We’ve talked a little about US equity taxes, but now let’s turn to a different country, and discuss how those same taxes are applied in Australia. If you’re not subject to Australian taxation this might sound irrelevant to you, but we’re going to need two countries to talk about the final details of international tax, so I’d encourage you to stick with it. As ever, I’m not a tax professional: if you spot something that seems off here, I’d love to hear from you.
🇦🇺 An overview of Australian taxes
Overall, the Australian tax system is much less complicated than the US system. While some taxes are levied at a state level (GST, land tax, and payroll tax being among the most common), none of these taxes need to be considered by individuals for income or capital gains. Because of this, the amount of tax you’ll pay on equity is the same, regardless of where in Australia you live. This simplifies our discussion, since we’ll only need to talk about how equity is taxed under one system.
Like the US, Australia’s income and capital gains tax system is progressive, with tax rates ranging from 0% to 45%. Australia has an additional 2% Medicare tax levied on most taxpayers, on all income, taking the top marginal tax rate to 47%. As in our discussion of US taxes, we’ll assume that all earnings are in the top tax bracket for simplicity, though the actual amount of tax you would need to pay is lower. (Note that Australia has a separate Medicare levy surcharge, chargeable if you earn over a certain amount and don’t have private health insurance. The cost of insurance isn’t related to your income and is approximately fixed, so we’ll leave the levy out, since in the limit you pay for private health insurance and its effect would round to $0).
Simplifying our discussion further, unlike the US tax system, the Australian system does not allow filing joint returns. While the amount your spouse earns might affect your eligibility for social welfare, it will not affect the amount of tax you pay. All individuals who earn an income must file their own returns.
📈 Capital gains tax
The implementation of capital gains taxes is quite different in Australia to the US. In Australia, capital gains on assets held for less than 12 months count as normal income, and are subject to the same 47% tax that all other income is. Capital gains on assets held for at least 12 months are eligible for a “capital gains tax discount”. While taxpayers must still include their gains in their normal income, they only include half the value of the gains, provided the asset was held for at least 12 months. For example, if you were to purchase a car for $1000, and sell it at least a year later for $2000, you would declare an income of $1000/2 = $500 on your tax return. That halved amount would then be taxed at 47%, as with all income, yielding an effective tax rate of 23.5%.
💼 RSUs in Australia
The issue of whether employee equity is capital in nature – i.e. the result of an investment decision – or compensatory – i.e. part of your income – has also been problematic in Australia. As in the US, the Australian Tax Office (ATO) addressed the issue by creating a particular set of rules for employee equity, called the Employee Share Scheme (ESS) provisions. Equity granted to employees is taxed under these provisions once, and thereafter is subject to the normal CGT rules that apply to non-employee equity.
As with ISOs in the US, ESS assets are designed to receive favourable tax treatment. While gains from ESS assets can’t be excluded from your tax return (except in cases where the company they are granted for is very small), the ESS provisions allow you to defer paying taxes until a later date, when your equity becomes liquid. This is designed to prevent employees from incurring a tax liability before they’re able to sell the underlying asset.
In practice, this is done with two tests: a test for “real risk of forfeiture”, and another for “genuine disposal restrictions”. You can only be taxed on an asset if you no longer have a real risk of forfeiting the asset, and if there are no genuine disposal restrictions that prevent you from selling or gifting the asset to another party.
When you’re granted equity, under Australian law, it is immediately created and given to you. However, if there is a vesting schedule on that equity, you’re considered to have a “real risk” of forfeiting that asset in the future, for example, if you were to leave the company prior to some or all of the equity vesting. This “real risk” disappears once you vest the equity, since it is now yours, regardless of whether or not you choose to remain at the company.
If your equity is in a public company, you’ll generally be able to sell your equity immediately or shortly after it vests, and so it will be taxable as normal income at that point. However, if your equity is in a private company, there may well be provisions preventing you from selling your equity, even after it has vested. These provisions can constitute a “transfer restriction”, and can allow you to defer taxation until the point at which you can sell the equity.
It’s important to note that you’ll need to pay tax once your real risk of forfeiture disappears, and your disposal restrictions (if any) are removed, even if you don’t choose to sell the equity at that point in time. The Australian Tax Office does not consider a lack of action on your part, e.g. choosing not to sell the asset, as a reason for you to avoid paying tax. This tends to compel employees at public companies to sell some of their RSUs as they vest, to cover the taxes on the portion of their RSUs (if any) that they wish to keep.
Summing all of this up gives us the following table:
| Event | Taxed amount | Highest tax rate |
|---|---|---|
| Grant | N/A | N/A |
| Vest or removal of disposal restrictions (whichever is later) | Value of stock on date of vest/removal of restrictions | 47% |
| Sale (< 12 months) | Gains on stock since vest/removal of restrictions | 47% |
| Sale (>= 12 months) | Gains on stock since vest/removal of restrictions | 23.5% |
🍴 Options in Australia
Things get a bit more strange in Australia when it comes to options. Currently, the ATO chooses to tax options only once they’ve been exercised – you can choose to defer paying taxes until that point, when your returns are more certain, but in doing so you will pay higher taxes (as you’ll be unable to start the time period of ownership required to claim the capital gains discount until you’ve paid tax under the ESS provisions).
It’s not possible to exercise an option in Australia until it’s vested, however if you choose to exercise an option while there are still disposal restrictions on the underlying share, you’ll continue to defer tax until the point that those restrictions are lifted.
That yields the following table for options, at present:
| Event | Taxed amount | Highest tax rate |
|---|---|---|
| Grant | N/A | N/A |
| Exercise or removal of disposal restrictions (whichever is later) | Value of option* | 47% |
| Sale (< 12 months) | Gains on stock since exercise/removal of restrictions | 47% |
| Sale (>= 12 months) | Gains on stock since exercise/removal of restrictions | 23.5% |
* We’ll come back to how options are valued by the ATO in the next section
However, this table is only accurate under the current tax regime. Australia’s tax law for ESS assets changed in July 2015, but does not apply retroactively: equity granted before July 2015 is still subject to the previous tax law, which took a different view of how options should be taxed.
The point of contention lies in whether or not failing to exercise an option, when the underlying share could be sold, is a “lack of action” on your part. As previously noted, your failure to realize income through inaction is not considered an acceptable reason by the ATO for you to defer paying tax. Prior to the 2015 tax change, the ATO did not consider the failure to exercise an option as a valid reason for that option to have its tax deferred. This meant that at the point where disposal restrictions on the underlying share were removed, options became immediately taxable, even if an employee had not exercised them.
That means that for equity granted prior to July 2015, the following table applies instead:
| Event | Taxed amount | Highest tax rate |
|---|---|---|
| Grant | N/A | N/A |
| Vest or removal of disposal restrictions (whichever is later) | Value of option* | 47% |
| Sale (< 12 months) | Gains on stock since vest/removal of restrictions | 47% |
| Sale (>= 12 months) | Gains on stock since vest/removal of restrictions | 23.5% |
💵 Valuing options
While Australia has generally tried to keep its equity law simple, the ATO crams huge amounts of complexity into how it chooses to value options. The most simple way to value an option is to take the difference between the value of the underlying share, and the cost to exercise: this is the amount of profit that could be made were you to exercise the option and immediately sell the resulting share.
The ATO is unsatisfied with that as a means of valuation though, since it allows companies to grant equity that is definitionally worthless, but that has historically proven to have worth in the long run, e.g. by granting options with an exercise price equal to the current value of the share. To take into account this likelihood that an option might increase in value in the future, the ATO has a complicated set of tax tables, which use the percentage discount being granted and how long the option is valid for, as a way of valuing potential future gains.
In practice, for a quickly growing tech company this will likely be a moot point, since the ATO takes the greater of these two valuations, and the spread between share and exercise prices will outpace the ATO’s calculated value of the option at a fast-paced company, but this is worth taking into account.
👋 Termination
There’s one additional part of the ESS provisions that we haven’t yet mentioned in our discussions, that of termination. The intent of the ESS provisions is that they should only apply to current employees of a company, so what should happen if you choose to leave the company prior to hitting an ESS taxation point (for example, prior to your disposal restrictions being removed)? The ATO simply decided that termination of your employment was also an ESS taxing point. This solves the problem quite neatly for an employer, who no longer needs to be able to inform past employees if their restrictions change.
That modifies our table for RSUs to look as follows:
| Event | Taxed amount | Highest tax rate |
|---|---|---|
| Grant | N/A | N/A |
| Later of vest or removal of disposal restrictions/termination of employment | Value of stock on date of vest/removal of restrictions/termination | 47% |
| Sale (< 12 months) | Gains on stock since vest/removal of restrictions/termination | 47% |
| Sale (>= 12 months) | Gains on stock since vest/removal of restrictions/termination | 23.5% |
For post-July 2015 options:
| Event | Taxed amount | Highest tax rate |
|---|---|---|
| Grant | N/A | N/A |
| Later of exercise or removal of disposal restrictions/termination of employment | Value of stock on date of exercise/removal of restrictions/termination | 47% |
| Sale (< 12 months) | Gains on stock since exercise/removal of restrictions/termination | 47% |
| Sale (>= 12 months) | Gains on stock since exercise/removal of restrictions/termination | 23.5% |
And for pre-July 2015 options:
| Event | Taxed amount | Highest tax rate |
|---|---|---|
| Grant | N/A | N/A |
| Later of vest or removal of disposal restrictions/termination of employment | Value of option* | 47% |
| Sale (< 12 months) | Gains on stock since vest/removal of restrictions | 47% |
| Sale (>= 12 months) | Gains on stock since vest/removal of restrictions | 23.5% |
Notably, this can make it very difficult for employees of private companies to retain their equity after they leave: even if their company is not yet liquid, they’ll be required to pay tax on their equity when they leave, and may not be able to afford the taxes required to do so.
While for most employees this will mean walking away with no equity for their work, for others, it will mean walking away with no equity and a large tax bill. For example, if an employee were granted options prior to 2015, with a 90 day window to exercise when they left – commonplace in the US, where this is not problematic – then they’ll be obligated to pay tax on those options at the time of their termination. If they choose not to exercise the options, for example, because the options are not yet liquid, the ATO will consider that inaction on the employee’s part, and will not refund the tax when the options expire 90 days later. A similar event would occur with RSUs, should an employee choose to leave a company prior to disposal restrictions being lifted, and without rescinding their equity.
🤔 Subjectivity and technicalities
You might have noticed me describing that the Australian tax system was “designed” to work in a particular way, rather than saying that it does. This is because many of the criteria that determine how equity should be taxed are poorly defined, both in the original law, and in case law that exists.
Take the “real risk of forfeiture”, for example. It’s fairly critical to have a clear definition for what constitutes a real risk, since it determines the point at which tax must be paid, which may well occur before the equity is sold. There is just a single piece of case law that defines what constitutes a real risk, and it is specific to one particular individual’s situation. It states that a six month vesting cliff for equity, where tax could not be deferred by more than three years, would constitute a real risk. It also states that a twelve month cliff for equity, where tax could be deferred indefinitely, would also constitute a real risk. What happens if you defer tax indefinitely, but have a cliff that is less than twelve months? The ATO provides no guidance on this.
The definition of a “genuine disposal restriction” is even more fraught. Understandably, prior to 2015, companies were eager to argue that they had disposal restrictions, as it allowed their employees to defer tax for longer. This led the ATO to impose requirements that a disposal restriction was in fact genuine. If there are caveats in an equity agreement allowing equity to be transferred with board approval (commonplace in the US), then the board must have a strict policy for when such a disposal would be approved, which would apply only in rare circumstances. Even if an equity agreement says that equity cannot be transferred, but an employee ignores this policy and transfers their equity, then the employee must be subject to harsh penalties (e.g. termination), or else the disposal restrction is not considered to exist.
These ambiguities make it difficult for either companies or employees to have certainty as to how their equity will be taxed. While the July 2015 tax changes made it easier for companies to opt into particular types of tax treatement (by specifically referencing certain tax law in their grants), it’s commonplace for large employers to file case rulings with the ATO to clarify how their equity will be taxed in Australia. These case rulings are applicable to all employees at that company, but aren’t much help if you’ve moved internationally while working for a company too small to have filed such a ruling.
We’ll come back to this problem in the next post, when the rubber hits the road and we talk about how the combination of two tax systems can lead to a bizarre set of problems.