Consultation is now open on proposed changes to tax rules for Employee Share Schemes (ESS) used by start-up companies. This proposal aims to provide start-ups with a tax deferral option for ESS awards, allowing companies to delay the point at which employees are taxed on their shares.
What’s being proposed?
Employee Share Schemes are a popular tool for start-ups to reward and incentivise employees without significant cash outlay, which is ideal for cash-constrained businesses. However, the current tax rules often result in employees facing tax liabilities when they receive shares at a value higher than the price they paid. This creates issues for start-ups, as employees may not have the ability to sell shares and fund their tax bill due to liquidity constraints.
The proposed changes would allow the tax liability on these shares to be deferred to a later date. Importantly, this is not intended as a tax concession as employees will still be taxed on the increase in share value between the original taxing date and the deferred date. However, it offers more flexibility in managing when the tax is due. The employer, on the other hand, will not receive a tax deduction until the deferred taxing date.
Additionally, for start-ups using the Research and Development (R&D) Loss Tax Credit rules, the proposal suggests amending these rules to include ESS costs as part of labour expenditure, potentially increasing eligibility for R&D credits.
The proposal is targeted specifically at start-ups, and the paper outlines the need for a clear definition of a “start-up.” Drawing on Australia’s approach, the proposal suggests a turnover threshold of NZ$15 million for unlisted businesses, although it remains silent on the age of the company. For comparison, Australia sets this threshold at AU$50 million with a maximum company age of 10 years.
The consultation seeks feedback on whether the tax deferral should be mandatory or optional, and whether the election to defer should be made by the employer or the employee. Since the deferral impacts employees’ ability to meet their tax obligations, it would seem logical for employees to have a say in whether to defer the tax. However, this does not appear to align with the officials' view, as the proposal suggests giving employers the power to make the election, with an obligation to provide certainty to employees regarding whether the deferral has been chosen. This approach could potentially recreate the very issue the proposal is trying to address—namely, if an employer chooses not to defer, employees may be left unable to meet their tax liabilities due to a lack of liquidity.
The tax deferral would generally last until the shares are sold, such as during an initial public offering (IPO). However, the paper suggests additional scenarios that would trigger the taxing date earlier, such as when an employee ceases employment or ceases to be a New Zealand tax resident. There is also a proposed sunset date of seven years, similar to how the rules initially applied in Australia, although they now increased this period to 15 years.
A significant aspect of the proposal is its potential impact on companies involved in research and development (R&D). The Issues Paper proposes that start-ups using the Research and Development Loss Tax Credit rules could benefit from an important amendment i.e. employee share scheme (ESS) costs would be included as part of labour expenditure for calculating eligibility for R&D tax credits.
Currently, labour costs are a major component in determining R&D tax credit eligibility, but ESS costs are excluded. The proposed change would align ESS costs with other labour-related expenses, which could provide further incentives for start-ups engaged in R&D to adopt employee share schemes. This amendment would recognize the value of employee share schemes as a way to attract and retain key talent, especially in innovative and technology-driven sectors, where R&D plays a critical role.
Including ESS costs in the R&D tax credit framework would offer start-ups an additional benefit, potentially increasing their access to valuable tax credits, thereby easing the financial burden on businesses during their development phase. This could provide greater support for New Zealand’s innovation ecosystem, fostering growth and competitiveness in start-up companies that are heavily involved in R&D.
A potential hidden agenda?
The cynic in me wonders if the proposed deferral rules are driven by the prospect that Inland Revenue (IR) could collect more revenue. By deferring the taxing point for successful start-ups, shares are likely to appreciate in value over time, potentially leading to higher tax revenue when the deferred taxing point is triggered. While the Issues Paper suggests that the after-tax effect for employees should be the same, this assumes no changes in tax rates or the employee’s personal circumstances.
In reality, if an employee faces a higher tax rate at the time of taxation—which is not unlikely as individuals advance professionally and earn more—this could lead to higher tax being collected. Similarly, any future changes to tax policy could result in a higher rate being applied, reducing the after-tax result for employees. This mechanism could, in effect, act as a form of tax on capital gains, despite New Zealand’s general stance of not taxing capital gains.
Nevertheless, despite these considerations, the proposal should be welcomed as an option for start-ups. It provides valuable flexibility and addresses real challenges around liquidity and valuation that have made employee share schemes less effective for start-ups in the past. Allowing employees and employers to better manage when tax liabilities arise could make ESS more attractive and accessible for early-stage companies.
Make your voice heard!
If you are part of a start-up or impacted by these ESS rules, now is the perfect time to share your thoughts. The consultation process is simple, and your feedback could help shape a more flexible and supportive tax framework for New Zealand start-ups. Do not miss this opportunity to contribute your feedback by 15 March 2025.
Have questions about the proposal or need help with making a submission? Get in touch with us today!
Author - Galina Bell
