Employees Tax
1614. Employees share schemes
March 2008 – Issue 103

 

 

Share option schemes

Share option schemes are relatively uncomplicated and the cost of implementation and maintenance are minimal, mainly because they require only a document containing the terms of the share option scheme and an option agreement to be concluded between the employer company and the employee.

 

In any option scheme the company grants employees an option to subscribe for shares in the company. Typically, the option may be exercisable by employees after a specific period of service to the company, such as 3, 5 or 10 years, or the granting of the option may be linked to the performance of the employees. The board of directors grant the options to employees selected by the board for that purpose. The board normally determines the employees who qualify for options and the number of shares which are to be the subject of each option, and options are granted by means of a resolution of the board.

 

The terms of an option given to the employee shall specify the number of shares in respect of which the option is granted, the dates upon which such option, or any part thereof, may be exercised by the employee, the option price and the date on which the option price is payable. The rules of the scheme can furthermore provide that an option shall lapse under certain circumstances, for example if an option holder ceases to be in employment of the employment company in certain specified circumstances, such as resignation, dismissal as a result of misconduct, or poor or substandard performance.

 

The option is often granted to employees at the market price of the shares at the time of the granting of the option, although the granting of options at a nominal price also occurs. The employees are not required to pay for the shares referred to in the option until they exercise the option. Only once the purchase price for the shares is paid does the employee take delivery of the shares. Upon exercise of the option, the employees can either pay for the shares with their own funds, which shares are then allotted and issued to them. Alternatively, the employees can pay for the shares with funds lent to them by the company. In the latter case, the shares are held in pledge, pending repayment of the loan.

 

The effect of section 8C

Any share option scheme whereby an employee or a director acquires an option to purchase shares in the employer company by virtue of his employment, falls within the ambit of section 8C of the Income Tax Act No. 58 of 1962 (the Act). The effect of section 8C is that if the equity instrument (i.e. the option) generates a gain, the taxpayer is required to include such gain in his income for the tax year in which the instrument vests in him. The gain is calculated by subtracting from the market value of the equity instrument at the time that it vests in the taxpayer the sum of any consideration paid by the taxpayer in respect of the equity instrument. This can be illustrated as follows:

 

On 1 December 2007 the market value of the shares in C (Pty) Ltd is R3 per share. Joe, an employee of C (Pty) Ltd, is given an option on 1 December 2007 to purchase 1 000 shares in C (Pty) Ltd at a price of R3 per share. Joe is, however, in terms of the option scheme only allowed to exercise the option after he has been in the employment of C (Pty) Ltd for a period of 5 years, i.e. on 1 December 2012. On 1 December 2012 he is still in the employ of C (Pty) Ltd and he exercises his options and acquires all of the shares. At the time of the exercise of the options the market value of the shares is R7 a share. Joe thereafter decides to hold the shares as capital assets until July 2021, when he disposes of them at a price of R22 000.

 

When Joe receives the options in 2007 he is not taxed on the value of the options as they are restricted equity instruments. In terms of section 8C, Joe is only subject to tax on the date when these equity instruments become unrestricted, which is the date when he becomes entitled to exercise the options and is free to dispose of the shares concerned. When Joe exercises the options on 1 December 2012, it is the difference between the market value of the options (which is essentially the market value of the underlying shares) i.e. (R7 000) and the price payable for the options (R3 000) which will be subject to income tax in Joe’s hands.

 

This will result in a total gain of R4 000 which is subject to income tax in Joe’s hands. C (Pty) Ltd will be obliged, in its capacity as employer, to deduct employees’ tax (PAYE) from this amount. In terms of paragraph 20(1)(h)(i) of the Eighth Schedule to the Act, Joe is allowed to treat the R7 000 (i.e. the market value of the options at the date of exercise) as the base cost of the shares. This means that when Joe disposes of the shares in 2021, he will be subject to CGT on the difference between R22 000 and R7 000, resulting in a total capital gain of R15 000.

 

The above example could become slightly more complicated if Joe is under no obligation to exercise the option in 2012, but is given flexibility with regards to the timing of his exercise. In such an instance the restrictions are still lifted in 2012 because Joe is entitled to exercise the option, thereby triggering the income tax liability in Joe’s hands notwithstanding the fact that he does not actually exercise the option. In this scenario it is important to carefully consider the terms of the option scheme to determine whether all the restrictions have indeed been lifted.

 

If, for example, there is a restriction on Joe in terms of which he cannot transfer or alienate his option rights, the scheme effectively continues to impose a restriction, which has the effect that the option remains a restricted equity instrument. Vesting will therefore only take place if this restriction is removed by the company or when Joe disposes of the option, whichever is the earlier. Provided that the restriction is not lifted by the company, it is then the exercise of the option that would trigger a disposal of the restricted equity instrument. This means that vesting for purposes of section 8C will only take place on such date as Joe exercises his option, and accordingly the employer is only obliged to calculate the gain and deduct employees' tax on the date of such exercise.

 

Share incentive trusts

Share incentive trusts, also referred to as a "SIT", have been used for many years as the vehicle to implement an employee share incentive scheme. From a commercial point of view, a SIT makes an excellent tool for holding shares on behalf of employees, which is the reason why they have been so popular.

 

Typically, a SIT model would involve the following steps:

 

The formation of the SIT and the issue and subscription of the shares in the employer do not have any tax consequences in the hands of either the employer or the SIT. However, the manner in which the SIT model is structured (i.e. for all of the employees in general or only for a select few) will determine the tax consequences in the hands of such employees.

 

Example 1: The general staff trust model

The general staff trust model is normally used where an employer wants the majority of its employees to become part of the SIT, whilst not requiring them to pay any consideration for the shares allocated to them. In these circumstances the provisions of section 8B, and not section 8C, of the Act would apply to the employees.

 

Section 8B was introduced in 2004 to promote long-term, broad-based employee empowerment by allowing employees to participate in the success of their employer with minimal tax cost. In essence, what section 8B does is to allow for the tax-free treatment of "qualifying equity shares" acquired by employees, even though these shares may be acquired at no cost or at a discount.

 

In order for a share to be a "qualifying equity share" for purposes of section 8B it must satisfy two requirements:

 

In order to qualify as a "broad-based employee share plan" the following conditions must be met:

 

The effect of section 8B is the following:

 

The critical element of any general staff trust model is that when the qualifying employees become beneficiaries of the trust and are granted the shares, they receive an immediate corresponding vested right to the shares as well as the income from the shares (i.e. the dividends). However, although the shares have vested in the beneficiaries, they will generally not be entitled to sell, cede, transfer, pledge or otherwise dispose of or encumber the shares until the expiry of a prescribed lock-in period. For purposes of section 8B the lock-in period is a maximum period of 5 years from the date of grant.

 

During the lock-in period dividends paid or any other distribution made by the employer in respect of the shares that have been granted to the beneficiaries, shall be paid or distributed to those beneficiaries. At the expiry of the lock-in period or on the death or insolvency of a beneficiary, whichever is the earlier, the shares that have been granted to each beneficiary shall be transferred to the beneficiary in question, or may be sold by the SIT on behalf of the beneficiary concerned, within a time limit determined by the trust deed.

 

For purposes of section 8B of the Act, no restriction may be placed on the disposal of the shares by the beneficiary other than the lock-in period. Should the employer wish to include, for example, a disposal of the shares in the case of a forfeiture event, then the tax benefits available by virtue of section 8B of the Act will not be available, and the provisions of section 8C would apply.

 

Example 2: The selected employee trust model

In terms of this model the shares are not allocated to the employees in terms of a specific broad-based share plan, but only to certain employees at specified times. In other words, the employer retains the right to decide which employees are to be allocated participation rights and the date of such allocation. The method used in determining the extent of the participation rights to be allocated is generally not prescribed by the trust deed and the employer has the sole discretion to oversee this process.

The allocation of participation rights to an employee shall give such employee a right to a number of shares and the income derived from such shares, as determined by the employer. The employees may be required to purchase the shares at a price to be determined by the employer, however, the payment of such purchase price could take place at the expiry of a prescribed lock-in period.

 

It is important to note that immediately upon the allocation of participation rights the employee becomes a beneficiary of the SIT. However, the employee does not acquire any vested right to any underlying shares, as the shares only vest in the beneficiary after the expiry of the lock-in period. At this time the beneficiary is entitled to instruct the trustees to either sell the shares and pay to him the balance after settling the amount outstanding on the purchase price; or transfer the shares to him provided he has made payment of the amount outstanding on the purchase price within a time period stipulated in the trust deed.

 

During the lock-in period the beneficiaries have a vested right to dividends paid or any other distribution made by the employer in respect of the shares, less any costs or taxes. Generally these dividends and/or payments are not paid to the beneficiary but are credited against the amount outstanding on the purchase price of the shares, if any. Because the employees acquire the right to shares in an employer company, the provisions of section 8C will apply. This means that the employees are taxed on the difference between the market value of the shares on the date when they become unrestricted and the consideration paid by the employee for such share. Although the concept of "vesting" for purposes of section 8C is different from the vesting of a trust asset for purposes of trust law, the vesting of the shares in a beneficiary of the SIT should coincide with the vesting requirements for purposes of section 8C.

 

The tax consequences of section 8C are explained through the following example. Peter is a senior manager of ABC (Pty) Ltd and is given the right to participate in 5 000 shares in ABC (Pty) Ltd, which shares are held by the ABC Trust in terms of an employee trust scheme. In terms of the trust deed Peter immediately acquires a vested right to the dividends received by the Trust in respect of the 5,000 shares, but the shares will only vest after a period of 5 years.

 

Peter does not pay any consideration for this participation right, but to obtain a vested right to the shares after 5 years he will have to pay a price of R10 per share. At the end of the 5 years the trustees vest the 5 000 shares in Peter, when the market price of the shares is R15 per share.

In terms of section 8C, Peter is taxed on the difference between the market value of the shares on the date they vest in him (R15) and the consideration paid by Peter per share (R10). This gain is subject to income tax in the form of PAYE in Peter’s hands.

 

The above example is based on the assumption that the trust acquired the shares in ABC (Pty) Ltd at the market value of R10 per share. To achieve such a purchase, the SIT may require third party funding to acquire the shares. Such funding could be in the form of a loan, but because the interest on the loan is not a tax deductible expense, it is generally more efficient to raise capital through preference share funding provided by a bank. The trust then uses the dividends which it receives in respect of the shares to repay such loan.

 

The situation above would be different if the Trust, for example, subscribed for the shares at nominal value.

 

This is because in terms of paragraph 11(1)(d) of the Eighth Schedule to the Act the vesting of a trust asset in a beneficiary triggers a disposal in the trust’s hands. Furthermore, in terms of paragraph 80(1) the gains realised on such disposal flow through to the beneficiary and are taxed in the beneficiary’s hands, and because the trust and the beneficiary are connected persons in relation to each other, the disposal is deemed to be at market value.

 

Using Peter’s example above, if the trust subscribed for the shares at a market-related price of R10, and vested these shares in Peter when the market price was R15, the R5 gain realised by the trust upon the disposal is taxed in Peter’s hands by virtue of paragraph 11(1)(d). However, because Peter is already taxed on the gains by virtue of section 8C, paragraph 35(3) of the Eighth Schedule provides relief against double taxation to the extent that the proceeds received by the beneficiary must be reduced by any amount that was taken into account when determining the taxable income of the beneficiary before the inclusion of any taxable capital gain.

 

Assuming, however, the trust did not incur any expenditure for the acquisition of these shares, it would mean that the prevention of the double taxation would only apply in respect of the R5, with the result that the R5 gain will be subject to income tax, whilst the balance of R10 will be subject to CGT in Peter’s hands.

 

Alternative share incentive models

The undesirable tax consequences introduced by section 8C of the Act could cause a SIT to become unattractive, with the result that employers may choose to revert to the more conventional share option schemes. However, with careful planning it is still possible for businesses to use SITs as a mechanism for employment share schemes without having to face all of the consequences of section 8C. Due to the fact that the operation of these types of models is technical and requires a careful analysis of goals of the incentive scheme, the types of employees who will be participating in the scheme (e.g. senior executives or all of the employees) and the particular circumstances of the company, a detailed discussion thereof falls beyond the scope of this article.

 

Edward Nathan Sonnenbergs Inc.

 

IT Act:S 8B,

IT Act:S 8C,

IT Act:S 8th Schedule par 11(1)(d), 20(1)(h)(i), 35(3), 80(1)