The taxation of employee share schemes (ESS) in New Zealand underwent fundamental reform in 2018. Despite Inland Revenue publishing a comprehensive and well regarded Special Report on the operation of the new regime in 2018, many aspects of the new rules have remained unclear. One of the more recent areas of uncertainty is the deduction available to employers under section DV 27 of the Income Tax Act 2007 (ITA 2007) when employees receive ESS income as a consequence of the sale of a business. This is because of the potential operation of the capital limitation in section DA 2(1) of the ITA 2007, which can override the deduction available under section DV 27. This question became a topical issue in New Zealand following the decision of the Full Federal Court of Australia in Clough v Commissioner of Taxation [2021] FCAFC 197 (Clough).  

Inland Revenue’s extensive review of the operation of the ESS rules during the course of this year has included detailed consideration of the availability of the deduction under section DV 27, taking into account the decision in Clough. As we discuss in this article, Inland Revenue’s final views on these issues, as outlined in Interpretation Statement 24/07 – Deductions of Parties to Employee Share Schemes 24/07 (IS 24/07), provide some welcome clarity and guidance for employers.

The Proposed Rules in PUB00364/B

Section DV 27(6) of the ITA 2007 governs deductions that employers who are a party to an ESS may take. Generally, an employer is deemed as incurring an amount of expenditure that is equal to the amount of the employees’ benefit calculated under section DV 27(6). However, in order for such an expense to be deductible, the amount must be deductible under ordinary principles as per the general permission (section DA 1) and general limitation (section DA 2) provisions. The first draft of what became IS 24/07 was outlined in draft interpretation statement PUB00364/B, which noted that in the context of ESSs, the capital limitation (section DA 2(1)) that denies a deduction to the extent the expenditure or loss is of a capital nature may be the most relevant general limitation. Further, in a business sale context, which inherently requires consideration of capital vs revenue issues, Inland Revenue concluded that Clough may apply in New Zealand.

In Clough, the Full Federal Court of Australia held that cash payments to terminate existing share entitlements (shares and options) of employees to facilitate a takeover of Clough were capital in nature and therefore not deductible by the employer. This was because the occasion for the expenditure lay in the corporate takeover and not in the nature of a working expense in the carrying on of the taxpayer’s business. In Inland Revenue’s view, the following factors which were present in the case, likely influenced the court’s finding in Clough that the cancellation payments were capital in nature:

• The cancellation of the option plan and incentive scheme was required under the Scheme Implementation Agreement (SIA) and the object of making the payments was to facilitate the takeover of Clough.
• The cancellation payments were made outside the terms of the option plan and incentive scheme.
• There was no evidence that the cancellation payments were to reward employees.
• The cancellation payments were not calculated by reference to the length of time particular employees had served or by reference to performance criteria they had achieved.
• There was no requirement the employees remain employed with Clough as a condition of receiving the cancellation payments.
• The cancellation payments were not connected with considerations of business operations, efficiency or expediency, or reducing future costs.

In paragraph 48, PUB00364B stated that:

“Although Clough is an Australian decision and decided under different legislation from New Zealand, it is relevant because it applies conventional capital and revenue principles that are followed in New Zealand, such as in Hallstroms.”

Criticisms of the application of Clough in New Zealand

During the consultation stage on the interpretation statement, different stakeholders expressed the view that Clough should not be apply in New Zealand and that its potential application may not align with commercial realities of New Zealand businesses with ESSs.

Arguments put forward for why Clough should not be followed in New Zealand included:

• Australia does not have an equivalent provision of section DV 27(6) in its tax rules. The deemed expenditure arising under section DV 27(6) is connected to a corresponding assessable employment income to the employee for their services to the company. Applying Clough would therefore create a mismatch between the tax treatment of income and expense arising from the cash payments.
• Vesting of shares or equivalent cash payments brought about by a liquidity event are awards for the accrued past service of the employees and are therefore connected with the company’s past income-earning activities. It is therefore difficult to characterise such awards as capital in nature, except if the award was provided to remunerate an employee’s involvement in a capital undertaking by the company.
• The application of Clough in NZ would be inconsistent with longstanding industry practice of treating such deemed expenses as deductible, especially if employees are not actively involved in the sale of the business. 

The final position in IS 24/07

On 22 August 2024, Inland Revenue published IS 24/07, which sets out the Commissioner’s final view on the deductions for parties to ESSs. Pleasingly, Inland Revenue has taken on board submissions it has received on the applicability of Clough in New Zealand.

Paragraph 45 of IS 24/07 now states that it is uncertain whether New Zealand Courts would follow the decision for the following reasons:

• Australia does not have a provision similar to our section DV27(6). Consequently, in Australia, if an employer issues shares to an employee, no deemed expenditure arises because the employer does not incur any cost – it only results in a dilution of share capital.
• One of the policy rationales of the ESS regime is to provide a tax neutral treatment of remuneration in the form of cash and shares. Therefore, deductibility rules should also apply consistently for remuneration in the form of cash or shares.
• Clough was decided on the specific facts of the case, and there was no evidence that the cancellation payments were made to reward employees.

Paragraph 46 of IS 24/07 goes on to state that:

“…if there is evidence that an ESS cancellation payment is to meet an existing obligation owed to employees for past employment services (that are revenue in nature), the payment is revenue in nature. This is the case even if the event crystallising the payment arises from a capital transaction, such as a sale of shares or a business where the terms of the ESS provide for an accelerated vesting on a liquidity event (such as a change of control).  However, the revenue outcome is less certain if the terms of the ESS do not provide for a liquidity event, as the employer is not obliged to make the cancellation payment.”

IS 24/07 also clarifies that the mere involvement of an employee in the sale process is not determinative that the deemed expenditure is capital in nature. The capital limitation is only likely to apply if either:

• the employee received an additional amount (i.e. in addition to a pre-existing ESS award) for assisting with the sale process (see Example 5 of IS 24/07), or
• the award was granted to employees for working on a capital project, and the services were performed during the vesting period related to a capital project (see Example 6 of IS 24/07).

Because of these changes, former Example 4 in PUB00364B has been removed from the interpretation statement. We also note that the examples provided in IS 24/07 (i.e., Examples 4 to 6) do not use Clough as the prescribed approach but now follow the general principles noted above. This means that the key consideration under the final rules is whether:

• the obligation to issue shares or make an equivalent cancellation payment exists before the liquidity event, and
• such awards were given in recognition of an employee’s past services.

Whether Clough will ultimately be applied by NZ Courts (if the facts come close enough to those of Clough) remains to be seen. IS 24/07 still contains a discussion of Clough (in the Appendix) but is now subject to a disclaimer that it is “uncertain” whether this will be applied in New Zealand as discussed above. The principles outlined in IS 24/07 now provide employers with some pragmatic solutions to avoid any deemed expenditure from closing out an ESS being considered capital in nature and, in turn, non-deductible. These include:

• Ensuring that the terms of an ESS provide for an accelerated vesting of shares (and if desired making an equivalent cash payment) on a liquidity event, so that any such event is clearly contemplated as part of the design of the scheme;
• If a cancellation payment is to be made, ensuring that there is evidence that the payment is to meet an existing obligation owed to employees (e.g., this can be explicitly noted in the offer letter to employees); and
• Ensuring that the award is not specifically connected with services performed by an employee on a capital project.

The issuance of IS 24/07 is welcomed. It provides some clarity that Clough is generally unlikely to be applied in New Zealand and that the existence of section DV 27 in the ITA 2007 means there is a different statutory framework compared to Australia under which an employer is able to claim deductions in New Zealand.  While the capital limitation in section DA 2(1) must always be considered, IS 24/07 provides employers with analysis and examples as to how to ensure that ESS income earned by employees in an M&A transaction will give rise to a deduction for their employer.  For any employer uncertain about the terms of their current ESS, this is a timely reminder to review the terms of their ESS to ensure that the scheme is fit for any future eventuality.

This article was written with the assistance of John Alcantara, a Solicitor in the Auckland Tax team.