Deferred tax benefit may bring tax surprises
Many executives receive shares and options from their employer as part of the remuneration package. Mostly this form of bonus is received without the need for any immediate cash or tax outlay. And because the shares and options are restricted from sale until some future date they often get filed away in the bottom drawer for some future review.
While this may be a fairly natural response to something that has no immediate impact, failure to manage these “gifts” can result in some nasty surprises.
These bonuses are not “free”. They come encumbered with future taxing points and unless you keep good records and have a clear strategy for managing them you may end up in an unexpected “liquidity trap”. The two case studies discussed below provide illustrations.
Tax assessed at time executive shares vest
Consider Geoff’s situation. He was issued with 100,000 shares in XYZ Limited back in 2008 when the share price was $1.00. He received them at no cost and there were no immediate tax consequences. Yet, he didn’t really own them as they were restricted from sale until June 2010.
Step forward to November 2010 and Geoff has watched his company’s share price soar to $2.10 a share. He has some spare cash and the company’s prospects look great, so he decides to buy some more exposure in XYZ Limited.
He’s feeling pretty good as he just received notice from his employer that the 10,000 shares issued in 2008 became unrestricted in June 2010. He now has full ownership and control of these shares that are trading above their June vesting price of $1.90.
By May 2011, the XYZ share price is a little softer at $1.70, but Geoff is feeling comfortable because he knows he does not have to sell and can ride through this dip in price.
He then receives his tax assessment for 2009/10 and is staggered to find that he has a tax bill of $88,350! His accountant informs him that $190,000 of taxable income was included in his return in relation to the 10,000 shares that vested in June 2010.
Despite Geoff’s objections, he has no alternative but to sell 52,000 of his XYZ shares at $1.70 a share to fund his tax bill. In hindsight, he may have done things a little differently had he been proactively managing this exposure.
CGT discount not available on executive share options
Seven years ago Jerry was issued with 10,000 options to buy shares in his employer, ABC Limited. His accountant at the time recommended that he pay tax upfront on these options as this would allow the gain on any future sale proceeds to be subject to capital gains tax (CGT) rather than income tax. This made sense to Jerry as he expected the share price to rise strongly and wanted to be eligible for the 50% CGT discount to minimise his tax.
The options matured last year when they were deeply in-the-money. They were originally issued when the share price was $25.00 and the price had risen to $49.00 at the time of maturity. Jerry chose to “exercise and sell” his options. This involved exercising the options, at a cost of $250,000, and instantly selling the shares, valued at $490,000. This not only solved his issue of how to fund the $250,000 exercise obligation but also left him with significant cash to reduce his investment debts.
Jerry was elated and celebrated his (and his accountant’s) decision to elect to pay the tax upfront as this allowed him the opportunity to be eligible for the 50% CGT discount. It would halve the tax, saving him up to $50,000!
In May 2011, Jerry receives his tax assessment for 2009/10 and is staggered to find that his tax bill is twice what he had expected! His accountant rather sheepishly informs him that he should have exercised the shares and held them for 12 months to be eligible for the 50% CGT discount. Jerry now has to re-borrow non-deductible debt to fund the additional tax.
In hindsight, Jerry should have planned for how he was going to fund the exercise obligation to allow him to hold the exercised shares for at least 12 months.
Executive shares and options need to be proactively managed
The two examples discussed above illustrate the “liquidity trap” that can arise without a clear understanding of the taxing points associated with Executive Shares and Options. There are numerous other issues to consider, including how you integrate these shares and options into your overall investment strategy.
You can imagine the additional complexities created when both shares and options are issued, each with varying vesting and maturity dates. Add to this the possibility that you receive these annually and the need for a sound strategy and system for managing these exposures is apparent.
If there is one area of your affairs that requires closer attention, it is probably those Executive Shares and Options you have filed away in your “bottom drawer”.