Earlier this month MBIE published a report, UpStart Nation, making proposals for how we could improve the startup ecosystem in New Zealand. Among these is the idea that we should change how we tax employee share programs.
Startup employees are taxed when they exercise stock options — that is, when they buy them and “realize” the gain — which they can do long before a company’s value or future is certain. In the eyes of the tax system, though, they owe tax the moment they’ve exercised their options.1
Exercising an option to buy company stock valued at $20 for $10 means you’ve technically made $10 even if you can’t yet sell the stock. You pay tax on that $10, and from then onwards any further appreciation in your shares is treated as a capital gain and thus tax-free. Herein lies the yin and yang of startup risk: the earlier (and cheaper) you exercise, the more of the eventual gain you stand to keep. But likewise, the more risk you take by paying for them before there’s certainty around their value and liquidity.
For many, that risk is too much to bear. Or they simply can’t afford to exercise. In that case, depending on the terms set by the employer, they may be able to exercise at the moment the shares become liquid (whether by going public or by being acquired). This approach is risk-free but means the entire gain is taxed as income.
The report points out that there’s a disparity here between employees and investors. Rowan Simpson makes a good summary of it in his critique of the report:
The current tax system we have in New Zealand means the tax paid by employees and investors in any successful business sale is calculated very differently. This is because investors pay cash to buy their shares in advance, so any gains on that investment are capital gains which are not currently taxed. Meanwhile employees earn their shares by working, which means they are a form of income, and that income is taxed (either immediately or eventually).
The report focuses on the straw man scenario where tax needs to be paid by employees immediately when shares are issued. This is true in theory, but in my experience very rare. Much more commonly these days, employees in high-growth startups are issued long-dated options rather than shares. This means the tax is deferred until an exit occurs. But tax is then due on the full value of those shares at exit, which can be very large amounts.
And then:
It’s difficult to argue that is fair - investors pay 0% capital gains tax on their gains while employees pay 39% income tax on their gains.
This is indeed a problem. Their proposal: either defer taxation until the employee can actually sell for cash or remove that tax altogether.
On the face of it the first option sounds great. But it’s unfeasible for all sorts of reasons. With all the possible twists and turns of an early-stage company, it’s very hard to say when an employee’s shares can really be considered sellable.
As for removing the tax altogether: it’s incredible to me that a group of people, when presented with this problem, would conclude that a reasonable solution is to tax no one. Having the option to own a part of the company you’re helping to build is a privilege very few get. The notion that these lucky few deserve special tax treatment as well is totally unnecessary.
In a follow-up post, Rowan makes the point that ESOP terms set by the employer are what really defines the outcome for employees. As someone who’s been around the block a couple of times now I wholeheartedly agree. I’ve had the fortune to work for two companies that had humane ESOP settings, and in the end that mattered a whole lot more than the taxes I owed2.
Generous ESOP settings should be the norm. Founders might think that restrictive terms will help with staff retention, and they’re kind of right. But often all it serves to do is keep people there in body but not spirit. For an ecosystem to flourish you want talent to have freedom of movement: the freedom to seek out the stage that suits them best. Things like 90-day expiry windows inhibit this freedom, and the people bound by these handcuffs trend toward low morale and productivity. I believe founders have a responsibility to get this right for their employees and the wider startup community. It’s a shame more don’t.
In my mind, the solution to all this is painfully obvious: just tax capital gains and move on. A broader tax base will mean less income tax, evening the burden between employees and investors while simultaneously correcting many of the distortions in our investment economy. It speaks volumes that this wasn’t even mentioned in MBIE’s report. Here’s Rowan again with the final word:
I don’t hear many of the people complaining about tax on ESOP advocating for a capital gains tax.
Everybody just wants to pay less tax.
I can’t help but feel that all this focus on “building the ecosystem” is a distraction. Given time, the ecosystem builds itself out of companies succeeding and spawning new companies. That’s exactly what happened with TradeMe, Xero, and now Vend (to name just a few). I’m now an investor in, consultant for, or co-founder of companies that were started by people I worked with at Vend. Which is ultimately what MBIE wants, right? More founders, more innovation.
You don’t need tax breaks to get there.
- 1.
For a thorough explanation of how this works, I recommend Rowan Simpson's Cost vs Value
- 2.
As a California resident at the time, I paid 45% tax on all Slack shares and 25% on Vend shares