By Robert Gad and Janel Strauss (ENS/Business Day May 2012)
The acquisition of shares by an employee share trust is typically funded by way of a loan advanced by the employer company to a trust on favourable terms, enabling the trust to acquire and hold shares in the company pending transfer of the shares to participants in the share scheme. The change in the Income Tax Act, 1962 from secondary tax on companies (STC) to dividends tax on April 1 2012 has affected these arrangements.
Under the STC regime, interest-freeloans to company shareholders were deemed dividends (section 64C(2)(g)) which were taxed at 10% on the gross amount of such dividend (that is on the principal loan amount) unless a specific exemption applied. Listed shares were effectively exempted.
Also exempted from the deeming provisions were loans advanced by a company to a trust to enable that trust to purchase shares in, among other things, that company with the view to reselling the shares to employees under a "share incentive scheme” for the ben-efit of the employees (section 64C (4)(i)). "Share incentive scheme” was defined to essentially include a scheme where not more than 20% of the equity shares of a company were held by directors, full-time employees or trustees for the benefit of such directors and employees. Provided these requirements were met, the interest-free loan was accordingly exempt from STC.
The Taxation Laws Amendment Act, 2009 proposed that a value extraction tax (VET) would replace the STC deemed dividend rules when div-idends tax became effective.
In particular, the proposed section 64Q(2)(c) mirrored the special exemp- tion under section 64C(4)(i). However, the VET provisions (and their exemptions) were deleted by the Taxation Laws Amendment Act, 2011.
In terms of the current dividends tax provisions, listed shares are no longer excluded from the deeming provisions of soft loans. In addition, there is no longer a special exemption in respect of loans to share incentive trusts. In accordance with section 64E(4) of the Income Tax Act, a com-pany will now be deemed to have paid a dividend to its share incentive trust by advancing an interest-free loan, if they are connected persons. This will typically be the case where the company is a beneficiary of the trust, or where the trust directly or indirectly holds 20% of the equity shares or voting rights in the company. In practice it is common for a company to be a beneficiary of its share incentive trust and where this is the case, the company and trust will therefore be connected persons in relation to each other, resulting in the interest-free loan to the trust being treated as a dividend.
The amount of the deemed dividend will be the difference between the official rate of interest (the repo rate plus 100 basis points) and the interest charged. Dividends tax at the rate of 15% will accordingly be levied annually on this interest differential until the loan is repaid.
An interest-free loan to a share incentive trust will therefore create a tax leakage if the parties are connected persons. However under the dividends tax provisions, the tax exposure is limited as only the interest differential will be subject to tax and not the principal amount of the loan (as would have been the case under the STC regime).
Alternative arrangements may be considered to mitigate this tax leakage. One such alternative involves employers granting employees "sweat equity”, in terms of which participating directors and employees receive shares in exchange for their services, rather than for cash. The new section 40 of the Companies Act, 2008 enables the issuing of sweat equity as it allows a company to issue shares for "adequate consideration,” which may include future services, benefits or payments, provided the issued shares are transferred to a third party (trustee) until the company has received the full consideration. The Companies Act permits a fair degree of flexibility in the way such an arrangement may be structured and is generally not prescriptive about the commercial or financial terms. Under the previous law, companies were prohibited from issuing shares unless those shares were fully paid up. Since the new Companies Act came into operation there is greater flexibility in structuring employee share schemes.
Section 240A of the Tax Administration Act, 2011 (as amended) requires that all tax practitioners register with a recognized controlling body before 1 July 2013. It is a criminal offense to not register with both a recognized controlling body and SARS.