Dividends now taxable in certain share incentive schemes

Companies must ensure that dividends declared to their employees after 1 January 2011 as part of their employee share incentive schemes are still exempt from income tax otherwise companies and their employees may be in for a surprise.

In the Taxation Laws Amendment Act, No 7 of 2010 (the Amendment Act) amendments were made to the Income Tax Act No. 58 of 1962 (the Act) to the effect that dividends declared in respect of employee share incentive schemes shares will no longer be exempt unless:

the restricted equity instrument constitutes an equity share; or
the dividend constitutes an equity instrument as defined in section 8C of the Act.

The critical issue to appreciate is the new definition of an “equity share” (which differs from the definition of an “equity instrument” in section 8C). An “equity share” is defined (with effect from 1 January 2011) in relation to a company as any share or similar interest in that company, excluding any share or similar interest that does not carry any right to participate beyond a specified amount in a distribution.

Importantly, if any share in an employ share scheme does not carry the right to participate beyond a specified amount in a distribution, it will not be regarded as an “equity share”. In addition, the new definition of an “equity share” requires the holder thereof to participate both in profits as well as a distribution of capital to be treated as an “equity share”. It is therefore no longer an argument (as was the case with the old definition of an “equity share”) that one would be dealing with an “equity share” if only one of the requirements is met (ie. entitled to participate in a distribution of either the profits or capital).

For instance, an ordinary share in a company should not be affected by these amendments. However, share incentive schemes have been implemented using preference shares which may limit the employee’s right to participate in the distributions of the company. Such shares held by an employee will not be regarded as an “equity share”.

Any dividends declared in respect of these shares (ie. shares that do not qualify as an “equity share”) on or after 1 January 2011 will not be exempt from income tax. The employee will be liable to pay income tax on these dividends and the employer will have a responsibility to withhold pay-as-you-earn (PAYE) on behalf of the employee. Accordingly, these amendments will have implications for both the employee who will no longer enjoy the benefit of an exempt dividend and the employer who has an obligation to withhold PAYE.

According to the SARS Explanatory Memorandum, the intention of the amendment is to align the treatment of capital distributions and dividends in respect of certain restricted equity instruments. Since 2008, capital distributions have been subject to income tax to prevent the partial cash-out by the holder of the restricted equity instrument, which reduces the value of the share. Similarly, in the case of a preference share, it was possible for a determined amount of dividends to be declared to the holder thereof before the shares vest in the employee. The employee therefore effectively “cashedout” in the form of exempt dividends before the vesting date and thereby reducing the value of the shares and ultimately the income tax liability falling within section 8C of the Act.

If companies have not done so already, they should revisit their employee share schemes to ensure continued compliance with the Act and to ensure that the scheme still incentivises their employees. Companies should also be mindful that other minor amendments have been made to the Act which may have an effect on the tax treatment of their employee share schemes.