Swan's sledgehammer crushes startups

On May 12, 2009, the Gillard government blindsided the industry, delivering a major blow to Australian startups when it announced changes to the taxation of employee share schemes.

For Australian Treasurer Wayne Swan, the changes would inject an extra AU$200 million into the budget over the next four years.

"We are strongly supportive of employee share schemes, but we are not supportive of those schemes being rorted and exploited so much so that it plunders the public revenue by tens of millions of dollars," Swan said.

But for the industry, it would spell the end of stock options in Australia.

In Australia, when employees receive remuneration in the form of shares or rights, the government taxes the difference between the market value of the share and the amount paid to acquire it (also known as the "discount"). But the government also taxes stock options as though they are income — even though the employee doesn't immediately receive a cash benefit.

Prior to 2009, employees could defer the tax — effectively making it an interest-free loan from the government — for a period of up to 10 years. Employees had the freedom to wait until their options suitably increased in value, so that when they paid the tax, they would realise a substantial financial benefit (although they would eventually also have to pay capital gains tax).

However, the subsequent tax rules, known as Division 83A of the Income Tax Assessment Act 1997, stipulated that tax be paid in the year that the shares are issued. This allowed the government to tax stock options sooner rather than later.

This is particularly a problem for startups and their employees, which can't afford to pay the tax upfront. Furthermore, it is not exactly clear when, or even if, an employee can realise the financial benefit from the stock option.

In response, some of Australia's largest employers, such as Woolworths and the Commonwealth Bank, immediately froze their employee share schemes. Business industry groups likewise railed against the unexpected changes, particularly the requirement to pay tax before the employees could realise any value from their shares.

Australian Industry Group chief executive Heather Ridout decried the government taking a "sledgehammer to a walnut", and former Woolworths CEO Roger Corbett said at the time that the government had made it impossible to use stock options.

A revised policy statement was released on July 1, 2009, and Assistant Treasurer Nick Sherry convened the Board of Taxation to consider other issues, including whether to establish separate tax deferral arrangements for startups and speculative companies — but the restrictive deferral provisions remained prohibitive.

In detailed submissions, Starfish Ventures, the Australian Private Equity and Venture Capital Association, and the hastily convened IT Industry Innovation Council (ITIIC) also begged for leniency, and warned of dire consequences for Australia's international competitiveness if the rules weren't changed.

"A cash tax on a non-cash benefit that may never eventuate flies in the face of natural justice," ITIIC chairman John Grant wrote in its submission.

On October 21, 2009, the government introduced new legislation based on the policy statement, which was approved by parliament on December 2, 2009.

When the Board of Taxation reported its findings in February 2010, almost 10 months after the new regime was introduced, there was one simple response to the pleas for a separate regime for Australian startups: A resounding no.

"The board recommends ... the government consider more targeted approaches to providing this support outside of the [employee share scheme] tax regime."

As it furiously scrounged every last grain from an already desolate, ravaged economic landscape, the Gillard government snatched away the juicy carrot that had previously tempted staff to toil for future riches, and in its place left a big, splintered stick.

It was collateral damage in the Labor Party's desperate battle for the hearts and minds of voters, and it demonstrated the power of its one key election weapon: To return the budget to surplus.

Tomorrow: The politics behind the decision.