Back To The Future: IRD Again Proposes Employee Share Scheme Deferral Regime For Start-up Companies

Avid readers of the Inland Revenue Department's (IRD) policy updates may get a sense of déjà vu when reading “Taxation of employee share schemes: start-up companies”, an issues paper that was released on 31 January 2025. The paper, which proposes changes to the Employee Share Scheme (ESS) rules for start-up companies, is an update of an issues paper by the same name released in May 2017.

The paper recognises the valuation and liquidity issues that are faced by start-up companies and their employees when an ESS benefit arises without a sale or an active market for the relevant shares. As a possible solution, it proposes that the timing of the income and tax calculations could be deferred for employees (with a corresponding deferral of the company’s deduction).

Officials note that when the May 2017 issues paper was released there “was relatively little reaction to the paper, and the proposal did not proceed”. The stated rationale for the resurrection of the proposal is that the 2023 Upstart Nation report highlighted timing of taxation for ESS as one of the key issues facing founders of start-up businesses. We expect that the proposal will proceed this time round, especially given the critical role that start-up companies will play in Government’s growth agenda.

A link to the issues paper is available here.

Who should read this? Why?

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The proposal is intended to apply to “start-up companies” who offer ESS benefits to their employees. While the proposal does not settle on a clear definition for start-ups, officials have indicated a willingness to adopt a flexible approach tailored to specific industries and raise a few options for defining what is a start-up company. Therefore, this proposal will be relevant to a broad range of companies across different industries that consider themselves start-ups. Directors and employees of such companies should consider the paper to gain a clear understanding of the scope of the proposed deferral scheme, along with the associated tax obligations and reporting requirements.

The proposed deferral regime

The paper (like the May 2017 paper) is seeking submissions on the desirability of a regime that would allow for deferred recognition of ESS income (and expenditure) until there was a “liquidity event” to fund the tax on the income. Under such a regime the employee would be taxed on the value of the shares at that time (less any amount the employee paid for them) and the employer would be entitled to a corresponding deduction at that time.

The paper seeks submissions on the details regarding the design of the deferral scheme including:

• the scope of the deferral measure;
• the nature and timing of any election for deferral;
• when the tax imposed should arise under the deferral scheme;
• timing of deductions for the employer; and
• matters of administration and compliance.

Our view

Under existing law, it is possible to structure an ESS so that it has the practical effect of deferring the taxing point, such as by using a long-dated option. However, options do not carry the same rights as shares (i.e., voting rights) and can be undesirable from the perspective of other shareholders. As a result, many start-ups do not use long-dated options and face valuation and liquidity issues when providing ESS benefits to their employees.

Providing start-up companies and their employees with another option for structuring their ESS is, in our view, a valuable and necessary improvement that could enhance their ability to attract and retain talent while addressing the inherent challenges the ESS tax rules pose for start-up companies.

The paper notes that the deferral of taxation yields an after-tax outcome for the employee which is equivalent to the upfront taxation but without the accompanying valuation and liquidity problems. As such, there is no risk to the core principle underpinning the taxation of ESS, namely that the ESS should not provide a relative advantage or disadvantage when compared to other forms of renumeration. That said, deferral would not provide a tax concession, Inland Revenue making it clear that deferral would see employees taxable on gains in the value of shares until the deferral taxing point occurs.

What next

Inland Revenue has explicitly noted that the release of the paper is an attempt to test whether there is appetite for a deferral regime and, if so, how one might operate in practice.

Given the proposal did not progress in 2017 due to a perceived lack of interest. Start-up companies interested in utilising a deferral regime for the taxation of ESS should consider the proposal carefully and make a submission to Inland Revenue.

Consultation closes on 14 March 2025.

Please contact our tax experts if you have any questions or would like assistance in making a submission.

This article was co-authored by Liam Sutherland (Solicitor) and Kevin Qian (Summer Clerk) from our Tax team.

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