South Africa: Employee Share Incentive Schemes – A Comparison Of The Old And The Newly Promulgated Income Tax Rules Affecting Such Schemes

Last Updated: 6 May 2005
Article by Ernie Lai King

FROM THE WRITER

Employers are advised to review their existing employee share incentive schemes in the light of the latest tax amendments and accounting disclosure requirements. The changes may place employer and employee in a disadvantageous position if the status quo, prior to 26 October 2004, is retained.

Introduction

Share incentive schemes form an important component of employee remuneration packages, which provide benefits to employer and employee alike. To the employer, the benefit lies in securing tenure of employment of executive staff, affording them a personal stake and thereby commitment to enhancing the economic value of the company, which is then hopefully reflected in a rising share price. The employee in turn is financially rewarded through the appreciation in the market value of his or her incentive shares.

It is in the nature of these share schemes to only provide benefits (real and potential) to participants while they remain employees of the company for a specified term. To this end, restrictions in one form or another are invariably introduced into the rules of the schemes to limit any benefit should employer and participant part ways under less than optimal circumstances.

Recently and in line with the King Code to move towards performance-based packages for executives, incentive share schemes are relying to a greater degree on "performance shares", where the number of shares to be awarded are dependent on the achievement of pre-determined targets.

Over the years share incentive schemes, taxable under section 8A of the Income Tax Act, were developed where the after-tax financial benefits to participants were optimised, for example income of a revenue nature was converted to that of a capital nature, which prior to 1 October 2001 allowed the participant to receive a totally tax free capital gain.

With the introduction of capital gains tax on 1 October 2001 participants were taxed on capital gains at an effective rate of 10%, which although obviously not as attractive as the pre-1 October 2001 position, still represented a 75% improvement on the 40% marginal tax rate applicable to income of a revenue nature.

The South African Revenue Service in its ongoing drive to close tax loopholes, especially those available to the so-called "wealthy taxpayer", introduced the new section 8C, which seeks to eliminate the past tax planning.

With effect from 26 October 2004, participants in employee share incentive schemes will be taxed under the new section 8C of the Income Tax Act in respect of any "equity instrument" acquired on or after that date. However equity instruments so acquired, by the exercise of any right granted prior to 26 October 2004, remain to be taxed under the old section 8A. The question of which equity instruments fall under 8C and which remain to be taxed under 8A is therefore one for careful consideration.

The tax amendments coupled with the advent of accounting standard IFRS2/AC139, which requires companies to disclose costs associated with share-based payments may place employer and employee in a disadvantageous position if the status quo, prior to 26 October 2004, is retained. The employer’s income statement will in future reflect an employee cost, which although reducing earnings may not be tax deductible while the future monetary benefit to the share scheme participant will be taxable at a marginal tax rate of 40%.

The issue of restructuring existing share schemes is very topical and highly complex including issues of liquidity, income tax, accounting disclosure, labour law and JSE listing requirements (although the problems are not limited to listed companies only). Employers are advised to seek professional counsel on this matter.

We at Werksmans have made a policy decision not to propose schemes, which seek to exploit the loopholes in the new 8C, as given SARS’ attitude any such exploitation is likely to be short-lived. We have instead worked within the new tax provisions and accounting rules to arrive at arrangements, which we believe can leave employer and employee in much the same position as before.

The current wording of section 8C has caused some interpretative anomalies and I understand that the South African Revenue Service is revisiting the section. My comments on the legislation are therefore as it stands at the date of this publication.

Old section 8A provisions

The taxing event under the old provisions arose on the exercise, cession or release of any right to acquire a marketable security where the right was obtained by virtue of employment or by virtue of holding office as a director or former director of the company. A marketable security was defined as "any security, stock, debenture, share, option or other interest capable of being sold in a share market or exchange".

On the exercise of that right, any "gain", being the excess of the market value of the marketable security, at date of exercise, over any consideration given by the participant, was included in the taxpayer’s income.

Where the participant ceded, for example to a family trust, or released the right, a gain was determined as the excess of any consideration received for such cession or release over any consideration given for the right.

Where a right was exercised and the marketable security acquired but due to a restriction imposed, for example, the participant was not allowed to dispose of the marketable security until some future date, the participant could elect to defer the tax payable on the gain until such time as the restriction fell away.

Where a right to acquire any marketable security was ceded or released for a consideration, which consisted of another right ("the second right") to acquire a marketable security, any inclusion in income was rolled over and taxes on any gains only became due on the exercise, cession or release of the second right.

Tag-along anti-avoidance provisions also caused any gain made by any person, for example a spouse or family trust, other than the participant, to be attributed back in the hands of that participant if that person only obtained the right, due to the participant’s employment or office of director. Similarly if the participant ceded the right to any person, otherwise than under a cession at arm’s length, the tag-along anti-avoidance provisions would attribute the gain back to the participant.

Where a participant acquired a marketable security under a share scheme on loan account and subsequently the market value fell below the original price paid, the provisions of another section in the Income Tax Act, provided a tax exempt escape route to the participant by allowing -

  • a cancellation of the transaction under which the participant purchased the shares; or
  • the repurchase from the participant of the shares at a price not exceeding the original selling price.

In summary, 8A provided for -

  • an inclusion in the taxpayer's income of any gain on the exercise, cession or release of any right to acquire a marketable security;
  • the deferral of the tax consequences of any gain, where a restriction was imposed on the participant from disposing of the marketable security acquired, until the participant is entitled to dispose of the marketable security;
  • a rollover of the tax consequences (where a right to acquire any marketable security was ceded or released for a second right) until the exercise, cession or release of the second right;
  • tag-along anti-avoidance provisions where a gain made by any person other than the participant was attributed back to the participant; and
  • an escape clause, stop loss provision, read with section 10(1)(nE), where in the event that the share price fell below the original acquisition or strike price, the share scheme participant was able to extricate himself or herself, without any adverse tax consequences, from the share scheme by either cancelling the transaction or disposing of the shares at a price not exceeding the original purchase price.

Section 8C provisions

The tax trigger causing an inclusion in income is now no longer the exercise, cession, release of any right to acquire a marketable security but the "vesting" of an "equity instrument" in the participant. This change seeks to eliminate a share scheme participant’s competence to convert revenue gains into capital.

The time of vesting is not simply the time of acquisition but depends on whether the equity instrument is subject to any restrictions. In the case of -

  • an equity instrument, which is not subject to any restrictions i.e. an unrestricted equity instrument, it is the date of acquisition; and
  • an equity instrument, which is subject to restrictions i.e. a restricted equity instrument it is the earliest of -

i) the date when all the restrictions cease to have effect;

ii) immediately before the taxpayer disposes of that restricted equity instrument;

iii) the date of termination of the option where the restricted equity instrument is an option (the wording of this provision is proving problematic);

iv) immediately before the taxpayer dies.

As any gain can only arise on vesting, the principle to defer any taxes payable, until such time as certain restrictions fall away, as seen in 8A, has continued in 8C albeit in a more elaborate manner. The downside is that the taxable portion of the gain is likely to be greater in a scenario of an appreciating share price and where the vesting period is delayed.

An "equity instrument" is defined as -

  • the equity shares of a company;
  • a member's interest in a close corporation;
  • an option to acquire a share or member's interest; and
  • any other financial instrument that is convertible to a share or member's interest.

In comparison to the definition of a "marketable security" in section 8A, a debenture will only be an equity instrument under 8C if it is convertible to a share or member’s interest.

A restricted equity instrument is one where a restriction is imposed on the instrument in one form or another, for example -

  • preventing the participant from freely disposing of the equity instrument at market value;
  • causing the participant to forfeit ownership of the equity instrument other than at market value;
  • by any person retaining the right to impose either of the above restrictions;
  • if the employer, an associated institution, or other person by arrangement with the employer, which parties I will collectively refer to as the "related parties" has, at the time the participant acquires the equity instrument, agreed to -

i) cancel the transaction under which the taxpayer acquired the equity instrument; or

ii) repurchase the equity instrument from the participant at a price greater than the market value at date of repurchase;

if there is a decline in market value of the equity instrument after acquisition. It is no coincidence that this particular restriction mirrors the wording of the old section 10(1)(nE) as it is does provide a stop loss escape clause to 8C as that former section provided to 8A. However being a restriction it may also prove, in some cases, a disadvantage, as the time of vesting is delayed and in a scenario of an appreciating share price the gain on vesting will be greater.

8C provides that any gain on vesting must be included in income but in contrast to 8A allows a loss to be deducted, should a loss arise on vesting and I now turn to the determination of a gain or loss on the vesting of an equity instrument. A gain is determined as the amount by which the market value on date of acquisition exceeds the consideration paid for the equity instrument. Conversely a loss is determined as the amount by which the consideration paid for the equity instrument exceeds the market value on date of acquisition.

In the case of a restricted equity instrument the gain or loss is determined when all the restrictions fall away. However where a restricted equity instrument is disposed of to related parties in terms of the stop loss escape clause restriction, mentioned above, the gain is determined by the excess of the amount received i.e. not necessarily its market value, over the consideration paid for that equity instrument. In the result, where the share price has declined below the original purchase price, the participant may disengage from the share scheme by selling the equity instrument's back to related parties at its original cost. Conversely a loss is determined as the excess of the consideration paid for that equity instrument over the amount received.

Where the restricted equity instrument is disposed of to an independent third party i.e. not a related party, the gain is determined as the excess of the market value of the restricted equity instrument, which may or may not be equal to the amount actually received, over the consideration paid in respect of the restricted equity instrument.

As with 8A, the new 8C also allows for the rollover of any tax consequences on the disposal of a restricted equity instrument in return for another restricted equity instrument ("the second restricted equity instrument"), where the latter is acquired from a related party by arrangement with the employer. The tax consequences are rolled over until the second restricted equity instrument vests.

Tag along anti-avoidance provisions are also included in 8C and apply under the following circumstances where a restricted equity instrument is disposed of -

  • to any person other than a disposal at arm's-length; or
  • to a person who is a "connected person", for example a relative or a family trust,

any gain or loss at the time of vesting will be attributed back to the participant. Under 8A, disposals of a right to acquire any marketable security to a family trust did not activate the tag- along provisions, provided that it was done at arm’s length. This is no longer possible under 8C and the tag-along provisions will act to attribute any gain made by the family trust back to the participant despite the participant having sold the restricted equity instrument to the trust at an arm’s length price.

In summary 8C provides for -

  • an inclusion in the taxpayer's income on the vesting of an equity instrument and no longer on the exercise, cession or release of any right to acquire a marketable security. This new section seeks to negate schemes like the deferred delivery share incentive schemes;
  • a deduction from income on any loss incurred on the vesting of an equity instrument;
  • the deferral of the tax consequences of participating in an employee share scheme until restrictions on an equity instrument fall away;
  • a rollover of the tax consequences, where a restricted equity instrument is disposed of for a second restricted equity instrument from a related party, by arrangement with the employer, until the second restricted equity instrument vests;
  • stricter tag-along anti-avoidance provisions where a gain or loss made by any person other than the participant may be attributed back to the participant; and
  • an escape clause where in the event that the share price falls below the original acquisition price, the participant may extricate himself or herself, without any adverse tax consequences by disposing of the equity instrument at a price not exceeding the original consideration paid.

Conclusion

Employers are advised to review their employee share schemes in the light of the new income tax and accounting disclosure rules as failure to do so may result in not only adverse consequences on their financial results but unexpected tax results for their employee share scheme participants.

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.

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