How traditional share incentives are taxed is changing their effectiveness as an incentive.
Recent media coverage related to the poor performance of various listed share schemes hints at problems with share incentives in general, however, share purchase schemes, have attracted little criticism despite numerous changes in the tax treatment of such schemes. This article summarises the tax considerations of share incentive strategies and how this may impact the employee and company.
If you belong to a share incentive scheme, you should already be aware of the following additional taxes:
- Interest on loans to employees for share purchase schemes are taxed as a fringe benefit,
- Gains made whilst the shares are restricted are subject to tax at the employee’s personal income tax rates (as higha s 45%!),
- Capital Gains Tax (CGT) on gains made on the subsequent sale of the share.
Senior executives at listed and unlisted companies generally belong to share purchase or share option schemes. Once the primary mechanism for management to accumulate wealth, such structures have become a tax minefield. The South African tax legislation related to share incentives has changed dramatically in recent years.
The profit arising under a share option scheme has always been taxable as income in the hands of an employee, but until recently (2016) the profit arising on a share purchase scheme was treated as a capital gain, taxable at a lower rate.
Equity instruments acquired by virtue of employment are governed by Section 8C of the Income Tax Act. Share incentives generally provide benefits (real and potential) to participants while they remain employees of the company. To this end, restrictions in one form or another are invariably introduced into the rules of the strategies to limit any benefit, should employer and participant part ways. The effect of this section is that if the equity instrument (i.e. the option or share purchase) generates a gain, the taxpayer is required to include such gain in their personal income for the tax year in which the instrument vests in their name.
The taxable gain (included in the employee’s tax return) is calculated by subtracting from the market value of the equity instrument at the time that it vests in the taxpayer from the sum of any consideration paid by the taxpayer in respect of the equity instrument. What this means is that gains on shares generally considered as capital and subject to maximum effective rate of 18%, is now taxed at one’s marginal income tax rate, which can be as high as 45%!
Essentially, all of the gains accruing to employees from “restricted” equity instruments are now subject to income tax.
Suggested questions for company boards and remuneration committee’s to consider prior to implementing an incentive structure include:
- What are the expected outcomes of the incentive structure for the company and participant?
- What are the risks and unintended consequences that may arise?
- Does the company have the resources available to plan, implement and manage the incentive on its own?
- What compliance, tax and reporting requirements are necessary?
A structured process for determining if an incentive structure is right for a company should be followed.
The next article in this series will cover the management buy-in structure, a specially designed structure that mitigates many of the risks highlighted in this article.
Do you require further information?
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