Phantom Stock: A Rising Trend for Accountants in Sydney
Accountants in Sydney increasingly recognise the growing significance of phantom stock, originally a US phenomenon, which has been adopted and adapted in the UK and is now gaining traction in Australia.
It is essentially an Employee Share Scheme (ESS) designed to remunerate key employees at some stage. As the remuneration is deferred, so is the tax.
What are Phantom Shares?
Phantom shares are a contractual agreement between a company and recipients of the phantom shares that provide a right to a cash payment at a future time or event, where the payment is tied to the market value (or the increase in market value) of the company’s real shares. It is simply a right to receive profits from the company later.
Phantom Shares vs. Traditional Employee Share Schemes (ESS)
This differs from most existing ESS, which issues company shares, options, or rights to employees at a discount to the existing market value. Due to recent changes in legislation, this discount can be taxable at the time of issue.
Most ESSs are complicated and require significant legal documentation. In contrast, a Phantom Share Scheme (PSS) can be flexible and requires minimal legal and tax paperwork.
Phantom shares are like a cash bonus deferred until the future but typically much more extensive than an annual bonus. The issue of phantom shares is contingent upon the phantom shareholder’s continued employment with the company. This is designed to retain key management.
Start-up companies can use phantom shares instead of shares or options to provide prospective contributors with the start-up’s success with a simple form of equity participation.
Phantom shares can be used by existing companies as a cash bonus plan.
When the future time or event is reached, the phantom share scheme pays out an amount to the phantom shareholder.
When the payout is made, it is taxed as ordinary income to the phantom shareholder (without any tax concessions) and deductible to the employer.
A PSS is similar to an ESS in that it requires the recipient of the phantom shares to become vested through performance targets or employment anniversaries. This vesting can trigger a taxing point, even though nothing has been paid out if the value of the phantom shares is tied to the value of the real shares.
A way to avoid this taxing point is to tie the value of the phantom shares only to the increase in value from the time of vesting to the time of the payout. Thus the value of the phantom shares at the time of vesting is zero and not subject to tax.
For accounting purposes, phantom shares are treated in the same way as deferred cash payments. As the amount of the liability changes each year, an entry is made to record the amount accrued. This accrual would usually not be tax deductible like a provision is not deductible until paid.
PSSs are tied to an increase in the real share price, whereas most ESSs are tied to vesting dates. An ESS can still benefit employees even if the real share price has not increased. As a result, a PSS may motivate management more to increase the real share price than an ESS.
PSSs are a way to share a stake in the business while avoiding the need for the new “owner” to invest cash or suffer taxable income. They also avoid the risk of having additional shareholders trying to control the company.
Based on the above, PSSs sound very attractive. However, a recent Federal Court decision has confirmed a possible alternative analysis if the scheme can be characterised as a “non-share equity interest” designed to raise finance. The judge concluded that the PSS was not designed to raise finance, so the amount paid was deductible to the company. This court case shows that different circumstances could have resulted in the payment being treated as a dividend and not deductible to the company.
This is an area in which care needs to be taken. It will inevitably attract the Australian Tax Office’s attention as a scheme to defer income.
If you have any question in relation to the above, feel free to reach out and contact us.
*Correct as of December 2014
*Disclaimer – Kreston Stanley Williamson has produced this article to serve its clients and associates. The information contained in the article is of general comment only and is not intended to be advice on any particular matter. Before acting on any areas in this article, you must seek advice about your circumstances. Liability is limited by a scheme approved under professional standards legislation.