Mr Eduard Sent (Sent) was sent packing by the Federal Court of Australia (FCA) on 16 April 2012, in an appeal against a decision by the Administrative Appeals Tribunal (Tribunal) on whether some or all of a payment of $11,600,000 to an executive share trust (Trust) was assessable as income in the hands of Sent (Sent v Commissioner of Taxation [2012] FCA 382). While the taxation of share incentive schemes in Australia differs from the position in South Africa, the case does highlight certain principles that are equally applicable in South Africa.
Sent was the managing director and chief executive officer of a public company (Employer). In about October 2001, it was determined that Sent was entitled to three bonus payments that fell into three categories, being bonuses that:
Had accrued and were payable;
were accruing, relating to periods which had been part performed; and
related to future periods which had not accrued in any sense (ie related to the future financial performance of the Employer).
Sent and the Employer entered into an arrangement, that in consideration for Sent waiving his entitlements to any remuneration or bonus payable to him, the Employer will issue him or his nominee with five million fully paid ordinary shares in the Employer (the Shares). Shareholder approval was obtained on 30 November 2001 for the issue of the Shares to Sent or his nominee.
However, the Trust was only created in December 2001. As part of establishing the Trust, an arrangement was entered into where among others, the Employer would settle money on the trustees (ie the $11,6 million payment to the Trust (the Payment)), which would be used to make loans to eligible employees (Sent in this case) for the purpose of applying to the trustees for units in the Trust. Monies received by the trustees for units in the Trust were to be used exclusively to acquire the Shares. The units could not be cancelled at the instigation of a unit holder (Sent) within 12 months of their issue.
The issue for determination was whether the $11,6 million Payment to the Trust by the Employer, in whole or in part, should be assessable as ordinary income. The Tribunal had found that only a portion of the payment was assessable as ordinary income in the 2002 year of assessment.
The FCA found that the entire Payment was assessable as ordinary income and stated the following:
The fact that some of Sent’s bonus entitlements were contingent and subject to claw back in that they were based on the Employer’s future performance, and may be viewed as having been paid before the services were provided, does not mean that the Payment loses its character as income. The timing of a payment as against the provision of the services is not determinative of its character (at paragraph 44).
It is not correct to describe Sent’s entitlements as contingent or subject to claw back at the time of the Payment. Some of Sent’s bonus entitlements were contingent insofar as they related to the future financial performance of the Employer. However, once the share issue deed was executed and approved by the shareholders on 30 November 2001, Sent had an unconditional entitlement to be issued the Shares in substitution of these bonus entitlements (at paragraph 48).
Even though there were a number of restrictions on Sent’s ability to receive the benefit from the Trust (eg the existence of a vesting period, his inability to cancel units), it did not accept that these matters bear on whether he derived income when Payment was made on 21 December 2001. The dealings between Sent, the Trust and Employer after that date are dealings with income already derived (at paragraph 90).
If Sent had been made a direct payment of his future bonus entitlements, subject to the condition that his services be provided in the future (and if that amount was repayable if he did not do so), then it might be that the payment would not be assessable as income on the basis of the principle in Arthur Murray (NSW) Pty Ltd FCT (1965) 114 CLR 314 – because it was not yet derived (similar to the accrual principle in South Africa) (at paragraph 101).
However, once the share issue deed was entered into and approved by the shareholders his contingent entitlement was replaced by an unconditional right to be issued the Shares. Even more clearly, any contingencies were no longer operative on 21 December 2001 when the Payment was actually made without any conditions related to future financial performance being attached (at paragraph 102).
The case illustrates the importance of carefully implementing a transaction. If the share incentive scheme had be implemented carefully (ie an appropriate contingency or restriction was placed on the receipt of the Shares), Sent may at least have been able to defer a portion of his income tax liability to a later year of assessment.
In South Africa, s8C of the Income Tax Act, No 58 of 1962 (Act) provides that the income tax treatment will only arise on the vesting of the equity instrument (ie generally when all the restrictions placed on the equity instrument cease to have an effect).
However, it is unlikely that the provisions of s8C of the Act would have been able to assist Sent if the transaction was implemented in South Africa as there would already have been an accrual before the receipt of the units in the Trust. Employees looking to substitute their bonus entitlements for shares in a share incentive scheme must thus ensure that the scheme is implemented with care, taking into account s8C and the general taxing provisions of the Act, so as not to trigger adverse tax consequences.