The manner in which the South African tax legislature has historically attempted to deal with tax amendments is certainly not very proficient, and one cannot help but speculate what the thought process was behind the closed doors of National Treasury when the 2011 Draft Taxation Laws Amendment Bill, which was released for comment on 3 June 2011, was prepared. In the context of share incentive schemes alone, the following two examples are pointed out.
Proposed amendments to employee share incentive trust structures
From 1 January 2011, section 10(1)(k)(i)(dd) to the Income Tax Act, 1962 (“the Act”) provides that dividends in respect of a “restricted equity instrument”, as defined in section 8C, would attract income tax in the hands of the recipient. Thankfully and due to vigorous representations made by the public, the legislature added an exclusion to ensure that this provision would not apply if such restricted equity instruments are equity shares. The reason for the introduction of this section was, as stated in the 2010 Explanatory Memorandum, to align the treatment of dividends with capital distributions on restricted equity instruments, to ensure that in both instances the receipt is treated as ordinary revenue. This reason seems to be slightly nonsensical, as a replacement of a taxable capital distribution with a tax-free dividend in the context of an incentive scheme is exceptional and would, in most instances, make little or no commercial sense. However, let’s not speculate on what thoughts were devised behind those closed doors when this reason was written down on paper.
Employee share ownership trusts, which are most commonly used in incentive schemes, unfortunately did not fall outside the ambit of this peculiar amendment. This is because the scheme is typically structured in such a manner that the trust acquires the underlying shares, while the participant acquires a restricted vested right to the income and gains accruing on those shares, without having a right to the underlying shares. The primary objective is, especially in the private company environment, to prevent the shares from being traded in the hands of employees and the public, whilst creating a mechanism whereby the employee can participate in the benefits of such shares through its vested right.
It was accepted that the trust, by virtue of it being the recipient of the dividend, would be subject to section 10(1)(k)(i)(dd), as section 8C(5)(b) provides that if an equity instrument was acquired by any person other than the participant (i.e. the trust) by virtue of the participant’s employment or office of director, then the provisions of section 8C of the Act will effectively apply as if the beneficiaries had acquired the equity instrument themselves. Accordingly, because the shares held by the trust are deemed to be subject to section 8C, the dividends that accrue to the trust will become subject to income tax by virtue of section 10(1)(k)(i)(dd), unless such shares were unrestricted or constituted restricted equity shares.
During the existence of the trust the income accruing to the participants in terms of their vested rights will be subject to income tax in terms of the normal principles applicable to trusts, as contained in section 25B of the Act. In terms of this section, a vesting trust is transparent for income tax purposes, which means that any income derived by a trust for the benefit of a beneficiary with a vested right to such income is deemed to have accrued directly to the beneficiary. This is commonly referred to as the “conduit principle”, and has the effect that any dividends which accrue to the trust and vest in the beneficiaries will retain their nature as a dividend and remain exempt in the hands of the beneficiaries by virtue of section 10(1)(k) of the Act. However, because section 25B is a deeming provision, the contention was that the dividends were not received in respect of the participants’ vested rights, and as a result the provisions of section 10(1)(k)(i)(dd) would only apply to the trust or, put differently, the dividends which were received in respect of the shares held by the trust. Accordingly, section 10(1)(k)(i)(dd) will apply at the trust level, and not to the participant.
The 2011 Draft Taxation Laws Amendment Bill, however, introduces another exemption to section 10(1)(k)(i)(dd), namely any restricted equity instrument that constitutes an interest in a trust, the value of which is determined with reference to an equity share, if that interest meets the requirements prescribed by the Minister of Finance by regulation. The Explanatory Memorandum explains that the 2010 amendment was overly broad, which has caused the holding of shares through employee trusts to be affected as well. It is stated that the purpose of the proposed addition is to add a carve-back, in terms of which the anti-avoidance rule is limited without opening pre-existing avoidance.
Whilst this forward-thinking of the legislature, i.e. ensuring that the participants’ vested right falls under the exemption, is welcomed, it is unclear as to whether this amendment is really necessary. As explained above, in our view the participant in the scheme was never affected by section 10(1)(k)(i)(dd) as it is the trust, being the holder of the share in respect of which the dividend is received, that will be subject to section 10(1)(k)(i)(dd). In addition, as the matter will be governed through regulation, it creates an opportunity for the Minister to distinguish between different types of employee share ownership trusts, on a basis which is currently entirely unclear. The only indication in the Explanatory Memorandum is reference to trusts within the context of black economic empowerment. However, it seems ludicrous that a distinction could be made on this basis. The result is that until the proclamation of the regulations, every existing or contemplated employee share ownership trust in South Africa remains in a state of flux regarding its future existence.
While there is certainly a lot to say about the introduction of this section, its absurd wording also finds application in the context of employee share ownership trusts.
As mentioned above, the primary objective of the trust is to prevent the shares from being traded in the hands of employees and the public, whilst creating a mechanism whereby the employee can participate in the benefits of such shares through its vested right. One of these benefits is that the trust, being the holder of the share, is given the right to require a third party to acquire that share at a market-related price, thereby ensuring that a trading market is created for the shares.
In terms of the proposed new section 8EA, the concept of a “third-party backed share” is introduced which means, inter alia, any share where the holder has a right, whether fixed or contingent, to require any party other than the issuer of that share to acquire that share from the holder. The effect of section 8EA is that any dividend received by or accrued to a person in respect of such third-party backed share must be deemed to an amount of income received, i.e. it loses its status as a tax-free dividend.
In the context of the employee share ownership trust, section 8EA essentially means that in order to ensure that dividend receipts will remain tax-free (that is of course on the assumption that the provisions of section 10(1)(k)(i)(dd) are not already triggered), the trust would have to give up its right to require a third party to purchase the shares at a market-related price. Put differently, the effect of section 8EA is to remove any protection which the trust has to ensure growth and benefits for its employees.
The good news is that the legislature has provided for an exemption. Provided that the third-party backed share was issued on or before 31 May 2012, a written application may be submitted to the Commissioner: SARS and if the Commissioner, in consultation with the Minister, has approved the transaction after being satisfied it does not erode the tax base in South Africa, the dividends will remain tax-free. Whilst it is not clear how one would convince the Commissioner and the Minister that tax-free dividends do not erode the tax base in South Africa, what is definite is that certainty in tax law unquestionably would not form part of taxpayers’ rights anymore.
Considering the 2011 Draft Taxation Laws Amendment Bill, perhaps it is better to accept that what happens behind those close doors should stay behind them.