Intellectual Property Research Institute of Australia

Intellectual Property Research Institute of Australia Working Paper No. 09/2005

Sellers of Labour or Investors of Intellectual Capital?

by

Cameron Rider

Date: October 2005

Abstract: IP spin-off companies typically face cash-flow constraints which prevent them offering competitive cash-based compensation packages to employees. An important mechanism for counteracting this disadvantage is the use of employee shares in lieu of cash salary– ie the grant of shares which can be acquired by employees at a deep discount to market value (the “acquisition discount”). However, current Australian tax law inhibits widespread use of employee shares by IP spin-off companies, by generally treating the acquisition discount as taxable employment income at the time of grant of the shares, notwithstanding that the discount will be an unrealised and contingent gain, subject to high levels of investment risk. This paper considers whether this treatment is conceptually appropriate as a matter of tax policy; or whether the acquisition discount should instead be treated as a normal capital gain on a share investment, taxable only when subsequently realised on sale of the share. It is observed that Australian tax policy currently purports to resolve this conceptual problem on the basis of legal form - the acquisition discount is taxed as employment income because it arises as a matter of legal form from an employment contract. This paper argues that the problem should instead be approached from the perspective of economic substance: is the acquisition discount properly treated as the economic equivalent of a cash salary, or should it instead be treated as an unrealised and contingent gain of a share investor? In considering economic substance, the relationship between risk and reward is relevant. The traditional employee does not take a position of significant investment risk in relation to the company which rewards them for the sale of their labour; they receive a guaranteed, fixed and regular cash salary payable regardless of the economic fortunes of the enterprise. By contrast, the holder of an employee share in an IP spin-off company share investor does take a position of significant investment risk in relation to IP spin-off company; they invest their intellectual capital in the spin-off company, and their reward, including the ultimate realisation of the acquisition discount, depends wholly on the economic fortunes of the enterprise: In other words, their economic risk profile is that of an investor, not a seller of labour. Hence, a conceptual approach based on economic substance indicates that, as a matter of tax policy, the acquisition discount on employee shares in an IP spin-off company should receive investor tax treatment, and be taxed as a capital gain only when realised on sale of the share. It should not be taxed as employment income.

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