Keeping your executive and management appropriately incentivised remains a key part of business strategy driving success, profitability and sustainability. Incentive schemes have gone through many changes and exotic structures the years, primarily to take advantage of tax loopholes but also to keep pace with global best practice.
We can loosely categorise these incentive schemes into two types - STIP's and LTIP's:
An STIP (short term incentive plans) is a formal scheme that details the conditions, amounts, and schedule in which the executives receive a bonus based on their performance over a period of one year or less. The main benefit of the short-term incentive plan is to align the executives' goals with the company's short-term strategy and to reward them for achieving specific financial or operational targets. The bonus amount is usually calculated as a percentage of the base salary and may vary depending on the level of performance achieved.
An LTIP (Long term incentive plans) is a formal scheme that looks to establish a deferred compensation strategy that rewards executives for reaching specific goals that lead to increased shareholder value over a period of more than one year. The goals may be based on financial or operational performance measures, such as earnings per share, return on capital, or total shareholder return. The rewards may be in the form of cash or equity-based awards, such as restricted stock, stock options, or performance shares. The purpose of an LTIP is to align the executives' interests with the company's long-term strategy and to retain and motivate them for sustained growth.
STIP's and LTIP's are typically made up of one or more of (or combination of) the following strategies –
1. Bonuses payable for performance / employment duration
2. Phantom shares based on performance / employment duration
3. Actual shares based on performance / employment duration
A Phantom Share is a type of bonus compensation that mimics the financial returns of a share, while not being a share at all. A Phantom share gives an employee the right to receive a cash payment based on the value of the company's shares. Unlike actual shares, Phantom shares do not confer any ownership rights or voting rights to the employee. The cash payment is usually made at a specified future date or event, such as an exit or liquidity event.
Key Issues Faced
Regardless of the way in which the STIP or the LTIP is set up, the perennial challenge is to ensure the following two key criteria are as far as possible always met –
1. The STIP/LTIP must engender the correct behaviour in executives. STIP's are often notorious for creating short term benefits at the expense of long-term goals and, if not properly structured, can foster poor management behaviour; and
2. The proceeds under any incentive plan must be structured in a way that always seeks to reduce the tax incidence for the employee being incentivised (or manage the timing of the tax event to a time when there is liquidity).
Full Quantum Schemes
An analysis for companies listed on the Johannesburg Stock Exchange between 2002 and 2015 will reveal that share options were the most popular share-based incentive until 2008, but were then replaced by share appreciation rights (SAR's) and later by full quantum schemes.
A full quantum incentive scheme is a type of share-based incentive that grants executives actual shares in the company, subject to certain performance and/or service conditions. Unlike share options or SAR's, full quantum schemes do not require the executives to pay an exercise price to acquire the shares. Full quantum schemes include performance shares and restricted shares. Performance shares are granted based on the achievement of predefined performance targets, while restricted shares are granted based on the continued employment of the executives for a specified period.
Full quantum schemes are largely considered to be the most favourable mechanism to align the interests of executives and shareholders more closely than other types of share-based incentives.
Section 8C of the Income Tax Act
Section 8C of the of the Income Tax Act ("the Act") includes, in a taxpayer's income, any gains or losses made upon the vesting of an equity instrument (usually a share in a company or an option) that is acquired by virtue of that taxpayer's employment or the holding of any office of director.
Section 8C –
1. Is an anti-avoidance mechanism designed to prevent employees from paying a reduced rate of tax on what is essentially remuneration for employment, by taking shares or other rights instead of cash;
2. makes the receipt or accrual of shares or other rights in connection with one's employment, taxable as income; and
3. seeks to delay the tax until such time that the employee becomes entitled to the full value of the share or rights under the relevant scheme.
Loosely speaking, a taxpayer becomes subject to section 8C when a taxpayer acquires an unrestricted equity instrument for a purchase price which is less than the market price (in which case the difference is taxed) or upon the vesting of a "restricted equity instrument" that was acquired by the taxpayer (in which case the excess of the market value at date of vesting over the purchase price is taxed).
A restricted equity instrument is defined in section 8C(7) of the Act and it includes the following common scenarios that would constitute the equity instrument being considered to be "restricted"-
1. an equity instrument is subject to any restriction (other than a restriction imposed by legislation) that prevents the taxpayer from freely disposing of that equity instrument at market value;
2. where the taxpayer could forfeit ownership of the equity instrument or the right to acquire ownership of the equity instrument, at a price other than at market value;
3. the taxpayer is precluded from selling the equity instrument for a certain specified period;
4. the holder of the equity instrument has to sell the equity instrument to the company for less than market value if he or she leaves the employ of the company before the expiry of a certain period.
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.