Shares And Options

This page provides some information on shares and options that may be useful to Australian share and option holders who are not particularly familiar with shares and options.

Warning: The information on this page is provided on an "as is" basis and should not be interpreted as formal or professional advice on these matters by Ross Williams. Ross Williams accepts no direct or consequential liability for errors or omissions in this page. For definitive advice on equities and tax, please consult qualified lawyers and accountants.

Why Companies Exist

Hundreds of years ago, all businesses were owned and run entirely by individuals or partners or groups of partners. This worked, but suffered from the disadvantage that the resources available to the business tended to depend on the individual wealth of the partners and the extent to which they could organize loans and other finance deals personally.

At some stage (I don't know when (I would guess in the 1600s)), the corporation was invented. Instead of a business consisting of a group of partners who accepted all the liability of the business and got all the profits, businesses could now consist of corporations that were "legal persons" in their own right in the eyes of the law. As legal persons, corporations can make and spend money, be fined, obey or break laws and reap the benefits or consequences of their actions. If a corporation runs out of money, it is liquidated and ceases to exist.

Instead of being owned by partners who accept all the benefit and liability of the business, corporations are owned by shareholders who can benefit from the profits of the business but are protected from any liability incurred by the company. If a shareholder invests money in a company, the worst that can happen to them is that they lose all the money they have invested; they cannot lose ten times that amount because the company is liquidated with massive debts. The company is run by a board of directors who accept responsibility for the company's actions and draw a salary. The separation of benefit and liability allows professional investors to distribute their wealth in a large number of companies without fear of losing all their money because of a single investment in one mismanaged company. Because they are protected in this way, investors need perform less work investigating a company before investing in it. This contrasts strongly with the investigation they would need to perform if they were to become partners in a non-corporation partnership and overall makes capital markets more fluid than they would otherwise be.

Another advantage of corporations is that the corporate structure allows there to be a very large number of shareholders. This means that a community of (say) ten thousand people can join forces and each invest one thousand dollars each to create a corporation with ten million dollars. If corporations didn't exist, the corporation could not be created unless there were a few partners who could get together and gather the money using their own resources. Thus, corporations allow businesses of greater size to be created than would otherwise be possible, and this enables economies of scale to be created in the economy.

Note: The terms "corporation" and "company" mean much the same thing.

Shares

Every company is owned by its shareholders. At any point in time, every company has a certain number of shares "on issue". If you own shares in a company, the proportion of the company that you own is the number of shares you own divided by the total number of shares on issue. So if a company has one hundred million shares on issue, and you own one million shares, then you own one percent of the company.

The shareholders of a company control the board and certain important decisions a company can make about its shares. The amount of power a shareholder has depends on the proportion of the company's shares that they own.

Trading Shares and Share Value

Each shareholder is free to sell their shares to other parties at a price negotiated by the two parties. The price that shares are trading at at a given point in time is known as the share price. The share price may vary on a day to day or month to month basis, depending on what the company is doing. Investors make money from shares by selling them at a higher price than they bought them and by accepting dividends issued by the company.

Dividends

If a company makes a profit, it may choose to issue the profit (after paying corporate tax of about 33% (Australia)) to its shareholders. This is called a dividend.

Creating New Stock (Important Point)

Many people who are unfamiliar with corporate structures imagine that companies have a fixed number of shares (e.g. 1,000,000) and all that happens is that those shares are purchased and sold. This is largely true.

However, in companies that are growing it is very common for the company to issue new stock to various parties. This is just like printing money in that it dilutes the proportional holding of the existing shareholders. For example, if a company had one million shares on issue, and it created 100,000 new shares and gave them to someone, then the previous shareholders would end up with 10/11 of the proportion of the company they owned before.

Companies create (issue) new shares for a variety of reasons. A company might issue some shares to key employees as part of their salary package, or it might issue some shares to one of its suppliers as a form of payment. However, the most usual reason that a company issues shares is to raise cash, and if it does it carefully, the existing shareholders, while suffering a dilution in their proportionate ownership, do not suffer a reduction in their dollar value.

For example, suppose that a company has 1,000,000 shares on issue, and those shares are trading at $1. Suppose that the company sells 100,000 shares to the public at $1 per share. After this has taken place, the company has 1,100,000 shares on issue, but now has $100,000 of cash that it didn't have before. Thus, whereas the company was worth $1,000,000 before the issue, it must now be worth $1,100,000, and a shareholder who previously owned 100,000 shares which were 1/10 of the company and were worth $100,000 now owns 100,000 shares that are 1/11 of the company but are still worth $100,000. Thus, if a company issues new stock at the current trading price of the company, it dilutes the proportion of the company owned by existing shareholders, but it does not dilute the value of their shareholding.

High-growth companies usually fund their growth by issuing batches (rounds) of stock to investors at increasingly high prices. At each round, the proportion of the company that existing investors own is reduced ("dilution"), but the value of each of their shares goes up (because the fact that the round has sold at the new higher price proves that people are prepared to pay the new higher price for the shares). This is why the shareholders tolerate the dilution. As the share price increases, the company has to issue less and less new stock to generate the same amount of cash, so the severity of the dilution usually decreases as time goes by.

Companies often issue shares and options to employees and other people and entities that are in a position to add value to the company.

In summary, the ability to create ("issue") new stock is an important way in which companies can increase their value. The creation of new stock always reduces the proportion of the company that existing shareholders have, but they don't usually mind so long as the issue does not reduce the share price. High growth companies are constantly diluting their existing shareholders while simultaneously increasing their value.

Escrow

Sometimes a company imposes a restriction on some of its shares so that they cannot be sold for a period of time. Such shares are said to be in escrow.

Options

An option is a formal promise by a company to sell the option-holder a share in the company at a particular price. This price is known as the option's exercise price (or strike price).

An option has an expiry date after which the option becomes null and void.

So, for example, you might own an option to purchase a share in a company at twenty cents with an expiry date of 1 October 2005. This means that, at any time before 1 October 2005, you can pay the company twenty cents and demand that the company issue you with a single share in the company in return. This is known as exercising the option.

Typically investors will own a large number of options. Thus, someone might say that they have "100,000 options with a strike price of 30c and an expiry date of 1 May 2005".

What investors typically do with options is keep them until the share price is significantly higher than the option strike price. They then exercise the options to buy shares and immediately sell the shares to access the profit (being the difference between the share price and the option strike price). Investors may also wait until the the share price is getting near the option strike price and exercise the options and then wait one year before selling the shares so as to to halve the tax payable on the increase in value (see a later section on tax).

Valuing Options

There are many ways of valuing options, but the simplest and most obvious is simply to subtract the option strike price from the current share price. For example, if a company's shares are trading at $1 and you have an option with a strike price of 30c, then the option is worth 70c because you could instantly exercise it at a cost of 30c and then sell it for $1, yielding an instant profit of 70c.

If the current share price is lower than the option price, then the option is worthless at that instant of time. However, it may become very valuable in the future if the share price rises past the option's strike price.

Example: If you owned 10,000 options with a strike price of 30c in a company whose shares were trading at $1, then the value of the options is 10,000 x ($1 - 30c) which is $7000.

Trading Options

Options can be bought and sold, just as shares can.

Capital Gains Tax On Shares

In Australia, there is a Capital Gains Tax (CGT) law that means that if you purchase stock at a price X and later sell it at price Y, and Y is greater than X, then the gap (Y-X) is treated as income and you pay income tax on it as if you had earned it working in a job. If your income puts the top part of your regular salary in the top marginal tax bracket (in Australia roughly 50% tax) then any increase in the value of your shares will be taxed at about 50%. Note: For the purposes of simplification, the remainder of this page will assume that the top marginal income tax rate is 50%. This is very close to the truth in Australia, where it is (from memory) 48.5%.

The tax is only payable when you sell (dispose) the shares. If you just hang onto the shares as they increase, you don't have to pay any tax as the years roll by and the shares become more and more valuable.

There is a special rule that means that the capital gains tax on a disposal is halved if you are an individual (as opposed to a company) and have owned the shares for more than one year. This means that the capital gains tax rate will be about 25% for those in the top marginal tax bracket (of about 50%).

For example, if you purchased 100,000 shares for $0.30 in May 2000 and sold them for $0.80 each in March 2001, you would make a profit of $50,000 and pay about $25,000 in capital gains tax. However, if you sold them in June 2001, you would pay only about $12,500 in capital gains tax.

Rule of thumb: When you sell shares, the increase in value is taxed at 50% if you have owned them for less than one year, and 25% if you have owned them for one year or more.

(The above assumes that you are in the top marginal tax bracket).

Note: If you lose  money on shares, the loss is tax deductible. (I'm not sure if it's generally deductible, or only deductible against future capital gains).

If shares are owned by a trust and the proceeds of the disposal of shares are allocated to an individual, then this disposal qualifies for the 50% reduction in capital gains tax (provided that the shares have been held by the trust for at least a year). If the proceeds of the disposal are allocated to a company, then the 50% reduction in CGT does not apply to that allocation.

Capital Gains Tax On Options

The act of exercising an option is the same as the act of purchasing a share, except that the option is destroyed in the process. So there is no tax payable at that time. However, if you then immediately sell the share (as many option holders do), you must pay capital gains tax on the increase in value (between the price you paid and the price you received). As you only just bought the share, you must pay the full capital gains tax.

Rule of thumb: If you exercise an option and immediately sell the share, the profit is taxed at 50%.

(The above assumes that you are in the top marginal tax bracket).

The CGT one-year exemption means that, ignoring the original cost of acquisition (which is usually higher for shares than for options), it is generally better to have shares (if you can keep them for a year) in a company than options in a company.

If you sell an option instead of exercising it, you will pay capital gains tax on the difference between the amount you originally paid for the option and the amount you sold it for. I am not sure if the one-year CGT rule applies in this case.

ESOP Options

There is a special class of options called ESOP (Employee Share Option Plan) Options that can be exercised and the shares sold as if they had been owned for one year. Only options issued under a particular ESOP benefit from this exemption. Options obtained by employees other than ESOP options do not benefit from the exemption.

How To Calculate The Value Of Your Shares And Options After Tax

The following assumes that you are in the top marginal tax bracket and that the current share price is P:

Shares owned for less than a year: If you purchased a share for X and have owned a share for less than one year, its value to you after tax is about P - (0.5 x (P-X)).

Shares owned for at least a year: If you purchased a share for X and have owned the share for more than one year, its value to you after tax is about P - (0.75 x (P-X)).

Options: If you own an option with a strike price of S, then its value to you after tax is about 0.5 x (P-S).

ESOP Options: If you own an Employee Share Option Plan (ESOP) option with a strike price of S, then its value to you after tax is about 0.75 x (P-S).

Example: A shareholder purchases 100,000 shares for $10,000 (10c each) and gets 50,000 options with a strike price of 50c for free as part of the deal. The shareholder holds the shares and options for two years and then sells the shares and exercises all the options and sells the resulting 50,000 shares. How much does the shareholder make after tax if the share price at the time of sale is $1?

Answer: The 100,000 shares will sell for $1 each, yielding $100,000. As the shares were purchased for $10,000, this is a capital gain of $90,000. As the shares have been held for a year, the tax rate is 25% so $90,000 x 0.25 tax is payable which is $22,500, yielding an after-tax yield of $77,500 and an after-tax profit of $67,500. The options will cost $25,000 (50,000 x 50c) to exercise and the resulting shares can be immediately sold for $50,000 (50,000 x $1) thus yielding a capital gain of $25,000, which will be taxed at 50% as the shares resulting from the exercise of the options have been held for less than a year. Thus, the options will yield a net after-tax yield (which is also the after-tax profit as the options were free) of $12,500. In summary, the shares and options together will yield an after-tax yield of $90,000 ($77,500 + $12,500) and an after-tax profit of $80,000 ($67,500 + $12,500).

Disposals At Less Than Market Value

One disposes of stock when one transfers ownership of the stock to another person. The rules described above determine the amount of tax that must be paid when a share is disposed at market value. However, if a share is disposed at less than market value, special rules apply.

If the buyer and the seller are at arms length (i.e. they are unrelated (in specifically defined ways)) then there is no special rule; the seller pays tax as described above, and the buyer pays no tax at that instant but makes a note of the purchase price so that the capital gains tax can be calculated when they sell the share later.

However, if the buyer and seller are not at arm's length (e.g. they are married or are parent and child), then the tax office assumes that the seller is trying to evade capital gains tax by selling the shares to the buyer at less than market price while getting some secret value from the buyer in some other way unknown the tax office. For example, a son might sell 10,000 shares whose market value is $1/share to his father for $0.10/share in the knowledge that the father will let the son live in the father's beach house for the next six months free of charge.

For this reason, the tax office has a concept of imputed value. If you dispose of an asset to a related party at less than market value the tax office pretends that you were actually paid market value, and taxes you on that! Thus, in the example above, (assuming the son originally got the shares for $0.05/share) in practice the tax office would charge the son capital gains tax on $9500 which is the difference between the son's original purchase price and the current market value, even though the son only received $1000!

Note that, while the tax office charges the seller the tax on the difference between the seller's original purchase price and the imputed market value, the tax office is fair in that it allows the buyer to list the imputed market value as their buy price for the purpose of calculating their capital gains tax later when they sell the share at a later date. In this way, the tax office charges tax on the capital gain on the asset as it moves from owner to owner without taxing the same capital gain twice.

Gifts In The Form Of Shares And Options

If you give a related or unrelated party a gift of cash, no tax is payable by either party (unless there is employer/employee or supplier/supplyee relationship). However, if you attempt to give shares and options to someone, this counts as a capital asset disposal event in capital gains tax law and you will be taxed on the capital gain that occurred since you purchased the asset.

This means that it is expensive to give away stock to friends and relatives if it has increased in value since you acquired it! For example, if you founded a company (purchase price of shares zero) and a few years later had a million shares worth $1/share, then if you wanted to give 10,000 shares to a friend, then the tax office would impute a disposal value of $10,000 and you would pay capital gains tax on that. In this case, as the shares had been owned for more than one year, the capital gains tax would be 25% or about $2500 (assuming top marginal tax rate). The friend would pay no money for the shares and no tax upon receiving the shares and would list the imputed purchase price of $10,000 as the purchase price for the purpose of calculating the capital gains tax when they sell the shares later.

Options are treated in a similar way. Suppose that you founded a company and give yourself a million options with a strike price of 10c. After a few years, the company's share price is $1 and you give a friend 10,000 options. This is a disposal event, and as the options have increased in value by $9,000, you would pay capital gains tax on the capital gain of $9,000. The friend would pay nothing at the time they receive the options.

All this means that one must be very careful about making gifts of shares and options. Here are three ways to avoid CGT when giving away shares and options:

Give away shares only when they are worthless: You will pay almost no CGT if you give away shares when you are just founding your company, as the shares will be worth almost nothing at that point in time. Similarly, if your company looks as if it is about to be liquidated, that's a great opportunity too! :-)

Charge the receiver just the CGT: If the recipient has a little cash spare, you could charge them just the CGT. For example, if you want to give them 10,000 shares and their market value is $1/share, you could charge them $2500 which is the CGT you will have to pay on the disposal.

Give options whose strike price is above market value: If the current share price is 50c, and you have options whose strike price is 60c, you can give away as many as you like and pay no CGT. However, the moment the share price rises above 60c, you will have to pay CGT to give away the options.

It's important to understand that the three techniques above do not reduce the amount of tax ultimately paid to the tax office. They just change the time of its payment. All that these techniques do is organize for the tax to be paid by the givee at the time that they sell the shares (and have just received a lump of cash of which a portion can easily be carved off and sent to the tax office) rather than paid by you at the time you give the shares to the givee (having received no cash for the shares ever!).

When Is Capital Gains Tax Payable?

As I understand it, for an individual, capital gains tax is payable a certain period of time after your personal tax return is lodged. Thus, the tax payable on all transactions during the financial year July 2000 though June 2001 is payable by (say) May 2002. Thus there may be a significant delay between the time when an asset is disposed and the time when the capital gains tax for the disposal is made.

Tax Payable On Acquisition

As I understand it, there is no tax payable upon acquisition of shares or options, even if they are purchased at less than market value from a related party. Thus, if someone gives you shares or options, you need not be concerned that you will have to pay tax before you have disposed of them.

However, if the purchaser is an employee of the seller, and the transaction is made at less than market value, then the tax office may charge tax on the difference between the sale value and the market value. For example, if a company issued an employee with 1000 free shares that were trading at $1 each, the tax office would treat the transfer as if the company had simply paid the employee $1000 cash.

It's All Terribly Complicated

This page is intended as an introductory guide to new shareholders operating under Australian law. The law regarding these matters is very complex and it is likely that this page oversimplifies in places and is plain wrong in others. However, probably most of this page is accurate. If it isn't, I'm in a lot of trouble. :-)

Warning: The information on this page is provided on an "as is" basis and should not be interpreted as formal or professional advice on these matters by Ross Williams. Ross Williams accepts no direct or consequential liability for errors or omissions in this page. For definitive advice on equities and tax, please consult qualified lawyers and accountants.

Ross Williams (ross@ross.net)
5 July 2002

Revised 5 July 2002.