Share scheme amendments will affect employees’ taxation
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.