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RA 15/01

Revenue Alert

Revenue Alert RA 15/01 relates to employee share purchase agreements, timing of the acquisition of shares and reclassification arrangements.

A Revenue Alert is issued by the Commissioner of Inland Revenue, and provides information about a significant and/or emerging tax planning issue that is of concern to Inland Revenue. At the time an alert is issued, risk assessments will already be underway to determine the level of risk and to consider appropriate responses.

A Revenue Alert will identify:

  • the issue (which may be a scheme, arrangement, or particular transaction) that the Commissioner believes may be contrary to the law or is inconsistent with policy;
  • the common features of the issue;
  • our current view; and
  • our current approach.

An alert should not be interpreted as being Inland Revenue's final position. Rather, an alert outlines the Commissioner's current view on how the law should be applied. For any alert we issue, it is likely that some investigatory work has already been carried out.

If people have entered into, or are thinking of entering into, an arrangement similar to the one described, they should talk to their tax advisor and/or to Inland Revenue for advice about tax implications.

Employee share purchase agreements

  1. Employee share purchase agreements are arrangements to sell or issue shares in a company to an employee in connection with the employee’s employment or service. New Zealand tax law requires employees to return the benefits obtained under a share purchase agreement as employment income. The benefits are measured in most cases as the difference between the amount payable to purchase the shares and the value of the shares purchased at that time. Such arrangements are commonly used to attract and retain staff. They are often made subject to conditions, such as length of service, or the level of performance of the employee or the company over a period. Often shares are allotted to trustees for the employee during any such qualifying period. Different tax outcomes arise depending upon whether the shares are subject to an option to purchase or have been acquired at the outset (with or without any constraints or conditions).
  2. For example, Mr Smith is employed by Company Limited. Company Limited enters into a share purchase agreement to issue Mr Smith 100 of its shares at $2, at the option of Mr Smith, if he remains employed with Company Limited for three years. After three years, Mr Smith exercises the option in the share purchase agreement and subscribes for 100 shares at $2 (i.e. pays Company limited $200 for 100 shares). At the date Mr Smith acquires the shares, Company Limited's shares have a market value of $3 a share. Mr Smith is required to return $100 as income, being the difference between what he had to pay Company Limited to subscribe for the 100 shares (i.e. $200) and the value of the shares when acquired (i.e. $300).
  3. The policy behind taxing the benefit to an employee under a share purchase agreement is that any discounted price of the shares offered to employees relates to their employment relationship. The difference between this discounted price and the market price on the date of acquisition, which will be the date of exercise in the case of an option, is therefore income to the employee. Effectively, it is a payment to the employee by the employer company for the provision of the employee’s services.


  1. We have recently been examining a number of employee share purchase arrangements. We have identified several that could be seen as altering the tax treatment Parliament intended to apply to a share purchase agreement. We have concerns under both the specific provisions relating to share purchase agreements and section BG 1 (Tax avoidance), and wish to alert taxpayers to these.

Acquisition date arrangements

  1. The point of focus in a section BG 1 context is identifying the time at which the shares should be treated as being acquired. Parliament intended that employee shares be valued (to see if there is a taxable gain) at the time they are acquired. For example, mere options do not give rise to liability unless they are exercised and shares consequently acquired. We have focussed recently on arrangements that raise concerns as to the point in time at which the acquisition takes place. For instance, some arrangements seek to change (usually to bring forward) the time at which the employee acquires the shares, compared to when this really occurs from a commercial or economic point of view. The tax effect is to reduce or eliminate the tax liability on any subsequent increase in value of the shares.
  2. Generally, this involves creating arrangements, between the employer and employee, that take the legal form of acquisitions but that are not, at the time, actually acquisitions as a matter of commercial and economic reality. Parliament appears to have contemplated that the value of the benefit is determined at the time that a share is actually acquired, not earlier.
  3. Arrangements of this sort vary a good deal, and we will look at a number of criteria in combination when deciding whether to investigate a case. These include, for example:
    1. The level of control the employee has over the shares while they are part of the share purchase agreement. (It is accepted that restrictive covenants over disposition of the shares are a very common element of employee share plans.)
    2. Whether during any restrictive covenant period the employee can exercise rights attaching to the shares (such as voting rights), and whether the benefit of dividends, if any, is passed to the employee in commercial and economic reality.
    3. Whether the employee has any direct or indirect rights to dispose of the shares in a way that negates the original acquisition or otherwise means the employee is not exposed to real commercial risk on ownership of the shares.
    4. Whether the nature of the arrangements put in place (which often include the shares being held by trustees for an interim period) means that benefits attaching to the shares during the restrictive period are enjoyed more by the employer (or someone else) than the employee.
    5. Whether, as a matter of commercial and economic reality, the arrangement is more likely to be categorised as an option rather than a full acquisition of the shares.
  4. The following example is an arrangement that is structured legally as a share acquisition, but that has features and attributes that indicate it is not, commercially and economically, a real acquisition of the shares.
Example 1 - An in-substance option  

Corp Limited enters into a share purchase agreement with its employee, Mr Wright. Under the share purchase agreement Mr Wright acquires 100 shares in Corp Limited that are held for his benefit by Hold Trust (this occurs in Year 1). Hold Trust is a trust established for the benefit of employees of Corp Limited. Mr Wright does not receive any voting, dividend or other participation rights in the shares while they are held by Hold Trust; these rights are instead held on trust for Corp Limited.  Subject to certain performance criteria being satisfied, the shares will vest in Mr Wright after 3 years. However, Mr Wright has a right to reject the transfer of the shares on vesting.  The shares are acquired for $2 per share (i.e. $200), which is funded by way of a loan from Corp Limited to Mr Wright. If the performance criteria are not satisfied, or Mr Wright exercises his right to reject the transfer of shares on vesting, Mr Wright must transfer his beneficial ownership in the shares to Corp Limited in full satisfaction of the loan amount outstanding.  If the shares vest and are transferred to Mr Wright, he must repay the loan in cash.

The shares have a value of $2 per share when acquired, so Mr Wright does not return any income. This is on the basis he paid market value for the shares and therefore there is no benefit to him under the share purchase agreement.

Three years later the shares vest and are transferred to Mr Wright. At this time the shares have a value of $4 per share. The shares are sold for $400 by Mr Wright and the $200 loan from Corp Limited (for the purchase of the shares) is repaid, resulting in a gain of $200 to Mr Wright. Mr Wright does not return this $200 gain as income on the basis that the shares were acquired from Corp Limited when they were legally acquired by Hold Trust (for Mr Wright’s benefit) and had a value of $2 per share. Thus, Mr Wright had already acquired the shares when the trust subsequently transferred legal title in the shares to him, when the shares had a value of $4 per share. Accordingly, Mr Wright treats the $200 gain as a capital gain that accrued while he owned the shares.

Inland Revenue's current view on Example 1

  1. Parliament intended that the benefit under a share purchase agreement is the difference between the value of the shares at the time they are acquired by an employee and the price the employee has to pay for those shares. For the value of the benefit to be determined at the time of an up-front acquisition, Parliament would expect the employee to assume the benefits and risks normally associated with ownership of shares from that time, and would not expect the employee to have a choice as to whether to retain the shares at a later date.
  2. In Example 1, while the shares are acquired by Hold Trust (in Year 1) for the benefit of Mr Wright, Mr Wright does not possess the rights associated with ownership of the shares (e.g. voting and dividend rights) until legal ownership is transferred to him (in Year 3). The arrangement has features and attributes more like an option than ownership. Normally, where an option exists for shares, the option holder is not able to exercise the rights associated with those shares prior to exercising the option. In addition, Mr Wright has the ability to reject the transfer of shares on vesting at no economic cost to him. This means the arrangement’s commercial and economic reality falls short of being an acquisition, as Mr Wright will only accept transfer of the shares if they have gone up in value.
  3. Given the facts, features and attributes of Example 1, considered in aggregate, the arrangement appears to have the legal form of share ownership but, in economic and commercial reality, falls short of being an acquisition. A possible tax benefit of such an arrangement is illustrated by Example 1. If the shares do subsequently vest in the employee (i.e. when they enjoy the rights normally associated with ownership of the shares), the increase in the value of the shares from when they were legally acquired (in Year 1) to when they subsequently vest in the employee (in Year 3) is not assessable income to the employee.
  4. In Example 1, the real economic and commercial acquisition of the shares occurs in Year 3. This is when legal title passes to Mr Wright and Mr Wright no longer has the right to reject the transfer of the shares. He also becomes entitled to exercise the rights associated with the shares (e.g. voting and dividend rights). At this time (i.e. Year 3), the shares had a value of $4 per share, compared with the $2 per share Mr Wright paid for them.
  5. Therefore, we consider it is strongly arguable that Example 1 does not make use of the legislation in a manner that is consistent with Parliament’s purpose and could be a tax avoidance arrangement. Accordingly the Commissioner is likely to apply section BG 1 to the arrangement. This is unless the taxpayer can show that the arrangement did not have a more than merely incidental purpose of tax avoidance (which would be difficult to do based on the facts above). In reconstructing the arrangement, the $200 gain in value of the shares from Year 1 to Year 3 would be treated as assessable income by the Commissioner.
  6. There are many different employee share purchase scheme arrangements. Some arrangements will exhibit some, but not all, of the features found in Example 1. For example, an arrangement may allow the employee to exercise the rights associated with shares (e.g. voting and dividend) pending vesting of the shares and transfer of legal title to the employee. Alternatively, an arrangement may not allow the employee an option as to whether the shares vest at the end of a vesting period. Such arrangements may still be tax avoidance. Each case will need to be considered on its own facts, and the various attributes weighed against Parliament’s intention for the employee share purchase scheme provisions.

Reclassification arrangement

  1. Another area of concern is arrangements that rely on the reclassification of shares to artificially reduce the value of the shares acquired. While such cases may also involve issues relating to the valuation of the original class of shares acquired by the employee, we believe that the general anti-avoidance rule should apply to such arrangements.

    An example of such an arrangement is set out below.
Example 2 - Reclassification of shares  

Liability Limited enters into a share purchase agreement with its employee, Mrs Jones, for her to purchase 100 Class B shares that are non-transferrable and have no voting or dividend rights in Liability Limited. The only right the Class B shares have is to reclassify to ordinary shares in two years if certain qualifying criteria (e.g. increased sales of Liability Limited) are met. The Class B shares were valued by the Company at $1 per share and Mrs Jones paid $100 to purchase them, although at the time the market value of ordinary shares in Liability Limited was much higher.

Mrs Jones does not return any income on the acquisition of the Class B shares on the basis she paid market value for their purchase and therefore there is no benefit to her under the share purchase agreement (i.e. she paid $100 to buy $100 worth of Class B shares).

The criteria for reclassification is met two years later and the 100 Class B shares held by Mrs Jones are reclassified as ordinary shares of Liability Limited, which have a market value of $9 per share at that time.

Under the arrangement Mrs Jones has received ordinary shares worth $900 (100 ordinary shares with a value of $9 per share) and has only had to pay $100 (paid $1 per share for 100 Class B shares). Despite an $800 gain, Mrs Jones returns no income. This is on the basis she purchased the shares (i.e. the Class B shares) at their value and that the reclassification of the Class B shares to ordinary shares is not taxable.

Inland Revenue's current view on Example 2

  1. Parliament contemplated that the benefit to an employee under a share purchase arrangement would be the value of the shares acquired less the price paid by the employee for those shares. In determining this benefit, Parliament would expect that the shares from which the employee derives the benefit are the same shares that are valued, and that they carry materially the same rights as when they were valued. In Example 2, the real benefit Mrs Jones derives under the share purchase agreement occurs when the Class B shares reclassify to ordinary shares. In economic and commercial reality, the Class B shares are a right to receive ordinary shares on the satisfaction of certain criteria.
  2. In Example 2, what is valued as the benefit under the share purchase arrangement is not the actual shares that Mrs Jones benefits from (i.e. the ordinary shares). Instead, what is valued is the highly contingent right to those ordinary shares based on the right to reclassify the Class B shares if the qualifying criteria are met. The value of this right is significantly reduced due to the high degree of uncertainty that the qualifying criteria will be met and the Class B shares will reclassify to ordinary shares.
  3. The arrangement therefore gives a contingent right to acquire ordinary shares the legal form of a share (i.e. the Class B shares). Further, it greatly reduces the taxable benefit derived from those ordinary shares because of how contingent the right to them is. We consider that Example 2, viewed in a commercially and economically realistic way, does not make use of the legislation in a manner that is consistent with Parliament’s purpose and is therefore a tax avoidance arrangement.
  4. In Example 2, the real economic benefit to Mrs Jones of the share purchase agreement is the 100 ordinary shares she acquired (which had a value of $900) through the reclassification of the Class B shares (which only cost her $100). Parliament’s purpose for share purchase agreements was to tax this benefit (i.e. the $800 gain). Therefore, we consider that the employee would be taxable on that benefit (i.e. $800).

Current status

  1. We may ask for information from some taxpayers who have implemented employee share purchase schemes. Being asked for information does not necessarily mean that a taxpayer has done anything incorrect and in many cases no adjustment is subsequently made to a taxpayer’s assessments. The purpose of this Revenue Alert is to indicate, however, that there are certain attributes of employee share purchase arrangements that are more likely to give rise to an investigation.
  2. Where the Commissioner becomes aware of arrangements (through either disclosure by taxpayers or the audit activity of the Commissioner’s staff), if possible, discussion will be had with the company and its tax advisors before formal commencement of an investigation. If, following those discussions, the Commissioner forms the opinion that the arrangement results in more tax being payable by the employees (or former employees) of the company, the taxpayers will be contacted with details of the Commissioner’s concerns and given the opportunity to make a pre-notification voluntary disclosure. The Commissioner will take into account individual circumstances.
  3. If you consider that our concerns may apply to your situation, we recommend you discuss the matter with your tax advisor or with us, and depending on the outcome of those discussions, consider making a voluntary disclosure.

    Guidelines for making a voluntary disclosure are contained in our booklet Putting your tax returns right (IR280) and Standard Practice Statement 09/02 Voluntary disclosures (May 2009).
Legislative references Sections CE 1, CE 2, CE 6 and BG 1 of the Income Tax Act 2007.
Date issued: 13 November 2015
Authorised by Graham Tubb
Group Tax Counsel
Legal & Technical Services
Contact (via email) [email protected]
Media queries: Peter Van Schaardenburg
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04 890 1698