There's a huge problem with the startup Employee Share Scheme legislation when it comes to tax

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When it introduced startup legislation to parliament on Wednesday, the federal government’s aim was to remove upfront taxation on employee options.

And while the Employee Share Scheme changes do mean options will, from July 1 for eligible companies, be taxed when they’re either converted into shares or exercised, there is an exception.

If an employee leaves the startup before the taxing point – and they still hold options – they would be required to pay income tax then, even though they may not have realised any value from them.

It’s a sticky point for employees.

According to the explanatory memorandum:

“If the employee is provided with ESS interests under a deferral scheme and they meet certain conditions, they will be assessed for tax purposes in the income year that the deferred taxing point occurs.”

But it’s also not good for startups with limited cash, according to specialist adviser and solicitor Raena Lea-Shannon, who believes the valuation approach could potentially spawn a whole new industry for accountants and valuers.

The memorandum states: “The amount assessed will be the market value of the ESS interests at the deferred taxing point, reduced by the cost base of the interests.”

As a deferred taxing point includes when an employee resigns, Lea-Shannon said: “when someone resigns the shares will have to be valued again to calculate the amount upon which they will be assessed ‘reduced by the cost base of the interests’ ie. reduced by the amount calculated based on the initial market valuation. Lots of valuations there.”

As for how the ATO will deal with startup valuations, including working out the market value of assets or non-cash benefits, that’s still being determined.

However, small business minister Bruce Billson said he was committed to establishing a process which was streamlined. The explanatory memorandum also states the government is supporting the ATO to work with industry and approve safe harbour valuation methods and standardised documentation.

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