09/23/2024 | News release | Distributed by Public on 09/23/2024 04:16
The taxation of employee share schemes (ESS) in New Zealand underwent fundamental reform in 2018. Despite Inland Revenue publishing a comprehensive and well regarded Special Report on the operation of the new regime in 2018, many aspects of the new rules have remained unclear. One of the more recent areas of uncertainty is the deduction available to employers under section DV 27 of the Income Tax Act 2007 (ITA 2007) when employees receive ESS income as a consequence of the sale of a business. This is because of the potential operation of the capital limitation in section DA 2(1) of the ITA 2007, which can override the deduction available under section DV 27. This question became a topical issue in New Zealand following decision of the Full Federal Court of Australia in Clough v Commissioner of Taxation [2021] FCAFC 197 (Clough).
Inland Revenue's extensive review of the operation of the ESS rules during the course of this year has included detailed consideration of the availability of the deduction under section DV 27, taking into account the decision in Clough. As we discuss in this article, Inland Revenue's final views on these issues, as outlined in Interpretation Statement 24/07 - Deductions of Parties to Employee Share Schemes 24/07 (IS 24/07), provide some welcome clarity and guidance for employers.
Section DV 27(6) of the ITA 2007 governs deductions that employers who are a party to an ESS may take. Generally, an employer is deemed as incurring an amount of expenditure that is equal to the amount of the employees' benefit calculated under section DV 27(6). However, in order for such an expense to be deductible, the amount must be deductible under ordinary principles as per the general permission (section DA 1) and general limitation (section DA 2) provisions. The first draft of what became IS 24/07 was outlined in draft interpretation statement PUB00364/B, which noted that in the context of ESSs, the capital limitation (section DA 2(1)) that denies a deduction to the extent the expenditure or loss is of a capital nature may be the most relevant general limitation. Further, in a business sale context, which inherently requires consideration of capital vs revenue issues, Inland Revenue concluded that Clough may apply in New Zealand.
In Clough, the Full Federal Court of Australia held that cash payments to terminate existing share entitlements (shares and options) of employees to facilitate a takeover of Clough were capital in nature and therefore not deductible by the employer. This was because the occasion for the expenditure lay in the corporate takeover and not in the nature of a working expense in the carrying on of the taxpayer's business. In Inland Revenue's view, the following factors which were present in the case, likely influenced the court's finding in Clough that the cancellation payments were capital in nature:
In paragraph 48, PUB00364B stated that:
"Although Clough is an Australian decision and decided under different legislation from New Zealand, it is relevant because it applies conventional capital and revenue principles that are followed in New Zealand, such as in Hallstroms."
During the consultation stage on the interpretation statement, different stakeholders expressed the view that Clough should not be apply in New Zealand and that its potential application may not align with commercial realities of New Zealand businesses with ESSs.
Arguments put forward for why Clough should not be followed in New Zealand included:
On 22 August 2024, Inland Revenue published IS 24/07, which sets out the Commissioner's final view on the deductions for parties to ESSs. Pleasingly, Inland Revenue has taken on board submissions it has received on the applicability of Clough in New Zealand.
Paragraph 45 of IS 24/07 now states that it is uncertain whether New Zealand Courts would follow the decision for the following reasons:
Paragraph 46 of IS 24/07 goes on to state that:
"…if there is evidence that an ESS cancellation payment is to meet an existing obligation owed to employees for past employment services (that are revenue in nature), the payment is revenue in nature. This is the case even if the event crystallising the payment arises from a capital transaction, such as a sale of shares or a business where the terms of the ESS provide for an accelerated vesting on a liquidity event (such as a change of control). However, the revenue outcome is less certain if the terms of the ESS do not provide for a liquidity event, as the employer is not obliged to make the cancellation payment."
IS 24/07 also clarifies that the mere involvement of an employee in the sale process is not determinative that the deemed expenditure is capital in nature. The capital limitation is only likely to apply if either:
Because of these changes, former Example 4 in PUB00364B has been removed from the interpretation statement. We also note that the examples provided in IS 24/07 (i.e., Examples 4 to 6) do not use Clough as the prescribed approach but now follow the general principles noted above. This means that the key consideration under the final rules is whether:
Whether Clough will ultimately be applied by NZ Courts (if the facts come close enough to those of Clough) remains to be seen. IS 24/07 still contains a discussion of Clough (in the Appendix) but is now subject to a disclaimer that it is "uncertain" whether this will be applied in New Zealand as discussed above. The principles outlined in IS 24/07 now provide employers with some pragmatic solutions to avoid any deemed expenditure from closing out an ESS being considered capital in nature and, in turn, non-deductible. These include:
The issuance of IS 24/07 is welcomed. It provides some clarity that Clough is generally unlikely to be applied in New Zealand and that the existence of section DV 27 in the ITA 2007 means there is a different statutory framework compared to Australia under which an employer is able to claim deductions in New Zealand. While the capital limitation in section DA 2(1) must always be considered, IS 24/07 provides employers with analysis and examples as to how to ensure that ESS income earned by employees in an M&A transaction will give rise to a deduction for their employer. For any employer uncertain about the terms of their current ESS, this is a timely reminder to review the terms of their ESS to ensure that the scheme is fit for any future eventuality.
This article was written with the assistance of John Alcantara, a Solicitor in the Auckland Tax team.