Are gains from the sale of share scheme shares being correctly taxed?
28 August 2014
Posted by: Author: BDO South Africa
Author: BDO South Africa
This article, which examines the taxation treatment that results from the sale of share scheme shares, concludes that it is advisable to hold any shares for a period of at least three years before disposing of them – including shares acquired in terms of an employer's share incentive scheme.
Section 8C of the Income Tax Act (‘the Act') taxes gains and allows for the deduction of losses arising on the vesting of ‘equity instruments' that are acquired by virtue of employment, or office of director of any company, or from any person by arrangement with the taxpayer's employer. The most common type of ‘equity instrument' encountered is an equity share acquired by the taxpayer in his or her employer company - for example, in terms of a share incentive scheme.
In the case of a ‘restricted equity instrument', the vesting date is usually the date on which the restrictions causing the instrument to be classified as a ‘restricted equity instrument', cease to have effect. In the case of an ‘unrestricted equity instrument', the vesting date is the date on which the instrument is acquired. Section 8C applies, notwithstanding the three year deemed capital rule contained in section 9C of the Act. Section 9C, in effect, states that the proceeds from the disposal of an equity share are deemed to be of a capital nature where the taxpayer had been the owner of the shares for a continuous period of at least three years.
If the shares vest in the taxpayer, who retains them beyond the vesting date, it is usually assumed that when the shares are eventually disposed of, capital gains tax (‘CGT') rules apply to the portion of the gains or losses arising from the disposal, that were not previously dealt with on revenue account in terms of section 8C.
For example, assume shares are acquired on day one for R100 and are subject to a one year sale restriction. If the open market value of the shares is R120 when the sale restriction ceases to have effect, the taxpayer will be subject to income tax on R20 as a section 8C gain. If the taxpayer sells the shares for R150 after another year has elapsed, the further gain of R30 is typically regarded as a capital gain. This is probably because taxpayers and their advisors believe that the revenue consequences have already been dealt with in terms of section 8C and, therefore, that any further income tax consequences must be dealt with in terms of the provisions of the Act dealing with CGT (the Eighth Schedule to the Act).
The wording of the Eighth Schedule probably fosters this belief, since it contains specific provisions as to how the base cost of shares is determined when section 8C has applied. For example, in paragraph 20(1)(h) of the Eighth Schedule to the Act, it deems the market value that was taken into account in determining the section 8C gain or loss to be included in the base cost of the shares, thereby preventing the taxpayer from being taxed twice on the same amount.
Is it revenue or is it capital? However, it is important to note that there is no provision in the Act, other than section 9C, that would deem the proceeds from the eventual disposal of shares to be of a capital nature. The general principle to be applied is that if an amount is revenue in nature, then it is not taken into ‘proceeds' in terms of paragraph 35(3)(a) of the Eighth Schedule to the Act. Similarly, if an expense qualifies as a deduction in terms of revenue tax provisions, then it is excluded from base cost by virtue of paragraph 20(3)(a) of the Eighth Schedule. CGT, therefore, plays ‘second fiddle' to revenue tax.
This suggests that if shares are held for a period of less than three years (or are otherwise ineligible for the deemed capital treatment afforded by section 9C ), then the taxpayer may well have to account for the proceeds on revenue account. Unfortunately, the Act does not specifically cater for this scenario and a number of anomalies can result when one takes such shares in as trading stock of the taxpayer in terms of section 22 of the Act.
Section 8C applies ‘notwithstanding' section 9C – for example, if the ‘vesting date' occurs four years after the taxpayer acquired the shares at which date the taxpayer disposes of the shares, he or she will be subject to revenue consequences in terms of section 8C insofar as the market value on vesting date is concerned and will not find protection in section 9C from this revenue treatment.
However, section 9C is available, in appropriate circumstances, to the sale of shares that were acquired in terms of a share scheme. For example, assume shares are acquired and that they vest on acquisition – at which point that taxpayer would be taxed in terms of section 8C. Also assume that the taxpayer disposes of them after holding them for a period of three years. In this circumstance, the proceeds would be deemed to be of a capital nature in terms of section 9C.
So if equity shares have vested, have been dealt with in terms of section 8C, and the shares are held for a period of three years before disposing of them, it is submitted that the proceeds are deemed to be of a capital nature in terms of section 9C. If, however, the taxpayer disposes of the shares before owning them for a period of three years, he or she may well have difficulty in proving that the proceeds are of a capital nature .
Important test – intention of acquisition
Section 9C does not apply to the following categories of shares: non-equity shares other than participatory interests in a portfolio of a collective investment scheme in securities; shares in share block companies; shares in non-resident companies other than JSE-listed shares; and hybrid equity instruments as defined in section 8E.
In terms of section 102 of the Tax Administration Act No. 28 of 2011, it is the taxpayer who bears the burden of proving that an amount is not taxable or the rate of tax applicable to a transaction.
The most important test for the capital or revenue nature of proceeds arising on the disposal of an asset (including shares) is the intention with which the asset was acquired and held by the taxpayer . Proceeds will be of a revenue nature if the asset was acquired for speculative resale and of a capital nature if the asset was not acquired for speculative resale, but acquired and held, for example, in order to earn dividend income.
Importantly, the taxpayer bears the onus of proving that the proceeds are of a capital nature. Decided South African case law relating to the proceeds arising from the disposal of shares does not generally support the contention that the proceeds from the disposal of shares is of a capital nature, unless the shares are acquired with the intention to hold them more or less permanently, so as to produce dividend income .
Many employees holding shares acquired in terms of their company's share scheme view the shares as the source of speculative profit – to profit from an increase in the value of the shares as the dominant reason for acquiring the shares. This, as opposed to the intention to hold the shares as long term investments, is the hallmark of a revenue asset.
In these circumstances it is therefore advisable, from a tax point of view, to dispose of such shares only after having held them for a minimum of three years, in which case section 9C may afford protection. Specifically in the case of employer share schemes, the employee may have another argument for the proceeds being of a capital nature. That is, it may be argued that the reason for taking up the offer of the shares was because participation in the employee share scheme would be seen as a "patriotic” move by management of the employer and would be likely to boost the employee's future career prospects. This implies that there was no speculative intention on the part of the employee in acquiring the shares.
However, even were a Court to deviate from the cases previously decided in holding that where the shares were not acquired on a more or less permanent basis that the proceeds may be of a capital nature, the employee would still bear the burden of convincing the Court, on a balance of probabilities, of his or her stated intention
In summary, it is advisable to hold any shares for a period of at least three years before disposing of them, including shares acquired in terms of an employer's share incentive scheme
See for example ITC 1462 (1988) 51 SATC 168. See for example CIR v Tod 1983 (2) SA 364 (N). However, in a more recent case before the Income Tax Court, ITC 1867 75 SATC 273, it was held that the idea of shares ‘for keeps' is reflective of an old, static economic order that no longer exists. However, the Court held that, notwithstanding that shares do not have to be held ‘for keeps', the taxpayer still has to show that the shares are intended to be an investment of a considerable duration. As a caveat, it must be pointed out that decisions of the Income Tax Court, unlike those of the High Court, do not create binding legal precedent.
This article first appeared on bdo.co.za.