Employee share incentive schemes are ordinarily implemented by Employer Companies in order to incentivise and retain employees ("Participants") and for such Participants to receive indirect benefits from the appreciation in the growth of such company. Situations may, however, arise where a decline in the market value of the shares of the Employer Company may cause an impoverishment for the Participants. For this reason Employee Share Scheme Documents ("the Scheme Document") ordinarily contain "stop loss" provisions which aim to prevent the Participants from being detrimentally affected by a decline in the value of the Employer Company’s shares.

It is often stipulated in the Scheme Document that, if the purchase price of such share exceeds its market value on a specified date, the participant has a put option to sell the share to the Share Incentive Trust ("the Trust") of the Employer Company. Accordingly, from a commercial perspective, the Participant will not suffer an economic loss as a result of the decrease in the market value of the shares of the Employer Company should such Participant exercise his/her put option to sell such share to the Trust.

In certain situations, on a literal wording of section 8C of the Income Tax Act No. 58 of 1962 ("the Act"), the tax treatment of the exercise by such Participant of his/her put option to sell the share to the Trust may lead to anomalous results.

As a result of the right which the Participants would have to "put" the shares to the Trust at the strike price in the event of the strike price exceeding the market value of the shares on delivery date, the share will likely remain a restricted equity instrument (hereinafter referred to as the "restricted equity instrument") in terms of paragraph (f) of the definition of restricted equity instrument contained in section 8C of the Act. A question which requires consideration is whether the restricted equity instruments coming up for delivery would "vest" in the Participant on the delivery date.

Vesting of restricted equity instruments

In accordance with section 8C(3)(b) of the Act, restricted equity instruments are deemed to vest at the earliest of a number of circumstances (which are not dealt with in this article). Of relevance, however, is section 8C(3)(b)(ii) which provides that restricted equity instruments are deemed to vest (if such occurs earlier than any other situation contemplated in section 8C(3)(b) of the Act) "immediately before that taxpayer disposes of that restricted equity instrument, other than a disposal contemplated in subsection (4) or (5) (a), (b) or (c) ... "

As the Participants will dispose of their shares at a consideration which is more than the market value of such shares (and the transaction would therefore arguably not constitute an arm’s length transaction), and assuming the Participants are not "connected" to the Trust, section 8C(5)(a) of the Act may be applicable and accordingly, there will be no vesting of the shares in the Participants prior to their disposal to the Trust as contemplated in section 8C(3)(b)(ii) of the Act.

It may be argued, however, that section 8C(5)(a) of the Act was intended to combat certain tax avoidance transactions - other than stop losses. Although on the literal wording it is applicable, it seems anomalous that it results in a vesting loss being imputed to the Participants after disposal of the shares pursuant to the stop loss, as explained below.

Since the matter is not entirely clear cut, an analysis of both (a) the consequences arising should the shares be deemed to vest in the Participants as well as (b) the consequences which may arise should the shares not so vest in the Participants, is required.

Tax considerations should the shares be deemed to vest in the participants

Disposal of the share by the trust to the participant

Should the shares vest in the Participants immediately prior to their disposal by the Participants to the Trust (i.e. if section 8C(5)(a) is not applicable), as the strike price of the share upon the time of vesting will exceed the market value of the shares, a loss equal to the difference between the strike price and the market value of the shares will arise in accordance with section 8C(2)(b)(ii) of the Act. This loss will be suffered in the hands of the Participant in terms of section 8C(1)(a)(i) of the Act.

Subsequent disposal of the share by the participant to the trust

The gain realised by the Participants (equal to the difference between the market value and the strike price) upon the subsequent disposal of the share to the Trust, could arguably constitute a taxable fringe benefit granted by the Employer Company to the Participant in terms of the Seventh Schedule to the Act. Accordingly, such gain is to be included in the gross income of the employee for the relevant year of assessment. However, it may be argued that, as the gain in question did not arise as a result of a transaction in respect of which section 8C applies or the cancellation of a section 8C transaction, such gain will be exempt from tax in the hands of the Participants in terms of section 10(1)(nE)(ii) of the Act as it constitutes a repurchase by the Trust of shares previously purchased by the Participant under a share scheme. On this basis, the gain arising in the hands of the participant upon the subsequent disposal of the share to the Trust will constitute exempt income and no tax liability will arise for the Participants upon such disposal of the shares to the Trust.

Alternatively, should the gain realised by the participant upon disposal of the share to the Trust not be regarded as a fringe benefit, such may possibly be regarded as a disposal for capital gains tax purposes. In such event, in accordance with the Eighth Schedule to the Act, a capital gain equal to the difference between the market value of the share and the strike price will be realised in the hands of the Participant.

Tax considerations should the shares not be deemed to vest in the participants

Disposal of the share by the trust to the participant

The share will not vest in the Participant, accordingly there will be no tax effect in terms of section 8C of the Act.

Subsequent disposal of the share by the participant to the trust

In accordance with section 8C(5)(a) of the Act, as the shares would be transferred by the Participants to the Trust in terms of a non-arm’s length transaction, should the shares thereafter "vest" in the Trust, any gain or loss realised by the Trust in respect of such vesting would be deemed to have been made by the Participants. Accordingly, as the Trust would acquire the shares at the strike price which exceeds the market value, and (presumably) the shares would vest in the Trust upon acquisition by the Trust (as all restrictions pertaining to the shares as they relate to the Participants would then presumably cease to have effect), a loss will arise in the hands of the Trust in accordance with section 8C(2)(b)(ii) and such loss will be deemed to have been incurred by the Participants in terms of section 8C(5)(a) of the Act.

On this basis, should the shares not be deemed to vest in the Participants prior to the Participants transferring the shares to the Trust, a loss will be deemed to arise in the hands of the Participants upon the receipt of the shares by the Trust (and the vesting thereof when the last of the restrictions ceases).

Should the shares be regarded as capital in the hands of the Participants, as the Participants would not obtain any vested rights to the shares, in accordance with paragraph 11(2)(j) of the Eighth Schedule to the Act, any disposal of shares to the Trust would be disregarded. Accordingly, no capital gains tax liability would arise in the hands of the Participants.

Recoupments

There seems to be no income tax recoupment or other provisions which would reduce the (deemed) loss suffered by the Participants.

Conclusion

It is evident that section 8C of the Act does not satisfactorily address the scenarios that may arise in practice. While there will arguably be no tax liability for the Participant or the Employer Company in respect of the share delivery or repurchase in question, depending on whether the shares vest in the Participant prior to the re-sale of such share to the Trust, under certain circumstances, the Participants arguably have a tax loss available to them. The existence thereof seems to be anomalous as it is not matched by their commercial position.