A recent article in The New York Times by David S Miller serves as a reminder of the different tax treatments that can arise when employees acquire shares in a company under a share purchase agreement or through share options.
The article focused on Mark Zuckerberg, the founder of Facebook, who is expected to exercise share options worth US$5 billion of the US$28 billion that his ownership stake in Facebook is said to be worth when it goes public.
The exercise of the options would come at a tax cost as it is expected to produce a tax bill of more than US$2 billion which the writer suggested would "quite possibly make him the largest taxpayer in history". He is expected to sell some of his shares in order to pay the tax bill.
The article points out that, because the United States taxes gains on shares only when the shares are sold and the gain is realised, Mr Zuckerberg may be able to avoid paying tax on any increase in the value of the remaining shares by simply using the publicly traded shares as collateral to fund his lifestyle. The writer suggests that this was a method used by Larry Ellison to pay for a very expensive yacht.
The purpose of the article was to promote a mark-to-market basis for the taxation of capital gains on investments for the super wealthy - i.e. a "Zuckerberg" tax. The objective is not only to collect more tax from the super wealthy, but also to address a perceived inequality between say a Lady Gaga who derives her 'megawealth' from an income stream of royalties and license fees while entrepreneurs who create a company derive their wealth from growth in the value of their shares.
This is a debate which is familiar to New Zealand where the introduction of a capital gains tax has long been debated by various consultative groups including the Valabh Committee in 1990, the McLeod Review in 2001, and the Tax Working Group of 2010/11. Each of these reviews recognised the difficulty of trying to design a successful capital gains tax.
Any capital gains tax which is on a realisation basis could simply prevent transactions happening because holders of assets would defer transactions indefinitely or, as the article suggests, borrow against those assets without realising the gain.
In contrast, a capital gains tax designed to tax gains on an unrealised basis through say a mark-to-market method has the disadvantage that taxpayers would need to find the cash to pay tax on a gain that may never eventuate.
No doubt that debate will continue but in the meantime it is worth revisiting the key features of the taxation of employee share purchase agreements in New Zealand. The fundamental principle is that an employee (or an associate of an employee) who derives a benefit from a share purchase agreement is taxed on that benefit in the year in which it is derived.
The benefit is the difference between the value of the shares received and the cost paid for the shares. The benefit is derived in the year in which the employee (or the associate) acquires ownership of the shares. Where the shares are acquired through share options, the shares are deemed to be acquired in the year the share options are exercised (or sold), and not when the share options are granted or vested. Where a share price escalates in value, the deferral of the tax point under the share option can result in more tax to pay than if the shares were acquired at the beginning.
Although the benefit is included in the employee's "monetary remuneration", the income tax payable on the benefit is not collected through the PAYE system (the benefit is not a source deduction payment like salary and wages). This can potentially expose employees to a surprise tax bill, particularly where:
• they are not normally required to file an income tax return because all of their income is taxed at source (e.g. resident withholding tax on interest and PAYE on salary and wages); or
• the benefit is sufficient to expose taxpayer to use-of-money interest on provisional tax that should have been paid.
Because New Zealand has a tax year which ends on 31 March, there can be a significant advantage from exercising the share options or acquiring the shares in April instead of in March, as the employee's provisional tax liability is then prospective and so there should be no use-of-money interest exposure on underpaid provisional tax.
Many share purchase agreements contain restrictions on when an employee can sell the shares or to whom they can be sold. However, the restrictions are often not sufficient to fall within the limited parameters allowed in the Income Tax Act (i.e. restrictions which can be factored in to reduce the value of the benefit).
Once the employee has obtained the benefit of the shares by way of a share purchase agreement or the exercise of options, then the implications of being a shareholder should also be understood. This will differ if the shares are overseas shares, which could be an interest in a "Foreign Investment Fund", or New Zealand domestic shares.
A well-designed share plan, whether it be an agreement to purchase shares or through share options, can be an effective and valuable tool to retain and incentivise key employees and in some cases allow a transition to new shareholders.
* Iain Craig, BDO New Zealand International Tax Co-ordinator
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