July may have bought respite from the business pressures leading up to financial year end, but by August most companies should be considering how to improve performance this year. Smart remuneration should be considered in this context.
Smart remuneration is about many things. These include sharing the business rewards between employer and employees, linking and bonding employees through values such as shareholder focus; and building productivity through key performance indicators such as profit, safety and client service.
Smart remuneration is pivotal to attracting and retaining key employees and aligning the interests of boss and worker.
But as with all multi-dimensional tools, it is critical to match the remuneration program to the need. My following comments may help to achieve this aim.
Old concept, new rules
Robert Menzies spoke of the potential for full employment being obtained through profit sharing in his election campaign in 1949. But despite half a century or so of government support for the concept, a wide gap has evolved between "big end of town" executive option packages and shop-floor participation in employee share ownership plans. There is still very low takeup of the latter.
Smart remuneration, or incentive, programs sit above fixed remuneration and rewards. As with most aspects of remuneration, understanding the taxman's role is the key to appreciating why successful programs achieve the right outcomes.
Incentive programs may be classified as having features which are tax-advantaged, tax-neutral and tax-sensitive. In simple terms, tax-advantaged attributes are featured in plans which fall within one or other of the two concessions established by Division 13A of the Income Tax Assessment Act 1936.
Tax-neutral features are those aspects which really have nothing to do with tax, but are covered by the usual tax laws in relation to associated income and expenses. Tax-sensitive features are those identified by the taxman as involving inappropriate interpretation of tax laws and potential tax avoidance.
Division 13A allows for two classes of tax-advantaged employee incentive schemes. Tax-exempt plans are appropriate for providing annual benefits, by way of share or option entitlements issued at a discount, in the manner of a bonus. Tax-deferred plans are more appropriate for participation in the capital growth of an enterprise.
A tax-exempt employee share ownership plan (ESOP) under Division 13A provides an annual tax shelter of up to $1000, subject to the conditions that shares or rights cannot be forfeited, nor can they be disposed of within three years of issue or upon termination of employment.
Such a plan must be made widely available in a given business context, to at least 75 per cent of the Australian employees with at least three years service with the employer. No participating employee may hold more than 5 per cent of the voting shares in the employer entity.
A tax-deferred ESOP is another option available through the provisions of Division 13A. No assessable income is derived upon entry into an appropriately structured plan of this nature, but assessment is deferred provided that qualifying shares or rights are acquired under the plan.
Assessment of the discounted amount is deferred until the earlier of: disposal of the shares or rights (except by exercising the rights or options); when any restrictions or conditions cease; on termination of the employee; or after ten years have passed.
When shares are provided at a discount, the assessable amount is simply the market value of each share at the time of issue, less any employee contribution. When options or rights are granted at a discount, the assessable amount is worked out according to prescribed tables.
These tables, contained in Division 13A, are based on: the amount--if any--paid to acquire the options; the ratio of market value of the shares on exercise to the amount paid to acquire the rights or options; and the period until the last day for exercise of the rights.
There is no limit to the amount protected by the concession for tax-deferred plans. Another important distinction between tax-exempt and tax-deferred plans is that the rule requiring that the benefit be shared by at least 75 per cent of the employees does not apply when the tax-deferred benefit is granted by way of rights or options.
The gulf which has developed between workforce share ownership plans and executive options-based plans may be sheeted back to that distinguishing characteristic. Whether tax-advantaged plans take the respective forms of either tax-exempt or tax-deferred, use of shares allows dividend access plus capital growth, while use of rights allows only access to capital growth until options are exercised.
Division 13A overrides capital gains tax provisions for tax-deferred incentive programs. This means that the 50 per cent tax discount otherwise available for assets held for more than 12 months does not apply in these cases.
Another significant tax attribute of tax-advantaged plans is that, because the shares or rights must be held by the relevant employees, the resulting assessable income on dividends and disposal goes to the individual employees, rather than to investment entities.
Interest-free loans may be made to employees to fund purchase or shares or options without FBT liability. Repayment of employee loans may be funded from dividends while employed. Salary sacrifice arrangements may be coupled with incentive programs.
There are a number of design fundamentals for incentive programs to consider. Common to the design of all tax-advantaged programs is that equities are transferred to employees at discount. That transfer should be on favourable terms for the employer, as well as employees.
The employer obtains those benefits by careful use of the variables inherent in program design, including: conditions on transfer relating to length of service; selection of the key performance indicators which trigger eligibility; the period for which equities must be held before disposal; and the manner and length of any restrictions or conditions.
A key design feature of any good incentive program is providing clear documentation and communication to the prospective participants and allowing input from them at design stage.
They also should be provided with details of the extent of discount--which varies according to employee's length of service, etc.--and the grant of equities or associated options and rights.
Entry to the program may be effected by, say, a participant electing to exercise the options held at the given exercise price, which may be an established trigger price less the individual discount. Payment of exercise price might be deferred, according to plan design, as a way of "handcuffing" the particular employee. Under such arrangements, no money needs to be paid until after a specified period or early termination of employment.
Healthcare and hygiene giant Johnson & Johnson offers its employees the choice to partake in either a tax-exempt incentive program, or a tax-deferred plan. Participants in the former plan choose to make a salary sacrifice in order to receive $1000 of entitlement annually.
They hold shares in a parent entity, purchased by a trustee company established especially for this purpose. The tax-deferred plan, on the other hand, allows the trustee company to acquire shares in the parent entity on behalf of selected employees, at no cost to the employee.
There are successful smart remuneration packages which do not obtain the Division 13A entitlements. BrightStar Environmental is an Australian-based environmental services company that specialises in solid waste and energy recycling.
It offers its employees the incentive of a cash bonus made at a future date (conditional on the growth of the employer partnership); as well as the opportunity to participate in a phantom option structure.
The BrightStar Environmental entitlements are offered for no consideration, and employees involved can nominate a vesting or exercise date of three to ten years after the grant has been made. The cash then payable on the exercise date is calculated by deducting the exercise price from the notional share value.
The tax outcomes of this kind of tax-neutral incentive plan are that there is no assessment on the grant or vesting of options, nor is there a capital gains tax discount available on the cash bonus. It is considered ordinary, assessable income.
It is crucial, however, to tailor a plan for the specific context. There are real traps in adopting off-the-shelf plans, particularly those within the taxman's sphere of concern.
Trigger issues include whether employer contributions in off-the-shelf plans are deductible or instead assessable to the relevant employees; and whether the benefits fall foul of FBT law. Failing this, the taxman may use the general anti-avoidance provisions to strike down any tax benefits which do pass through those holes in the cheese.
With companies considering their 2003-2004 budget outcomes, now is the time to consider these smart incentive programs which match mutual rewards with maximum yield--and help bridge the age-old gap between workers and capitalists.…