The tax implications for the various participants of a share incentive scheme are complex and the legislation is not necessarily clear. In recent years, share incentive schemes have been a particular focus of the South African Revenue Service (SARS) and the National Treasury, and there have been regular amendments to the tax legislation. It is no wonder that SARS is issuing a number of binding private and binding class rulings that relate to share incentive schemes.
Binding Private Ruling 161 is one such recent ruling. Released on February 5 2014, the ruling deals with the income tax and employees' tax consequences for the employer and the trust used to facilitate an employee share ownership plan (ESOP).
The purpose of the ESOP is to allow qualifying employees to participate in the benefits attributable to the shares of a Johannesburg Stock Exchange-listed holding company (HoldCo). This update does not discuss the mechanics of the ownership plan in detail, but the following should be noted:
- The trust allocated notional units to the participants of the ESOP to determine their participation in the dividends and net capital proceeds attributable to the HoldCo shares.
- The employer made an annual contribution to the trust, which would be used by the trust to acquire shares in the HoldCo.
- As soon as the trust had acquired the HoldCo shares, the trust would confirm with the founder of the trust that units were available for allocation to qualifying employees. If the qualifying employees accepted the units, they would become participants of the ESOP.
- Importantly, the rights attached to the units entitled the participants to:
- an immediate vested right to dividends received by the trust;
- an immediate vested right to the net capital proceeds realised by the trust on disposal of the shares; and
- a vested right to the shares held by the trust when the trustees exercised their discretion to vest the shares in the participants.
- The participants were 'locked-in' for a specific period and were not entitled to dispose of any of the units or shares during the lock-in period. Participation in the ESOP was subject to a number of other restrictions.
One of the more contentious issues that Ruling 161 considered was whether the contributions by the employer to the trust for purposes of the ESOP were deductible for purposes of Section 11(a), read with Section 23(g) of the Income Tax Act, (58/1962). For instance, were such contributions by the employer to the trust "in the production of its income" and "not of a capital nature"? These questions were especially relevant given that the contributions received by the trust would not necessarily be included in its gross income (which was confirmed in Ruling 161).
There is case law (Provider v Commissioner of Taxes, 17 SATC 40) to support the argument that – provided that the contributions to the trust are made by an employer in respect of its own employees and the undertaking to do so is given upfront – the employer should be entitled to a deduction for its contributions to the trust. Ruling 161 confirmed that the employer's contributions to the trust for purposes of this particular ESOP would be deductible under Section 11(a), read with Section 23(g) of the act. A similar ruling was issued in Binding Private Ruling 50.
However, in Ruling 161, no opinion was expressed on the application of Section 23H of the act. Whereas in Ruling 50, SARS indicated Section 23H would apply, but did not indicate how it would apply. The purpose of Section 23H is to match the date on which the expenditure may be claimed by a taxpayer to the date on which the benefit is enjoyed by the taxpayer (ie, where the benefit is not enjoyed by the taxpayer in the same year of assessment). Unfortunately, it was not clear over which period the deduction was to be apportioned in Ruling 161, or whether the employer would be entitled to a deduction each year that a contribution was made to the trust.
Where an ESOP is implemented using a special purpose vehicle, the issue often arises that the special purpose vehicle has no cash from which to withhold the employees' tax obligations, triggered as a result of the vesting of a restricted equity instrument in a participant in terms of Section 8C of the act (ie, on the lifting of the 'lock-in period'). Ruling 161 indicated that:
- if the trust has no funds, the employer will be liable to withhold employees' tax on each Section 8C gain made by a participant; and
- if the trust has funds, the trust will be required to register as an employer and withhold an amount of employees' tax.
Ruling 161 also indicated that employer's contributions to the trust will not be subject to donations tax under Section 54, and that the contributions received by the trust will be of a capital nature and thus not included in the trust's gross income in Section 1.
Binding private and binding class rulings are binding only between SARS and the applicant(s) to the ruling. Other persons may not cite binding private and binding class rulings in any proceedings, including court proceedings, against SARS. Taxpayers requiring certainty on the tax implications of share incentive schemes, which are complex and sometimes uncertain, should therefore apply to SARS for their own advanced tax rulings.
For further information on this topic please contact Andrew Lewis at DLA Cliffe Dekker Hofmeyr Inc by telephone (+27 11 562 1000), fax (+27 11 562 1111) or email (email@example.com). The DLA Cliffe Dekker Hofmeyr website can be accessed at www.cliffedekkerhofmeyr.com.