Disastrous tax consequences for share incentive schemes

The current wording of the tax legislation has the result that both employers and participants in share incentive schemes will suffer substantial negative tax consequences when participating in these types of schemes that are actually designed to incentivise employees and to align their interest with the employer companies.

The first issue to be aware of is the amendment that was introduced to the Income Tax Act, 1962 (the Act) last year dealing with the circumstances under which dividends received by a participant in a share incentive scheme will be exempt. In particular, it is indicated that a dividend will only be exempt if it is received in respect of a restricted equity instrument that constitutes an equity share. There is no quarrel to be made with reference to the fact that the dividend should arise in respect of a restricted equity instrument. The concept of a restricted equity instrument has been defined quite widely so as to include a contractual right or obligation, the value of which is determined directly or indirectly with reference to a share. In other words, if one only has vested rights against the trust or so-called units that derived their value from underlying shares, those units will constitute an equity instrument. Similarly, so-called Share Appreciation Right Plans (SARPs) will also fall within this concept given that the ultimate value is determined at least indirectly with reference to a share. It is irrelevant whether or not the participant will ultimately receive a share.

The concern, however, arises from the fact that the dividend will only be exempt if the restricted equity instrument “constitutes” an equity share. The definition of an equity share was also amended with effect from 1 January 2011 so as to mean a share excluding a share or similar interest that does not carry any right to participate beyond a specified amount in a distribution. In other words, preference shares or any share that does not entitle one to participate beyond a specified amount in a distribution will not constitute an equity share. To that extent, the principle can also be accepted that participation in preference shares should not result in the participant receiving an exempt dividend. However, the problem is that the restricted equity instrument itself must constitute an equity share. Should a participant therefore only have a right to participate in dividends or have a unit that ultimately entitles him to receive a share, any dividends that are passed through a share incentive trust will no longer be exempt. This seems to be inequitable especially in circumstances where the underlying shares may be ordinary shares that are held by the share incentive trust pending release thereof to the participants at some stage in the future. Any right against a share incentive trust will now result in the dividends no longer being exempt.

Another issue that has arisen relates to the fact that the dealings of the share incentive trust may become taxable, even though the intention is merely to benefit the participants. For instance, if a share is given at par value to a participant, one should appreciate that the trust and the participant are connected persons. Given the deeming provisions contained in paragraph 38 of the Eighth Schedule to the Act, the share is deemed to have been transferred by the share incentive trust to the participant at market value, thus resulting in a substantial tax liability for the trust. Once again this could hardly have been contemplated.

In the recent Budget Speech it was indicated that the current regime may be revisited. In particular, it was indicated that employers provide employment trusts which appear to result in unintended double taxation and allow for the conversion of disguised salary into tax free dividends. The goal is to ensure that only one level of ordinary tax properly applies. Hopefully, the legislation that will be introduced will make it clear that no double tax liability will arise in the share incentive trust and that an employee will still receive an exempt dividend in circumstances where his unit or vested right against the trust relates to an underlying ordinary share that is held for his benefit.

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