Loop­hole closed

Share scheme amend­ments will af­fect em­ploy­ees’ tax­a­tion

Finweek English Edition - - Creating Wealth - LEON ROOD

EM­PLOY­ERS AND EM­PLOY­EES alike would be well ad­vised to take note of the re­cent changes to the tax regime re­lat­ing to share in­cen­tive schemes. The Rev­enue Laws Amend­ment Act 2008 ( RLAA) con­tains var­i­ous amend­ments that will af­fect the tax­a­tion of such schemes and struc­tures.

Pre­vi­ously, it sought to reg­u­late schemes: wherein an em­ployee re­ceived shares in a com­pany, ei­ther for equal con­sid­er­a­tion or at a dis­count. For ex­am­ple, Di­rec­tor A is of­fered 100 shares in ABC Ltd at a dis­count of 25%. How­ever, al­though Di­rec­tor A re­ceives the shares to­day he may only sell them af­ter five years should he re­main in the em­ploy of ABC Ltd for that pe­riod (the so-called “lock-up pe­riod”). At the ex­piry of the five-year pe­riod Di­rec­tor A ac­quires un­re­stricted own­er­ship of the shares and he may sell them at will.

The In­come Tax Act de­ter­mines Di­rec­tor A won’t be taxed at the date of the of­fer and re­ceipt of the shares but rather upon the vest­ing of the shares (ie, when he ac­quires un­re­stricted own­er­ship). The amount sub­ject to tax­a­tion at the end of the five-year pe­riod will be the amount by which the mar­ket value of the shares, at the date of vest­ing, ex­ceeds the con­sid­er­a­tion paid by Di­rec­tor A at the time of the of­fer. That “gain” is in­cluded in Di­rec­tor A’s re­mu­ner­a­tion and taxed as rev­enue via the pay­roll. Any sub­se­quent sale of the ac­tual shares will be taxed as a cap­i­tal gain or rev­enue in the di­rec­tor’s hands.

Due to the prior word­ing of the def­i­ni­tion of “eq­uity in­stru­ment” only re­fer­ring to shares, share op­tions or fi­nan­cial in­stru­ments con­vert­ible to shares, many em­ploy­ers sought to avoid the sec­tion as a whole by im­ple­ment­ing struc­tures whereby an em­ployee would never ac­tu­ally re­ceive shares.

In­stead, em­ploy­ees re­ceived units or sim­i­lar in­stru­ments not con­vert­ible to shares, the value of which was linked to the shares. An ex­am­ple of such a scheme would be where an em­ployee share trust owns the shares and em­ploy­ees are of­fered units or rights to the value of the shares held by the trust without ever re­ceiv­ing the right to ac­quire the ac­tual shares.

Cer­tain phan­tom share schemes also of­fer some form of in­cen­tive, the value of which is linked to the ac­tual share value de­ter­mined over a pe­riod. At the end of the lock-up pe­riod the em­ployee merely re­ceives a cash amount cal­cu­lated with ref­er­ence to the shares. By us­ing th­ese schemes em­ploy­ers could of­fer their em­ploy­ees in­cen­tives without hav­ing to fall within the tax­ing pro­vi­sions of the Act, as em­ploy­ees never re­ceived “eq­uity in­stru­ments” as de­fined.

The RLAA ef­fec­tively closes that loop­hole by ex­pand­ing the def­i­ni­tion of “eq­uity in­stru­ment”. The fol­low­ing is added to the def­i­ni­tion: “Any con­trac­tual right or obli­ga­tion, the value of which is de­ter­mined di­rectly or in­di­rectly with ref­er­ence to a share or mem­ber’s in­ter­est.”

That ad­di­tion ef­fec­tively brings into the am­bit of the Act all schemes that utilise some form of de­riv­a­tive to cal­cu­late the value of the in­cen­tive but never pro­vide the em­ployee with the right to ac­tu­ally ac­quire shares. Con­se­quently, in the trust ex­am­ple above an em­ployee will now be taxed in terms of this sec­tion, de­spite the fact the em­ployee has a right solely to the value of the shares without any di­rect right in the shares them­selves.

All those com­pli­cated struc­tures are now fu­tile, as far as tax struc­tur­ing is con­cerned.

The above amend­ments are deemed to have come into op­er­a­tion on 21 Oc­to­ber 2008. As a re­sult of the amend­ment em­ploy­ers will have to re­visit their cur­rent schemes to de­ter­mine whether any cap­i­tal dis­tri­bu­tions or eq­uity in­stru­ments were of­fered sub­se­quent to that date.

Go­ing for­ward, em­ploy­ers will have to en­sure their share schemes are taxed cor­rectly as units in an em­ployee trust – for ex­am­ple, those of­fered this year – won’t at­tract the same tax treat­ment as those of­fered in the prior year. Fur­ther­more, care should be taken with eq­uity in­stru­ments that had fi­nan­cial penal­ties for not com­ply­ing with the em­ployer’s terms for is­su­ing the shares. Ef­fec­tive com­mu­ni­ca­tion to em­ploy­ees will also be es­sen­tial to en­sure they make in­formed de­ci­sions when elect­ing to par­tic­i­pate in such schemes.

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