Once the domain of the upper echelons of management, companies are now making employee share schemes (ESS) more widely available.

But before you decide to participate, it is important to understand how they work as they can carry unexpected income tax and capital gains tax (CGT) implications.

Employers often use the ESS in place of a pay rise or as an incentive tool to align the interests of employers and employees. There are different ways employers may offer shares.

One is a salary-sacrifice arrangement that allows employees to buy the shares at market value. The other allows employees to buy them from after-tax salary but at a discount to the market price.

James Proctor, technical services manager with IPAC Securities, says whichever one you participate in, the tax treatment is similar as long as the company shares are qualifying shares (see left).

In the first instance, the participant in the ESS can choose to have the tax deferred until a so-called cessation time. This is when any restrictions on selling the shares are removed. It may be when you leave the company, or up to 10 years after buying the shares.

"With the deferred-tax option, you are taxed at the market value of your shares at the cessation time, less any amount you paid to acquire the shares," says Proctor. "If you buy the shares by salary sacrifice you are deemed not to have paid anything for the shares."

The value of the shares is added to your taxable income for that year and taxed at normal income tax rates.

If, for example, you were in a scheme in which you bought $5000 of company shares every year from April 2003, you would pay income tax on the market value of the shares you bought in 2003 10 years later in 2013, says Proctor.

As for the shares you bought the following year - 2004 - you would pay tax on the market value of those shares in 2014, he says. "If you sell them straight off within 30 days of the cessation date you are taxed on whatever you sell them for," he says.

If you decide you want to keep them, you pay tax on their market value. "That market value becomes the cost base of the shares for capital gains tax purposes," he says.

To receive the 50 per cent CGT discount when you eventually do sell, you need to keep the shares for at least 12 months from the cessation date.

There is another taxation option with the ESS. That is, to elect to be taxed in advance. Why would you do this?

Proctor says it is because you may be eligible to have up to $1000 of shares under the ESS exempted from income tax. "It's like getting $1000 worth of income, tax-free," he says.

There are additional requirements to qualify for the discount. "The employee is prevented from selling the shares until the earlier of either three years or of leaving employment. All participants in the scheme must be offered the same number of shares," he says.

Of course, CGT will still apply. For that reason, Proctor says it makes sense to keep these shares for at least 12 months after the cessation time to gain the benefit of the 50 per cent discount on CGT.

So which option is best for you? Shalome Ruiter, a technical analyst at Challenger, says it may depend on the share's performance outlet.

"When deferring the assessable income until the cessation time, the income tax is paid on the market value [of the shares] at cessation time," she says.

In this instance, "no capital gains tax will be payable on that growth", she says.

This means that if the shares are expected to grow during that period, the income tax paid with the deferred option will be higher than if the shares had been assessable when acquired and the growth subject to CGT, she says.

What are qualifying shares?

Immediately after the acquisition of shares, the employee is not in a position to cast, or control the casting, of more than 5 per cent of the maximum number of votes that could be cast at a general meeting of the company. Source: Challenger Securities Limited.

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