Simpson Grierson - Upstart Nation #2: Taxation

21/08/2023·4 mins to read

Upstart Nation #2: Taxation

The Startup Advisory Council (Council) recently published a comprehensive report Upstart Nation (Report) aiming to accelerate innovation and development in New Zealand’s startup ecosystem. The Report sets out a detailed strategic plan to maximise the potential of New Zealand startups. We are taking a closer look at some of the recommendations.

In this update, we are looking at the Council’s recommendations relating to taxation of startups and their employees.

Employee Share Option Plans (ESOPs)

Working at an early stage startup is risky and can be less well paid than working for an established company. Startups commonly use Employee Share Schemes (ESS), including ESOPs, to compensate employees for the higher risk and lower salary. Employees receive options which they can exercise and convert to shares in the startup.

The Report suggests that taxation of ESOPs in New Zealand is one of the biggest challenges for startups. Employees are currently taxed at the time they exercise the option, rather than when they sell the share. Tax is assessed on the difference between the option exercise price and the then market value of the share. This means that employees may have to pay tax on non-cash gains on shares in a company that may or may not ultimately succeed, making exercise a risky financial burden for employees.

The Report notes that the other issue associated with the current tax treatment of ESOPs is that the startup has to assess the underlying value of its shares each time that an option is exercised. A startup may need to obtain a third party valuation in order to meet valuation requirements, which can potentially cost in excess of $20,000 each time. The Council’s view is that there is insufficient guidance from IRD on what it will accept as proof of value at the time of exercise, leading to a greater administrative burden on startups.

The Report faintly recommends solving the tax issues associated with startup ESOPs by exempting startup ESOPs from tax altogether. Perhaps recognising that this recommendation may be unlikely to gain traction with IRD policy officials or the Government, the Report’s fallback position is that the taxation of startup ESOPs should be deferred until when employees ultimately sell the shares, rather than when they exercise the options, and for IRD to provide more guidance on acceptable (informal) approaches to valuation.

Our view

It is relatively easy under current tax settings to structure an ESOP so that the tax event coincides with a company liquidity event, ensuring the employee does not have an unfunded (or ‘dry’) tax liability. However, the downside of this in some contexts is that the employee is not a shareholder (but merely an option holder) in the growth phase leading up to the liquidity event. This was recognised in a 2017 IRD consultation document (‘Taxation of employee share schemes: start-up companies’) which looked in some detail at the possibility of a deferral of the taxing point under startup ESOPs from option exercise to the time when the employee sells the shares (with tax on the full uplift in value realised on sale). The document noted various design challenges, such as how to define a “startup” and whether the deferral should be time-limited. The consultation process did not go anywhere at the time but this prior work obviously provides a starting point for possible re-engagement with IRD now.

Tax incentives for investing in startups

Many countries, including Australia and the United Kingdom, have introduced tax incentives to encourage investment in startups and venture capital. Typically, these incentives involve capital gains tax exemptions on investments in startups or startup funds and/or the ability to deduct a certain proportion of startup investments from income.

As New Zealand does not have a capital gains tax, the Report recommends developing tax incentives tailored to New Zealand’s tax system, such as allowing investors to deduct up to 30% of the capital they invest in startups or startup funds, capped at a maximum deduction of $200,000 per year and carrying forward unused deductions. The deduction would be available for individuals and investment funds, such as KiwiSaver funds. The Report estimates that the scheme would cost $40 million per year at current investment levels.

Our view

We expect the potential deduction regime would be more palatable to IRD policy officials and Government, and therefore potentially an easier ‘sell’, if the tax value of the deduction had to “repaid” by the investor (by adding back the deduction as income) in the event of a successful exit. In this way, the regime would be similar to the cash-out tax credit regime for R&D tax losses, which requires the cash-out to be repaid in the event of liquidity and other events.

Foreign Investment Fund (FIF) regime

The Report recommends exempting startup investors and founders from New Zealand’s FIF regime, as the regime currently hinders startup relocation through ‘flips’ and other arrangements. In order to further global investment and attract offshore investment, some startups need to relocate their head offices from New Zealand. Once they do, New Zealand based investors and founders may become subject to the FIF regime, which in some cases may require tax to be paid on a deemed rate of return from the investment (the so-called “fair dividend rate” (FDR)) irrespective of whether dividends are paid. The Report argues that in some instances there can also be effective double taxation as investment gains may also be taxed in the country of relocation (eg, if the entity relocates to the United States and New Zealand-based shareholders are subject to citizenship based tax in the United States).

Our view

There is a limited, existing FIF exemption for interests in New Zealand companies that ‘flip’ to so-called ‘grey list’ (high tax) jurisdictions, but maintain New Zealand operations meeting certain strict criteria. The exemption is available for a maximum of ten years from when the entity flips. There may be merit in the first instance in focusing any discussions with IRD or Government on the possibility of expanding this existing ‘grey list’ exemption, perhaps by removing the requirement for continued New Zealand operations. A possible quid pro quo would be to shorten the availability period of the exemption (perhaps to five years). It should be noted that the investor’s actual long-term investment gains are not taxed (including under the FIF rules) so a permanent FIF exemption would be difficult to promote. The double taxation argument is not a particularly strong one. In the case of the United States, the real issue is the United States’ citizenship based approach to taxing individuals, not the New Zealand FIF rules.