1. Prior to 26 October 2004
1.1. The taxation of gains realised by directors and employees has hitherto been governed by the provisions of s8A of the Income Tax Act, 1962 ("the Act"). That situation will change upon the promulgation of the Revenue Laws Amendment Bill, 2004 ("the Bill"), which it is thought is shortly to be promulgated. The Bill contains far-reaching changes to the existing regime. In terms of the Bill s8A is to be replaced with an entirely new s8C which will impose taxes on share incentive schemes in a far more extensive manner. In addition, a new s8B is to be introduced which will apply to the taxation of Broad-Based Employee Share Plans. These changes will take effect from 26 October 2004.
1.2. The existing s8A essentially applies only to the taxation of gains arising on the exercise of options to acquire shares in the employer company. That section also provides relief to the taxpayer where the employer has 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 will be taxed only in the year of assessment during which he or she becomes entitled to dispose of the shares. A further existing notable benefit for directors and employees is that, in terms of s10(1)(nE) of the Act (known as the ‘stop loss’ provision), taxpayers have been able to walk away from schemes, without penalty, where the employer agrees to cancel the transaction under which the taxpayer purchased the shares, or agrees to repurchase the shares from the taxpayer at a price not exceeding the sale price. These provisions have been applied in the past where the scheme is financially ‘under water’, with the result that taxpayers have been able to exit without penalty or tax in these circumstances, including forgiveness of the debt for the shares so purchased.
1.3. For years directors and employees have been able to avoid tax on gains arising out of share incentive schemes by virtue of the fact that the schemes have been constructed, basically, as share purchases (with many variations), rather than share options. Under a share purchase arrangement the taxpayer commits 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 is advanced to the taxpayer for this purpose, with or without interest. If the interest is less than the official rate, then that will constitute a taxable benefit in the taxpayer’s hands. On the date upon which settlement is due, the taxpayer repays the loan (sometimes out of the proceeds of a sale of the shares) and the shares are delivered to him or her free of tax in that the transaction constituted a purchase, rather than an option. In the result, the taxpayer is taxed only on a subsequent disposal of the shares and then, if he or she is not a share dealer, only at capital gains tax rates.
1.4. The benefits are obvious. Directors and employees, more particularly in the recent past, have realised what have been criticized as unconscionable gains free of tax. These gains are usually referred to in the press as gains on option plans, but in reality they are tax free gains arising from share purchase schemes. The perceived inequality of the situation is readily apparent, particularly as the gains are 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 Bill will replace 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 s8C is structured is totally different to that of s8A. It will apply 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 rights of ownership are conditional upon the occurrence of some other event.
2.3. The new concept to be introduced by s8C is that upon the 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 Bill will also provide 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. The Bill will also introduce a new s8B. This will apply to what will be known as Broad-Based Employee Share Plans.
3.2. Such plans will work as follows –
3.2.1. they will 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 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 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. 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.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.