You can look at the pros and cons of such an arrangement from the point of view of the company owner or from the point of view of the person who is getting the shares.
In this short analysis we look at the arrangement from the point of view of the person who is getting the shares: John is the supplier of IT hardware and consultancy services to Harry’s business.
John and Harry are good mates. Harry is starting up a Drone supplier business. John always wanted to be a part-owner of another company and he trusted Harry’s expertise. John thought that it was a good idea to accept shares in Harry’s company in consideration of John supplying his goods and services to the business.
Someone mentioned to John that he should think about Division 83A of the Income Tax Assessment Act 1997 (Cth), as it relates to employee share schemes. But John is not an employee and moreover, the shares are not issued to John at a discount but at market price, so Division 83A does not apply. John breathes a sigh of relief.
In addition, as John is not an employee of Harry’s business, John does not have to consider any applicable fringe benefits tax either. Another issue out of the way!
Harry has told John that Harry does not want the shares sold for three years. Harry needs some degree of continuity and consistency as he will be looking for additional investors in the near future. He wants to be able to show the investors that John and Harry are a united team. John has agreed to sign an escrow arrangement accordingly.
John does not know it yet but the upshot of his arrangement with Harry is that when John receives shares in Harry’s company as payment for the provision of the goods and services to Harry’s company, John is likely to suffer significant cash flow difficulties. These difficulties arise because of the way our income tax and GST laws work.
Both of these taxes can leave John out of pocket as he has an obligation to pay income tax on his business profits and GST on the transactions with Harry’s company.
Income tax consequences
When John receives the shares as a non-cash payment, our tax laws still consider the shares as having the character of income provided that they are convertible to cash.
Harry had told John that Harry was having difficulty in getting anyone to invest in his start up so John did not think that there was going to be any problem with tax. In those circumstances, the shares were unlikely to be ‘convertible to cash’, John thought – even though he knew that Harry’s company was likely to be a success eventually.
But he was not aware of section 21 of the Income Tax Assessment Act 1936 which states that the assessable income in such an arrangement is calculated at an “arm’s length value”, reduced by the recipient’s contributions, if any.
According to ATO TD 93/234, the market value is determined at the time the shares are issued. But Harry’s stipulation on the issue of the shares was that they had to be held by John for three years. John thought that this would get him out of a potential pickle.
However, section 21A(2)(b) of the Income Tax Assessment Act 1936 deals with that and says that any conditions that would prevent or restrict the conversion of the benefit to cash should be disregarded for the purposes of determining the arm’s length value.
So John is going to be out of pocket in that he will be unable to pay the income tax calculated on the shares he receives over the three year period.
And so three years eventually go by and John is desperate to sell his shares. Are the proceeds to be considered as income or as a disposal of capital?
According to IT Case No 726 (1951) 18 SAFTC 90, the receipt of the shares is likely to be at the end of the income producing activity and therefore their market value is to be considered as income. So what? John has already anticipated that as a result of the above analysis.
IT Case No 726 goes on to say that the movement in the value of the shares is generally assessed on capital account, unless it can be shown that John was carrying on a business as a share trader (which he wasn’t of course).
So the shares are received by John as an asset for CGT purposes, and their cost base is their market value: section 110-25(2) of the Income Tax Assessment Act 1997.
The time of their acquisition is the time when the contract was entered into to acquire them. But Harry and John didn’t have a written contract, only a handshake!
Section 109-5(2) of the Income Tax Assessment Act 1997 provides for that too. It says that where there is no contract, the acquisition time is the time of issue or allotment.
Under section 9-75 of the A New Tax System (Goods and Services Tax) Act 1999 (Cth), the “value” of a taxable supply is the “price” x 10/11.
The “price” (where shares are given for the supply of goods and services) is the GST inclusive market value of that consideration.
But Harry’s company, by issuing shares as consideration for John’s goods and services, is making a supply for GST purposes. In other words, the supply of the shares to John is also a supply for GST purposes. It is an input taxed supply, that is, it is a supply on which GST cannot be charged.
Therefore, when John receives the shares, they are received on a GST inclusive market value basis, and the GST component is nil.
So John must be careful not to short-change himself. If the value of John’s supply of IT hardware and IT services is $100,000, he will need to render an invoice for $110,000 and receive shares worth $110.000.
What can John do?
He is going to be out of pocket for income tax, GST and most likely other directly related costs.
One solution is to sell all or part of the shares to cover these costs and liabilities as they fall due. But the shares are escrowed.
John needs to negotiate to receive part of his remuneration in cash, equivalent to 1/11 of the GST inclusive value of his invoice.
As far as the income tax liability is concerned, it will be easier in industries with high profit margins for John to attempt to build the recovery of the income tax liability into the payment negotiation through part payment by cash.
Alternatively, John could borrow funds against the value of the shares issues, perhaps through a margin lending facility.
Always see a lawyer who can tell you what’s going to happen before it happens. That way, you are likely to stay in business as long as you want.
Leigh Adams is an Accredited Specialist in Business Law and he has a particular focus in this area.
If you have any questions, then feel free to contact Leigh on:
9570 7844 or 9964 0022 or email LWA@owenhodge.com.au.