taxation of employee share schemes for startups



The IRD has released its much-anticipated issues paper on taxation of employee share schemes for startups.

This is the third part of a substantial review undertaken by the IRD of the rules governing the taxation of employee share schemes.   The first two parts involved:

  • introduction of reporting rules, requiring employers to advise the IRD when shares and options are issued to employees, and when options are exercised; and
  • a Bill, currently before Parliament, that treats conditional employee share purchase schemes as if they were options for tax purposes. This means that employees will pay tax on the gains made through share purchase schemes in the same way that gains are taxed with option schemes.

The IRD’s paper addresses a problem that employees of startups encounter when they come to exercise their share options.  This problem will also arise with share purchase schemes once the new Bill comes into force.

Currently, an employee becomes liable to pay tax at the time a share option is exercised, with tax being payable on the amount of any gain made.

With listed companies, it is easy for the employee to work out the amount of any gain made because the shares are publicly traded, and it is also easy for the employee to sell the shares in order to crystallise their gain and to pay the tax that becomes due.

However, with startups, it is usually much harder for employees exercising options to determine the value of the shares purchased and thus the amount of any gain made.  It is also difficult, if not impossible, to sell those shares in order to crystallise the gain and pay the tax that may be due.  This leaves employees in an invidious position – paying tax on a notional gain, that may or not materialise many months or years down the track if/when the company is ultimately sold or listed.

To help alleviate these problems, the IRD is proposing that startups be given the option, when an employee scheme is set up, to elect to defer the tax date to the earlier of:

  • a liquidity event occurring (e.g. the sale of the company, sale of the company’s business, or an IPO);
  • 7 years from the date of exercise of the option (or in the case of a share purchase scheme, the shares ceasing to be held subject to conditions); or
  • the employee ceasing to be a New Zealand resident.

We think this deferral option will provide a material benefit to employees of New Zealand startups.

The event that most commonly triggers a decision to exercise options is an employee leaving the startup.  Usually, the employee will have a short period in which they can exercise their options (commonly 3 months) otherwise the options are extinguished.  However, the requirement to pay tax on the notional gain made at that point is often very unattractive to the employee, as there is no guarantee that the gain will actually materialise or if it does, it could be many years down the track.

It is not unheard of for the amount of tax payable to be equal to or greater than the exercise price of the options.  While an employee may be willing to take a punt on buying the shares and sitting on them in the hope that a liquidity event will arise, this is a much riskier decision when that tax burden is taken into account.  This deters employees from exercising their options in some cases, particularly more junior, less well paid, employees.

The IRD’s proposal will make it more attractive for all employees to exercise their options, not just senior, well off, employees.  We think this will particularly benefit younger employees and those with lower net wealth behind them, as people in this category find it harder to get the money together to pay tax lump sums under the current regime.

*Andrew was engaged by the IRD to undertake a review of an earlier draft of the IRD’s paper to provide input from a startup sector perspective.

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