Discretionary dividends received by a company

A “last minute” amendment in the Taxation Laws Amendment Act No. 22 of 2012, relating to the income tax treatment of dividends received by a company in certain circumstances, may have far-reaching tax implications for companies and therefore need to be taken into account for all dividends received or accrued on or after 25 October 2012.

Although the general rule is that all local dividends received by or accrued to a taxpayer are exempt from normal tax in terms of section 10(1)(k)(i) of the Income Tax Act No. 58 of 1962 (the Act), in certain limited situations this exemption may not apply and the local dividends may remain fully taxable in the hands of the recipient.

The amendment referred to deals with one of these limited situations and is contained in section 10(1)(k)(i)(ee) of the Act. This specific exception to the general rule, whereby local dividends will remain taxable, deals with two main scenarios, namely dividends received by or accrued to a company in consequence of:

Any cession of the right to that dividend (unless that cession is part of the disposal of all the rights attaching to the share), or
The exercise of a discretionary power by any trustee of a trust (unless that exercise is part of the disposal of all the rights attaching to the share).

It is the latter situation that is discussed in further detail in this article as this amendment is likely to impact many South African (SA) companies that operate employee share incentive trusts.

In practice, these employee share incentive trusts are generally structured as follows:

The trust owns the shares in the trading company on behalf of various qualifying employees.
The shares will only vest in the employees after a particular vesting period, depending on how long an employer wishes to “lock-in” the employee.
Any dividends that are declared by the company in relation to the shares held by the trust prior to being vested in the employee are usually left open to the discretion of the Trustees as to whether they will be distributed to the employee, left in the trust or distributed back to the company itself.

Prior to the introduction of the amendment contained in section 10(1)(k)(i)(ee), the most tax neutral option of dealing with dividends earned by an employee share incentive trust was for the trust to vest these dividends back in the company through the exercise of the Trustees’ discretionary powers. (Refer to item 2201 in which SARS provides a favourable ruling on dividend tax in this situation). Provided the trust deed is properly structured, this vesting results in no dividends tax or normal tax liability, either for the trust or the company.

However, this specific scenario is what the amendment referred to above aims to address and applying section 10(1)(k)(i)(ee) now results in the local dividend becoming fully taxable in the hands of the company, a situation which appears absurd in its application.

It is our understanding that the reasoning behind this particular amendment is Treasury’s perception that these types of arrangements are being used by companies to structure employee share incentive schemes to essentially erode the tax base and do not result in any taxable gain in the hands of the employees themselves despite the operation of section 8C of the Act.

Therefore, until Treasury obtains a better understanding of the exact mechanics of these types of employee share incentive schemes and is able to introduce an amendment that better caters for these specific scenarios, the above amendment will remain and it is up to all companies to carefully consider the rules of their existing employee incentive share schemes to prevent the unnecessary result of local dividends becoming fully taxable.

In this regard, companies would need to compare the dividends tax cost of retaining the dividends in the trust against the normal tax cost of having these dividends taxed in the hands of the company. In most instances the 28% corporate tax rate versus the 15% dividends tax rate would imply that it is more cost effective to retain the dividends in the trust, but this may not be the case where a company has an assessed loss available to shield the taxable dividend being vested by the trust.

Ernst & Young