1 Prior to 26 October 2004
1.1 The taxation of gains realised by directors and employees under share incentive schemes was previously governed by the provisions of s8A of the Income Tax Act, 1962 ("the Act"). That situation has changed with the introduction of the Revenue Laws Amendment Act 32/2004 ("the Amending Act") which was promulgated on 24 January 2005. The Amending Act contains far-reaching changes to the old regime. Section 8A of the Act has been replaced with an entirely new s8C which imposes taxes on share incentive schemes in a far more extensive manner. In addition, a new s8B has been introduced which will apply to the taxation of Broad-Based Employee Share Plans. These changes all take effect from 26 October 2004.
1.2 The old s8A essentially applied only to the taxation of gains arising on the exercise of options to acquire shares in the employer company. That section also provided relief to the taxpayer where the employer imposed a condition limiting the taxpayer’s right of disposal of the shares arising on the exercise of the option, until a later year of assessment. In those circumstances the taxpayer was taxed only in the year of assessment during which he or she became entitled to dispose of the shares. A further existing notable benefit for directors and employees was that, in terms of s10(1)(nE) (known as the ‘stop loss’ provision), taxpayers were able to walk away from schemes, without penalty, where the employer agreed to cancel the transaction under which the taxpayer purchased the shares, or agreed to repurchase the shares from the taxpayer at a price not exceeding the sale price. These provisions were applied in the past where the scheme was financially ‘under water’, with the result that taxpayers were able to exit without penalty or tax, including forgiveness of the debt for the shares so purchased.
1.3 For years directors and employees were able to avoid tax on gains arising out of share incentive schemes by virtue of the fact that the schemes were constructed, basically, as share purchases (with many variations), rather than as share options. Under a share purchase arrangement the taxpayer committed himself or herself to the purchase of the shares on day one, with the price being payable over a period of, say, five years. A loan was advanced to the taxpayer for this purpose, with or without interest. If the interest was less than the official rate, then that would constitute a taxable benefit in the taxpayer’s hands. On the date upon which the full purchase price became payable, the taxpayer repaid the loan (sometimes out of the proceeds of a sale of the shares) and the shares were delivered to him or her free of tax in that the transaction constituted a purchase, rather than an option. In the result, the taxpayer was taxed only on a subsequent disposal of the shares and then, if he or she was not a share dealer, only at capital gains tax rates.
1.4 The benefits were obvious. Directors and employees, more particularly in the recent past, have realised what have been criticized as unconscionable gains free of tax. These gains were usually referred to in the press as gains on option plans, but in reality they were tax free gains arising from share purchase schemes. The perceived inequality of the situation became readily apparent, particularly as the gains were mostly confined to the top echelon of management, with the rank and file getting minimal, if any, benefit.
2 On and after 26 October 2004
2.1 The new s8C of the Act has replaced the entire s8A. The old s8A will continue to apply to rights exercised under schemes in existence at 26 October 2004, but not to rights arising under schemes concluded on or after that date.
2.2 The basis upon which the new s8C is structured is totally different to that of the old s8A. It applies to share options, share purchases, deferred schemes and any other arrangement whereby a director or employee is granted rights to shares, and those rights are subject to one or other condition. Every share incentive scheme, whatever its structure, is in the very nature of things subject to various conditions. For example, the director or employee is not allowed to dispose of the shares until he or she has been in employment for a prescribed minimum number of years: the director or employee is not allowed to exercise voting rights whilst the shares are pledged as security for a loan: ownership does not pass until the full purchase price has been paid: or the rights of ownership are conditional upon the occurrence of some other event.
2.3 The new concept introduced by s8C is that upon any restriction ceasing to exist, i.e. when the employee acquires a vested right in and to full ownership of the shares concerned, the employee will, at that stage, be taxed on the difference between the consideration paid for the shares, and their market value at the date of vesting.
2.4 So, whatever the structure of the scheme, at the end of the day the director or employee will be taxed on the gain at normal income tax rates, as if it arose from employment. Thereafter, on a disposal of the shares in question, the director or employee will suffer capital gains tax if a gain is realised, or normal tax if he or she is taxed as a share dealer.
2.5 The Amending Act also provides for the deletion of the existing ‘stop loss’ provision, so that all gains or losses arising from the award of shares or options to directors or employees will be treated as income, or losses, and taxed accordingly.
3 Broad-Based Employee Share Plans
3.1 A new s8B has also been introduced. This applies to what are defined as Broad-Based Employee Share Plans.
3.2 Such Plans work as follows –
3.2.1 they apply to what will be known as ‘qualifying equity shares’ acquired by employees in the share capital of the employer or any other group company, for a consideration not exceeding the minimum subscription required by the Companies Act, which can be as little as 1 cent, or fractions of a cent, per share, depending upon the denomination in which the shares are issued;
3.2.2 employees who are already participants in other employer equity schemes will not be entitled to participate;
3.2.3 the Plan must be available to at least 90% of all employees other than those mentioned in 3.2.2 above;
3.2.4 each employee will be entitled to take up shares (on which the employee will be entitled to all dividends and full voting rights) in the employer company (or in any other group company) up to a maximum value of R9 000 over a period of three years. These shares can be taken up in any one, two or more of the three years, provided that the aggregate market value of such shares does not exceed R9 000, and
3.2.5 the employer will be entitled to a tax deduction for the market value of all the shares issued to participants in the plan limited to R3 000 per annum in respect of each employee, with the excess being carried forward for deduction in subsequent years i.e. the issue of such shares will be treated as a business expense, but at the same time it must be realised that the employer will receive very little if anything for the shares. Compare this to the current situation where for accounting disclosure purposes the cost of shares issued in respect of other employee equity schemes must be brought to account, but no tax deductions are permitted!
3.3 As the cost to the employee of his or her shares cannot exceed the minimum subscription price required in terms of the Companies Act to be paid for the shares concerned, the employee’s exposure will be minimal. If the par value of the shares allocated to the employee is, for example, R100, whilst their market value is R9 000, then the employee’s debt will be R100 and no more. This will obviously be less if the par value of the shares is expressed in cents or fractions of a cent.
3.4 The employee’s debt may or may not carry interest. Failure to charge interest, or to charge less than the official rate of interest, will not have any tax consequences.
3.5 The employer may impose restrictions on the right of the employee to dispose of the shares, but the employee may not be denied the right to dispose of the shares for more than five years. If the shares are sold within the five year period, then the employee will be taxed on the gain at normal tax rates. If sold after the five year period, then the gain will be taxed at capital gains tax rates.
3.6 In practice, the employee’s indebtedness for the purchase of the shares will be nominal and the risk minimal. In other words, if the share prices go ‘under water’ then the nominal debt will ultimately have to be repaid. If the investment is successful then the employee will stand to make a gain which will either be taxed at normal rates or at capital gains tax rates.
3.7 The potential benefits for all parties are enormous. The employee will be properly incentivised to perform; the risks to the employee are minimal; gains will be taxed in the normal course in most cases at low rates; the employer will be entitled to a tax deduction for the market value of the shares; and a solid foundation will be created upon which broad-based share participations can be achieved, and BEE objectives can be met.
4 Black Economic Empowerment Objectives
4.1 The Broad-Based Employee Share Plans will undoubtedly act as a platform for the acceleration of black economic integration in commerce, industry and other disciplines. The acceleration of the process can easily be achieved by an increase in the maximum permitted investment of R9 000, per participant, whenever deemed necessary to promote these objectives. At the same time the benefits to all interested parties will be maintained.
4.2 Expanding the scope of these Broad-Based Plans by creating special classes of shares for participants is also a possibility. Such separate classes of shares could be issued for fractions of a cent, with suitable adjustments to voting rights. The Listings Requirements of the JSE may, however, restrict this possibility where listed shares are involved.
4.3 But, overall, the impact of a Broad-Based Employee Share Plan could be significant in the context of Black Economic Empowerment objectives. Take, for example, a small cap R20 million unlisted company with 200 employees. Assume that all participate in the Plan. At a level of R9 000 each, shares to the value of R1.8 million would be issued to the participants. This would amount to an effective participation of 8.2% in the enlarged capital. What a significant step in the direction of Black Economic Empowerment in relation to existing and future Charters! And this process could be accelerated by simply increasing the maximum permitted participation of R9 000 per employee.
5 The legal structures for the above Schemes and Plans
We are developing schemes and plans to achieve these objectives of the new legislation. We should be pleased to assist and to advise on the legal structure and documents required for any of the aforegoing.
Established in the early 1920s, Deneys Reitz is one of the largest law firms in South Africa with offices in Johannesburg, Durban and Cape Town. The firm’s corporate client base includes the major financial institutions, mining houses, insurance companies, industrial conglomerates as well as professional firms and overseas companies. The firm’s 189 lawyers provide corporate clients with expert professional advice and assistance in all areas of law affecting these corporations.
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