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Preferred Compensation Structures

Wednesday, 01 December 2010   (0 Comments)
Posted by: Author: Harry Joffe
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Preferred Compensation Structures
The need

The changes to Section 11w of the Income Tax Act will mean that from 1 January next year deferred compensation structures will have no tax benefit at all.How then does a company or employer implement a plan to retain and reward key staff, while still ensuring it is tax efficient?

The answer

Preferred compensation allows a company or employer to retain key staff, while at the same time ensuring there is no negative tax effect from the soon to be implemented changes to section 11w. The plan works as follows:

•The company agrees with a staff member that if he/she stays with the company for the next five years they will qualify for a special benefit.
•In order to fund this, the company agrees to give the employee a special salary increase.The increase is obviously taxed in the employee’s hands, and deductible to the company as normal salary.
•The increase is calculated so that the after tax contribution will equal what needs to be contributed to the plan. For example, if the company wishes to pay an amount of R1 000 per month into the plan, they would have to give the employee an increase of roughly R1 650, so that after tax is deducted (assuming a 40% tax rate), the employee would clear R1 000 to contribute.
•The company and employee sign a special service agreement.

This is the most important part of the structure and will say the following:

•The company and employee agree that while the employee will get a salary increase of (say) R1 650 per month, the employee will be obliged to contribute the after-tax amount of R1 000 to a five-year endowment policy.
•The employee will also undertake to stay with the company for five years.
•The employee will further undertake to collaterally cede the endowment policy back to the employer for the five years, as collateral for the debt that he would incur if he does not stay with the company for the required five years.
•The employee will finally agree that if he does not stay with the company for the five-year period, the collateral cession will become absolute  and the company will take ownership of the policy.
•The service agreement will also contain provisions stating what happens if the employee dies while in service and stress that the increase is not pensionable and does not affect the employee’s bonus, leave pay or annual increase.

The benefits

•At the end of the five-year period, provided the employee is still in service, the company will cancel the collateral cession.The employee is therefore the unencumbered owner of the policy.There are no tax consequences, as the employee paid the premiums and was always the owner – a collateral cession has just been cancelled.There are no CGT consequences as the cession was only a collateral one.
•The increase is tax deductible to the employer.While the employee is taxed on the salary increase, they know that if they stay with the company for the five-year period, they will receive a valuable benefit, and that the policy they will ultimately receive will have no further tax consequences.
•The employer is unaffected by the imminent changes to section 11w, as the salary increase is a simple 11a tax deduction. 


The employer has found a way to ensure valuable staff is retained for at least a five-year period.The structure is tax deductible to the company.The employee knows that while they will be taxed on the increase, the policy they receive after five years will be free of any further tax to them.They can then continue with the policy or cash it in.
Source: By Harry Joffe (TaxTALK)



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