The Government’s Budget night announcement about employee share schemes received a fierce rebuke from business and unions alike, a novel feat in itself. After nearly two weeks of confusion, the Government made a welcome announcement that it will consult with business and industry before legislating any changes. Given the Government’s penchant for consultation and discussion (think the 20/20 Summit), why this wasn’t first suggested on Budget night remains a mystery.

The Government changed the way employees pay tax on the shares and options they receive, a move championed by Adam Schwab in Crikey this week and last. The prevailing view of those in favour of the changes is that the system contains loopholes and concessions, that executives rort the system and they do not pay their fair share of tax. Most of the criticism has been nothing more than white noise, generated by a general distaste for the massive remuneration packages received by executives of listed companies and based on seemingly limited knowledge of the tax laws.

Contrary to Schwab’s contention, the original announcement was flawed and destined to fail: it was manifestly unfair and didn’t target actual concerns. The real problem was the non-disclosure of the taxable value of shares and options, which the Weekend Australian said would cost revenue $100m to $1b annually. The system itself was fundamentally sound.

It is probably true that a small minority of employees have simply avoided paying tax (also known as tax evasion — a federal offence), but this conduct is not confined to executives and there is an element of tax evasion across all industries and income levels. Others were not so duplicitous and simply couldn’t decipher the complexities and vagaries that arise when the taxing point is deferred (by up to 10 years, but more commonly by three to five years), for some it was the result of poor advice.

The Government’s first action should have been to make companies mandatorily report this information in the same way that salary and wages are reported: on a group certificate. Additionally, withholding — again, akin to how tax is withheld from salary and wages — could have been implemented. These two measures would have addressed the actual problem and gone a long way to fixing it.

There were generally two ways that an employee could pay tax on the options and shares provided to them by their employer: defer paying tax until the shares vested, or elect to pay tax upfront when they are granted. If the employee defers the taxing point, they will pay tax in the future at their marginal tax rate (usually 46.5% including the Medicare Levy for highly paid executives and usually more tax is paid as, historically, the shares’ value appreciates over time), alternatively if they choose to pay tax up front they again pay at their marginal rate, but they obtain the benefit of the 50% capital gains discount from that point on. It seems to be a common misconception that employees can both defer the taxing point and at the same time use the CGT discount to reduce their tax, this is not true.

Employers typically grant shares and options that are quarantined for a number of years subject to designated performance hurdles being met. More often than not, the employee decides to defer the payment of tax for the simple reason the payment cannot be funded as the shares are unearned and can’t be sold. The importance of this point, on employees at all levels of the ladder, shouldn’t be underestimated: if the shares can’t be sold, the tax bill can’t be paid. Even though the employee may be able to amend a prior year tax return where the options are never exercised (for example, in a bear market), it doesn’t lessen the cash-flow impost at the time of grant. Moreover, why pay tax upfront if there’s uncertainty about ever taking possession of the shares?

The deferral of tax doesn’t actually deprive the Revenue at all, in fact deferral maximises the tax-take as tax is paid at the marginal rate on, usually, an appreciated value. The ability to defer the payment of tax for up to 10 years was at times abused and contrived arrangements could ensure the deferral until well after the last performance hurdle had passed. This is squarely in the gun and the Government is expected to restrict this practice, which is sensible providing it is commercially feasible and fair.

I say fair because taxing employees at the time of grant, as mandated by the Budget announcement, is patently unfair and contrary to the first principles of taxation. At the time of grant, the shares are unearned. That is, the employee has not yet performed the work that will entitle them to the ownership of the shares; it is possible that the shares will never be earned due to inadequate performance or the employee leaving.

If an employee is hired for three years and told they will be paid $100,000 cash each year, we don’t tax that income until it is earned. This is a pillar of tax law principle the world-over. It would be absurd to say “we know you’re contractually entitled to be paid $100,000 in three years’ time, so pay tax on that income today”. In much the same way, employees are now being told to pay tax on the value of shares they might earn in the future. Tax deferral is hardly a concession, but rather a necessity if share schemes are to remain commercially viable. The Government should allow the taxing point to continue to be deferred until the shares are earned.

Similarly, the capital gains discount available to those employees that elect to be taxed at grant is not a share scheme concession. The CGT discount is available to all individuals — employees or not — and applies equally to property, shares, units, options and any other form of capital investment. I can confidently declare that everybody reduces their tax on account of the CGT discount where possible: you, me, your parents, my parents, rich people, poor people, honest people, dishonest people (if they report the gain at all) — we all have access to the discount and all take what is prescribed by law as “ours”.

To single out and decry highly paid executives for taking advantage of the very same concessional tax rule that we all enjoy is really saying “we want rich people to pay more tax” (a comment not without merit). But here comes the rub: the new changes do nothing to limit executives’ ability to access the CGT discount; on the contrary, it has been supplanted as the only method available.

Business, having taken offence to the uncommercial and unworkable nature of taxing at grant and the affront to the notion that tax is paid on income earned, has raised two genuine questions. Firstly, can a company continue to issue options and shares and, in doing so, expose employees to a potentially massive tax bill without regard to the employee’s ability to pay the debt? Clearly no, as evidenced by the mass suspension of share plans since the announcement. Secondly, why are employees being asked to pay tax on income before it is earned?

The debate about the importance and effectiveness of employee equity ownership — from senior executive to shop-floor level — is legitimate but such a discussion should be had in the open rather than by clandestinely hijacking a tax issue and using it to attack executive largesse. The Productivity Commission’s review of executive remuneration is an appropriate forum, although its terms of reference — which includes the taxation of remuneration — have now been unilaterally diminished.

Schwab’s contention that shares schemes are unfair for employees of non-listed employers is too simplistic. For a start, private companies, unit trusts and partnerships can issue equity to their employees and often do so. But most privately owned and run businesses are closely held and the owners have and exercise day-to-day control which they don’t want to dilute.

Employees of listed companies don’t have a right to shares in their employer, the issuing of shares is a commercial decision about remuneration made by the board. That non-listed entities don’t tend to issue equity to all employees is a function of the commercial and market differences between listed and unlisted entities, not the tax laws and so-called concessions. Similarly, employees of non-for-profit and NGOs enjoy various other tax concessions such as fringe benefits allowances, that are not available to other industries.

On Budget night the Government should have announced a consultative review of how employee share schemes are taxed and, more importantly, how the income is disclosed. Two weeks on and this is finally what we have, better late than never.