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Taxing Executive Share Incentives: The Rules Need to Change

Friday, 16 September 2016   (0 Comments)
Posted by: Author: Dan Foster
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Author: Dan Foster (Webber Wentzel)

Recent and proposed tax amendments have undesirable and unintended consequences not only for executive compensation, but also for employee share ownership schemes.

Share 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.

The 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.  

Unlike 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.

A 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.  

With 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 entrepreneurial world.

It 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.

The 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. 

Perhaps 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).

But 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”.  

The 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.

Not 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.

But 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 section 8C.

Whichever 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.



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