Employee share scheme NALI doubts

The introduction of the non-arm’s-length expenditure rules has now brought uncertainty over employee share schemes involving SMSFs. DBA Lawyers director Dan Butler and senior associate Shaun Backhaus give their insights into the current status of the situation.

Acquiring shares under an employee share scheme (ESS) via an SMSF may appear attractive, but substantial uncertainty has arisen following the ATO’s recent Law Companion Ruling (LCR) 2021/2 on the application of the non-arm’s-length income (NALI) rules to such a transaction. This ruling focuses on NALI arising from the non-arm’s-length expenditure (NALE) changes to section 295-550 of the Income Tax Assessment Act (ITAA) 1997 that came into effect from 1 July 2018.

Typical ESS

Many employers, including small, medium and large employers, seek to encourage the ir employees to work in the best interests of the company by offering an ESS to align their employees’ interests with the business. Research suggests companies having an ESS generally perform better than companies that do not offer such plans.

Under an ESS, companies typically offer employees the opportunity to acquire shares in the organisation at a discounted price.

There are also a range of tax rules that cover the taxation of ESS interests and certain employees may qualify for some tax relief, such as the ability to defer the taxing point or obtaining a more favourable tax treatment compared to ordinary income under section 83A-115 of the ITAA.

Many ESS allow employees to nominate a related entity, such as a family member, a family company, a family trust or an SMSF, to acquire the shares on offer. Naturally, section 66 of the Superannuation Industry (Supervision) (SIS) Act 1993 needs to be considered if an SMSF acquires an asset from a member or related party. However, we will focus solely on the potential application of NALI in this article.

Note the tax rules generally assess the employee on any discount granted via an ESS even if the employee nominates another family member or related entity, such as an SMSF, that ends up acquiring the shares.

ESS discount treatment prior to LCR 2021/2

The ATO generally treats discounts on shares as assessable income to the employee.

Where the shares are nominated to an SMSF, the ATO has also treated any discount as a contribution. This is confirmed on the ATO webpage QC 26221 where the regulator states: “A super contribution is anything of value that increases the capital of a super fund and is provided with the purpose of benefiting one or more particular members of the fund, or all of the members in general.

“For example, when shares acquired under an ESS are transferred to an SMSF at less than market value, the acquisition results in a super contribution because the capital of the fund increases and the purpose of the acquisition is to benefit a member, or members, of the fund.”

The impact of LCR 2021/2 on ESS shares acquired by SMSFs

The ATO states in LCR 2021/2 that:

“[18] [NALE] incurred to acquire an asset (including associated financing costs) will have a sufficient nexus to all ordinary or statutory income derived by the complying superannuation fund in respect of that asset. This includes any capital gain derived on the disposal of the asset…”

It therefore appears the purchase by an SMSF of an asset like a share at a discount will result in all future dividends and net capital gain on disposal of that asset being treated as NALI and broadly taxed at 45 per cent. Moreover, the amendments introducing the NALE changes to section 295-550(1)(b) and (c) of the ITAA apply retroactively, regardless of when the ‘scheme’ was entered into. Thus, it appears SMSFs may be exposed to NALI on dividends and net capital gains for shares acquired at a discount under ESSs, despite those shares being acquired prior to 1 July 2018.

This analysis would appear to provide a big adverse impact on SMSFs acquiring ESS shares at less than market value. As such, advisers now need to alert clients to this risk or face potential professional negligence claims.

Does TR 2010/1-DC have any relevance?

The ATO also recently issued a revised draft for consultation ruling on what is considered a contribution in the form of Tax Ruling (TR) 2010/1-DC. This revised ruling seeks to clarify the divide between what is a contribution versus what is NALI. In particular, the ATO’s broad view is that an asset purchased for less than its market value gives rise to NALI. In particular, paragraph 25C states:

“25C. In circumstances where an … [SMSF] … purchases an asset under a contract at less than market value, the superannuation provider has incurred [NALE] under a non-arm’s-length dealing for the purposes of applying the [NALI] provisions in section 295-550. We do not consider that the difference between the consideration paid (if any) and the market value represents an in-specie contribution being made as the asset has been acquired under the terms of the contractual agreement and not through an in-specie contribution.”

An SMSF typically purchases ESS shares by paying the company directly. The company provides the discount to the SMSF as part of the ESS provisions. These provisions form part of the contractual terms and conditions relating to the SMSF acquiring the ESS shares as the nominated purchaser.

Thus, it appears the ATO’s latest view is that discounts offered to SMSFs on ESS shares are no longer contributions. This is a major change to the long-established practice based on TR 2010/1, which has been a binding public ruling that has been relied on for the past 11 years or more. The ATO’s latest draft view also differs from its current view reflected on its website at QC 26221.

TR 2010/1-DC remains in draft as a range of professional bodies have made submissions to the ATO to clarify the uncertainty with LCR 2021/2 before they can consider what submission can be made in relation to TR 2010/1-DC.

Is there a concession for certain discounts in LCR 2021/2?

LCR 2021/2 at [51] states:

“51. A complying superannuation fund might enter into arrangements that result in it receiving discounted prices. Such arrangements will still be on arm’slength terms where they are consistent with normal commercial practices, such as an individual acting in their capacity as trustee (or a director of a corporate trustee) being entitled to a discount under a discount policy where the same discounts are provided to all employees, partners, shareholders or office holders.”

However, many ESSs are only offered to a particular class of employee, for example, senior managers and executives, rather than to all employees and, in certain cases, shares may be offered to greater than say 75 per cent of permanent employees who have completed at least three years of service, for example, as required by section 83A-105 of the ITAA. Importantly, an offer to 75 per cent or similar cohort does not satisfy the ATO’s discount policy in LCR 2021/2 at [51].

The above analysis highlights the substantial uncertainty arising on this subject as a result of the ATO’s position reflected in LCR 2021/2 and 2010/1-DC.

Conclusion

SMSFs that acquire shares at a discount via ESSs risk NALI being applied to future dividends (including any franking credits) and any net capital gain on future disposal of the shares. We recommend that given the uncertainty that currently exists as outlined above, before an SMSF acquires any further ESS shares, expert advice from a tax expert with superannuation experience in dealing with the latest NALI developments be obtained. Indeed, advice should be sought before any dealing with shares previously acquired under an ESS as the tax impact is now subject to substantial uncertainty.

Companies and advisers providing ESS interests should be updating their disclosures to point out the uncertainty and risks noted above.