As a startup founder, there are several ways to pay your employees, and an employee share scheme (ESS) can be a great idea. An ESS is a fantastic way to reward employees for their excellent work and is a good way to motivate your employees. Paying competitive salaries in the early stages of your startup may be challenging, so paying employees with shares can help stabilise your cash flow. An ESS allows you to issue or transfer shares to a person who is an employee of your startup. You should always consult a commercial lawyer or tax advisor before establishing an ESS. This article will outline how you can pay employees with shares, the rules of an ESS, and what a tax-exempt ESS is.
Can You Pay Employees Through an ESS?
It is common for founders to pay startup employees through an ESS. Before you make an offer to your employees, you will need to establish an ESS. An ESS can provide more significant incentives for your employees to perform well as they are now partial owners of your startup. As your startup grows, the share value, employee equity, and the employee’s financial gain will steadily increase. An ESS may also attract potential future employees if you cannot pay competitive market salaries.
Given that an ESS involves an issue of securities, you need to ensure you comply with the Companies Act and Financial Markets Conduct Act (FMCA), as well as your company’s constituent documents (including your constitution and shareholders agreement, if any). Your lawyer can guide you through this process.
ESS Under the Financial Markets Conduct Act
Under the FMCA, you will not need to comply with standard disclosure requirements if you meet the following criteria regarding your ESS:
- you must make offers to employees as part of the relevant employee’s remuneration;
- funds cannot be the primary purpose behind the offer to the employee; and
- the total number of shares issued under the ESS in any 12-month period cannot exceed 10% of the total number of shares on issue.
In addition to such requirements, when offering employees with an ESS, you need to provide:
- a warning statement in respect of the ESS;
- basic information regarding the ESS, such as terms and conditions; and
- access to the employer’s most recent annual report and financial statements.
Your warning statement must outline the exemption under the FMCA that you rely upon as the employer. Its intended purpose is to:
- explain the nature of the offer;
- outline the risk of investment to the employee; and
- set out a general requirement on the employee to be prudent in their investigations of the ESS.
Rules of an ESS
The Inland Revenue Department (IRD) has specific rules on ESS, relating to taxation and reporting.
Income Tax Rules
If your startup employees receive shares and pay below market value when the shares are issued, this counts as income for the employee. Employment income may include any ESS benefits the employee receives, such as the employee:
- acquiring shares for free;
- buying shares for a price below market rate; or
- receiving payment for transferring or cancelling their rights to shares.
The taxable income is the difference between the market value of the shares at the time of issue and what the employee paid for the shares. The income is taxable on the “share scheme taxing date,” which is when:
- benefits are transferred;
- benefits are cancelled; or
- the employee owns shares in the same way as any other shareholder.
Reporting Requirements
As an employer, you will need to provide employment information about the taxable value of the ESS to IRD. You need to detail the:
- employee’s name and IRD number;
- taxable value of ESS benefit; and
- total tax and any student loan or child support deducted from the benefit.
You do not need to file employment information when:
- the employee is a former employee, and you have chosen not to deduct tax; or
- share benefit arises from an exempt ESS.
It is best practice to notify the employee that they will have reporting and tax payment obligations in respect of the benefit.
Tax-Exempt ESS
Your startup may be able to implement an “exempt employment share scheme.” Under an exempt scheme, your employee’s ESS benefit is tax-free. However, you must meet strict eligibility criteria to qualify for this. These requirements include the following:
- the maximum value of shares you can offer to each startup employee is $5,000 per year;
- the maximum discount you can offer to each employee is $2,000 per year;
- you must provide the scheme for at least 90% of your full-time employees;
- if you offer the scheme to part-time employees, then you must offer it to at least 90% of them;
- if you require a minimum spend from your employees, it cannot be more than $1,000 per year;
- the minimum period of service required before an employee can participate in the scheme cannot be more than three years; and
- if your employees have to pay an amount for their shares, you must provide an interest-free loan for the amount or let your employees pay in instalments.
You must inform IRD of an exempt ESS through the lodgement of an IR1211 form. You must also report the value of the shares issued to employees to IRD at the end of each tax year through the IR1212 form.
Understand how an Employee Share Scheme will help your NZ startup attract and retain great talent.
Key Takeaways
As a startup founder, you can use an ESS to incentivise your employees, particularly when you cannot pay market-competitive salaries. Before implementing your ESOP and issuing any shares under your ESOP, you must ensure you comply with the Companies Act and the FMCA, as well as your company’s constitution and shareholders’ agreement. You must note that you have tax and reporting obligations as well. Setting up a tax-exempt ESS is possible, although there are strict criteria you need to meet.
If you need help understanding if you can pay employees with shares or how to pay them with shares, you can contact our experienced startup lawyers, who can assist as part of our LegalVision membership. You will have unlimited access to lawyers who can answer your questions and draft and review your documents for a low monthly fee. Call us today at 0800 005 570 or visit our membership page.
Frequently Asked Questions
Tax is payable on any ESS benefit the employee receives. This can be deducted and paid to IRD by the employer, or the employees can pay the tax themselves. You do not need to pay tax on a tax-exempt ESS scheme.
You can pay employees through an ESS or an ESOP, although you must comply with the Companies Act and the FMCA.
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