Taxing Executive Share Incentives: The Rules Need to Change
16 September 2016
Posted by: Author: Dan Foster
Author: Dan Foster (Webber Wentzel)
and proposed tax amendments have undesirable and unintended consequences not
only for executive compensation, but also for employee share ownership schemes.
schemes have traditionally been designed as a long-term incentive intended to
bolster employee retention and reward.
Such incentives, however, typically make up a far larger portion of potential
executive pay as compared with rank and file employees. Usually on the basis
that management must have more skin in the game if their interests are to be
properly aligned with those of their shareholders. In the debate on executive pay, it is often
forgotten that share prices fall as well as rise, and that executives compensated
with equity are taking that risk along with shareholders, usually whether they
like it or not. The tax system principally
encourages and rewards risk-taking with lower tax rates applicable to capital
gains and dividends. However, this principle
is not reflected in how share incentives are taxed. Currently they are treated
like any other form of remuneration.
most profound example of this is when executives are required or invited to use
their own funds to co-invest with shareholders, sometimes using their post-tax annual
bonus. No tax problem arises here if the
shares are unrestricted, but that is rarely the case. Even where executives are treated like any
other shareholder, private companies typically require all shareholders, in any
case, to sign a shareholder agreement, or enter a voting pool arrangement. These restrictions may be benign (i.e.
typical pre-emptives) or may qualify as actual restrictions in terms of section
8C of the Income Tax Act.
listed shares, private company shares are not liquid and most investors are holding
out until a liquidity event occurs to which all shareholders are tied. This
presents no tax problems for the other investors, but for management it means
they may have acquired restricted shares by virtue of employment, even where
they have invested their own funds, and can only exit with the other investors. As When such an event does occur, they will
pay income tax on any gain at exit, while other shareholders will pay capital
gains tax. Both investors have taken the
same risk, but management have their gains taxed as income.
similar problem can arise in merger and acquisition (M&A) transactions and
private equity (PE) deals where business founders, who are also key managers of
the target company before and after the transaction, find themselves flipped
into shares on the wrong end of section 8C.
careful drafting and good advice, the problems noted above can be mitigated or
solved, but ideally such problems should not arise in the first place. Section 8C is simply too wide, and the
anti-avoidance rules too far reaching and complex. At the heart of the problem is that the
provision basically assumes that a restricted share must be remuneration if it
is acquired by an employee or director. This
view does not account for the commercial and economic realities of an
will therefore come as no surprise that deals and incentives are often designed
with one eye on section 8C, provided that the commercials and economics work
for everyone concerned. Inevitably, the
tools employed in an M&A or PE deal are taken out of the tool box again to
design more mainstream executive share incentives. The lacuna
(gap) identified way will subsequently generate more anti-avoidance rules, and
so on until the provisions become impossible to apply in practice.
recent changes to the capital gains tax rules for employee share trusts, and
the proposed amendments that will affect dividends and other amounts received
in respect of restricted equity, only serve to highlight how far we have
strayed from a common sense approach.
The new rules for share trusts could result in share vestings being taxed
at up to 73.8 per cent, while the revised proviso
to the dividend exemption could see "employment dividends” taxed at 57.52 per
cent. These kinds of punitive tax rates will
clearly not encourage executives who have skin in the game to drive value for
shareholders. In fact, it drives the use
of straightforward bonus plans, where the payment is at least tax deductible
for the employer. Tax policy is
effectively discouraging employee share ownership, which cannot be correct.
ironically, the biggest losers from these amendments will be participants in
broad-based BEE trusts. Dividend-backed loan funding of which will come under
increasing strain (the ones that are not already under-water or closing along
with the mines, that is).
why does it have to be this way, and how did we get to this point? From 2004 onwards, section 8C has taken a
very literal and strict "its remuneration, so tax it” approach to equity-based
compensation. There is no such thing as
a "qualifying scheme” or "approved scheme” (except for BEE purposes, of course,
but there is zero linkage to the tax outcomes, unfortunately), unless you are
using section 8B, which nobody is. In
fact, almost every share scheme or transaction I see is different, so it is no
surprise that one provision of the Income Tax Act struggles to corral all of this
variation into a box marked "income”.
tentacles of section 8C now stretch into section 10(1)(k) and through paragraph
80, laying traps for the unwary. Nowhere
in the Income Tax Act will you find any provision giving tax relief to either
the funders or the recipients of employee equity, despite the fact that the
state actively encourages, even insists, that businesses grow black ownership.
all countries have taken this path. Both
the US and UK offer tax advantages for employee share ownership plans (ESOPs),
as does Australia. The US goes so far as
to offer tax-qualified ESOPs linked to retirement savings plans, i.e. deferred
compensation. The creation of so-called
qualifying plans not only provides a tax incentive for employers and employees to
grow their wealth together, but can simplify the entire ESOP tax landscape,
i.e. either it qualifies or it doesn’t.
A checklist approach to qualification already exists in South Africa for
retirement funds and tax-free savings accounts (and indeed for BEE scorecards),
for example, so this would not be an entirely radical approach. SARS could audit the compliance of such plans
on a routine basis as it does for other forms of tax compliance.
qualifying plans will always have monetary limitations and narrow criteria,
which is great for simplifying broad-based ESOPs, but what about executive
incentives? Here there needs to be a recognition
of risk. An executive might have a
package where 50 per cent of his pay is at risk in the form of shares that may
turn out to be worthless, so there should be some tax upside. Furthermore, the executive may not be able to
extract value from this deferred compensation for many years. Ideally, the tax on such shares should be at
capital rates, and deferred until vesting.
If that is too good a deal, perhaps the shares should be subject to
income tax at grant, rebasing the shares for capital gains tax, with both that
income tax and the eventual capital gains tax only payable at
vesting/disposal. Similar rules could
apply to options. SARS then gets income tax on the value at award (i.e.
remuneration) but any growth is considered capital, with both deferred until a
liquidity event. Similar approaches have
been adopted elsewhere in the world. A
fairer outcome like this would certainly reduce the motivation to circumvent
route is taken, one thing is certain: we cannot continue on the current path.
This article first appeared on the September/October 2016 edition on Tax Talk.