Current as of December 2014
Phantom stock is a US phenomenon, that has been adopted and adapted in the UK and is now getting more attention in Australia.
It is essentially an Employee Share Scheme (ESS) designed to remunerate key employees at some stage in the future. As the remuneration is deferred, so is the tax.
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 of the company at a later date.
This differs to most existing ESS’s which issue shares, or options, or rights in the company 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 ESS’s are complicated and require significant legal documentation. In contrast a Phantom Share Scheme (PSS) can be very flexible and requires minimal legal and tax paperwork.
Phantom shares are like a cash bonus deferred until the future, but typically much bigger 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.
Phantom shares can be used by start-up companies, in lieu of shares or options, to provide prospective contributors with the success of the start up, 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 it is 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 are 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 so 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 in the same way that a provision is not deductible until it is paid.
PSS’s are tied to an increase in the real share price, whereas most ESS’s are tied to vesting dates. An ESS can still provide employees with benefits 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.
PSS’s 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 PSS’s 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” which is designed to raise finance. The judge concluded that the PSS was not designed to raise finance and so the amount paid was deductible to the company. This court case shows though, that different circumstances could have resulted in the payment being treated as a dividend and not deductible to the company.
This is clearly an area that care needs to be taken in. As it is a scheme to defer income, it will inevitably attract the Australian Tax Office’s attention.
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