Oct 28,2010 / News / Legal Brief

It’s back to the drawing board for many South African companies that run share schemes for their employees. Imminent tax law changes are set to erode the tax efficiency of many existing schemes, says tax law specialist Leon Rood of Werksmans Attorneys.

“The major change is that if employees receive dividends on certain restricted shares held under an employee share scheme, they can expect to start paying PAYE on those dividends,” says Rood. “The tax-free status of such dividends has made them a common feature of company share schemes. Understandably, the loss of this status will prompt companies to revisit their share schemes to assess the tax implications for their employees.”

Companies should review their schemes sooner rather than later. Rood says the upcoming tax changes, spelt out in the Taxation Laws Amendment Bill of 2010, will come into force on 1 January 2011.

“While not yet promulgated into law, the Bill has gone through Parliament and will certainly become an Act,” he says. “This means any affected dividends received or accrued on or after 1 January 2011 will be taxable.”

Rood says the Bill is specific about when PAYE must be paid on dividends received or declared through an employee scheme. “All dividends received in terms of a share defined in 8C of the Income Tax Act, 1962 are taxable unless the share is an ‘equity share’, or constitutes an equity instrument as defined in section 8C,” he says.

A definition of the terms ‘equity share’ has been inserted and refers to a share where the holder is not limited in participating beyond a certain distribution amount. “If there is a limit on the amount the holders may participate in, the equity instrument will not be regarded as an ‘equity share; and the dividends will be taxable.” One example of a non-equity share where the dividends will be taxable is non-participation preference shares – which have been used in executive share schemes in South Africa.

Capital distributions on section 8C instruments have been subject to tax since 2008 but, until now, dividend distributions have been exempt. Rood says the intention of the tax authorities is to bring the treatment of dividends from restricted shares into line with the treatment of capital distributions because they both have the same effect. Both allow for a partial cash-out by the holder during the restricted period, diminishing the value of the share by the time it is vested.

“When the restriction is lifted, there is no more value subject to taxation in the share,” says Rood. “National Treasury thus wants to prevent this process of value extraction by providing for the same treatment of distributions of dividends and capital.”

Another tax change of interest to companies with executive share schemes is the proposed new treatment of share swaps. Holders of restricted shares will still be able to exchange one equity instrument for another without paying tax, but with a proviso. “Roll-over treatment will only apply if the new equity instrument is from the same employer or associated institution, not from another (independent) employer or institution,” Rood says.

Similarly, an employee who acquires a restricted instrument from a co-employee or director will only qualify for roll-over treatment if both parties are from the same employer and not from different independent companies.

“Employers should take all these changes into account when revisiting the tax efficiency of their executive share schemes,” says Rood. “Companies also need to be aware that the amended tax laws may lead to some uncertainty as to the tax treatment of trusts and employees as the beneficiaries of such incentive trusts. This is especially relevant where the employees, as beneficiaries, have a right to income distributions from the trust. If a distribution of dividends in terms of such right is received, then the question may be raised whether the right of the employee must also be regarded as an ‘equity share’, for it to be received free of tax. The structure of these schemes involving trusts will hence require further consideration.”