure would be particularly relevant to small business upon whom prospectus requirements weigh most heavily. Easing prospectus requirements would make a major contribution to promoting ESOPs among unlisted companies generally.
4. To enable employees who benefit from a Division 83A tax-deferred ESOP to defer the tax liability until whenever they dispose of their shares.
Division 83A is inequitable in that ordinary shareholders can hold their shares in perpetuity, but employee share holders who benefit from the tax-deferred option are obliged to dispose of their shares at 7 years in order to meet the tax liability on them. The obligation to sell shares to meet tax liabilities directly contradicts one of the major objectives of employee share ownership - to promote long-term commitment to the wealth creating objectives of the business enterprise.
5. Wholly-owned domestic subsidiaries of foreign companies should be able to offer savings plans - which provide, inter alia, shares in companies other than the employer's company - to their employees.
The present restriction of Division 83A against using other than ordinary shares prevents the spread of employee ownership to companies which cannot offer employees an ordinary share. The classic case is provided by wholly-owned foreign subsidiaries. Wholly-owned foreign subsidiaries ought, therefore, to be able to offer employees equity in a savings plan. Employees' equity in a savings plan can be leveraged to effect an employee buy-out (or buy-in). In this way employee ownership can be used to repatriate foreign investment.
Longer term objectives
7. The Federal Government should adopt as policy that when it privatises an Australian Government entity it will specify that
- existing and future employees of the entity must be offered a substantial shareholding in it under an ESOP or similar plan. For example, shares could be allocated under this plan to enable each employee to secure shares to the value of 25 per cent of average weekly earnings in each year.
8. Financiers should be able to claim a tax deduction for special low-interest loans made directly to ESOPs (as distinct making the loan indirectly to the ESOP via the employer) where the loan is to be used for the purchase of new shares in the employer's company.
9. Australian foreign investment rules should stipulate that, after an established period not exceeding 10 years, a foreign-owned company must
- offer shares to its Australian employees through an ESOP or similar structure, and
- provide an opportunity for Australian employees to trade their shares either by listing on the Australian Stock Exchange or by some other mechanism.
Attachment A - The United States Model
US Tax incentives for ESOPs
1. Employer Tax Deduction:
Up 25% of payroll may be deducted from Corporations Tax obligations where the employer makes principal payments on ESOP loans to acquire employer securities for employees in a tax-free trust. Where the ESOP is not financed by a loan, only up to 15% of payroll may be deducted.
2. Employee Tax Deferral:
Stock acquired for employees' accounts is not taxed until distributed usually when the employee leaves the firm.
3. Deferral of tax on sale to an ESOP:
If at least 30% of an unlisted companies shares is sold to an ESOP, tax is deferred on any gain realised on the sale to the extent that the proceeds are reinvested in securities of other domestic operating companies.
4. Dividend Deductions:
ESOP Companies may claim a deduction for cash dividends paid on ESOP-held shares provided the dividends are either applied to repay an ESOP loan or paid out to employees.
5. Pension Plan Reversions:
Employee reversion of excess funds held in defined benefit pension plans are exempt from the 10% exercise tax on such reversion to the extent that the reversion amount is transferred to an ESOP. This relief was originally granted for a three-year period and has not been renewed.
Attachment B - The United Kingdom Model
Tax incentives for ESOPs
1. Employer Tax Deduction:
Employers get relief from corporations tax for setting up and running a Share Incentive Plan – or SIP – which is the government’s preferred model share plan. The relief covers:
- the cost of offering Free and Matching shares
- the salary allocated by employees to acquire Partnership Shares
- the cost of providing Partnership Shares where tis exceeds employee contributions
2. Employee Tax Concessions:
Under the SIP an employee can acquire three categories of shares
1. Partnership Shares
Up to 1500 pounds per employee per employee per annum and tax exempt if held in the plan for 5 years
2. Free Shares
Up to 3000 pounds per employee per annum and tax exempt if held in the plan for 5 years
3. Matching Shares
Up to 2 Matching Shares per 1 Partnership Share valued at up to 2500 pounds per employee per annum and tax exempt if held in the plan for 5 years
4. Dividend Shares
Up to 1500 pounds in dividends per employee per annum can be re-invested in further company shares tax free. Dividend Shares are tax- exempt if held in the plan for 5 years. However, the dividends used to buy Dividend Shares are taxed when Dividend Shares are withdrawn from the plan.
For more information on the development of employee share ownership in both the US and the UK, see the relevant topics on our ESOP Forum under "International Focus". |
