If your company gives you shares as part of an incentive scheme but your ability to share fully in the dividends paid by the company is limited, you may, as of this month, pay income tax on any dividends that are distributed to you.
This is in terms of an amendment to the Income Tax Act contained in the 2010 Taxation Laws Amendment Act, which was promulgated late last year.
Leon Rood, a senior associate at Werksmans Attorneys, says the amendment is likely to affect share incentive schemes offered to high-income earners.
Typically, these schemes use self-liquidating redeemable preference shares that make large tax-free payments in the form of dividends to an employee for a certain period. At the end of the period, the company redeems the shares for the same value at which they were sold to the employee, Rood says.
The value of the shares to the employee lies in the dividends paid, and when the shares vest and become free of restrictions, there is little or no value that is taxed.
The Income Tax Act provides that if your employer gives you shares that are restricted in any way – for example, you cannot sell the shares until you have been with the company for a certain number of years and you can lose the shares if you are fired – the value of those shares vests in you when the restrictions are lifted. At that stage, you pay income tax on the value of the shares you receive, less anything you paid for the shares.
In the case of these types of redeemable preference shares, the value on vesting is diminished, and in this way, Rood says, the employees have been able to receive cash from the shares in the form of dividends that is essentially tax-free. It is this kind of share incentive scheme structure that the latest tax amendment seeks to address.
From January 1, dividends paid on all shares that are not “equity shares” as defined in the Income Tax Act are taxable. Equity shares are defined as those in which your participation is not limited beyond a certain distribution amount – such as beyond a certain level of dividends.
Rood says it is still possible to set up correctly structured share incentive schemes that reward deserving employees by offering them a share in the growth of the company and that are also tax-efficient.
Such a scheme would not restrict the amount or level of dividends paid to the employee, and would ensure any dividends were paid tax-free. Other restrictions on, for example, the sale of the shares for a certain period, may still be imposed, he says. This kind of scheme will enable you, as an employee, to receive tax-free dividends, but when the shares vest, you will pay income tax on the value of the shares you receive in excess of that which you have already paid for the shares.
For example, Rood says, you could receive shares worth a R100 a share from your company, but you may be restricted from selling the shares for three years. Three years later, the shares are worth R200 a share. At this stage, the shares will vest in you, and you will pay income tax on R200 a share, less whatever you paid for the shares, which in this case is nothing.
Income tax applies as if you had received the value of the shares as a cash bonus.
If you keep the shares for another three years before selling them, for say R300 a share, you will pay capital gains tax (CGT) on the shares (unless you are regarded as a share trader), Rood says. You will be able to use the market price of the shares when they vested as your base cost, so your capital gain will be R100 a share, he says.
A CGT exemption, currently for gains of up to R17 500 a year, applies, and only 25 percent of the capital gains above the exemption are taxed at your marginal tax rate. This means the highest effective rate is 10 percent of the gains that exceed the exemption.
The latest amendment to the Income Tax Act may also may also apply if you are offered shares as part of a broad-based share incentive scheme. However, as long as the dividends you are paid on those shares are not limited the dividends will continue to be tax-free and the rules related to those schemes will apply.
The Income Tax Act states that to qualify as a broad-based scheme, at least 80 percent of the employees who are employed on a full-time basis and who have been with the employer for at least a year must be entitled to participate in the scheme. In addition, in terms of the scheme, no employee may receive shares worth more than R50 000 in total within any five-year period.
If you receive shares that qualify as broad-based scheme shares, you will not pay income tax on the value of those shares provided that you keep them for at least five years from the date of the grant. Thereafter, when you sell them, you will pay CGT on the gain you have made. Your base cost will be the amount, if any, you paid for the shares.
However, if you sell the shares within five years, you will pay income tax on the amount for which you dispose of the shares.
Rood says the latest amendment may also affect some share incentive schemes that make use of trusts and and where employees are beneficiaries of the trust with a right to income distributions.
The question will be, Rood says, whether such distributions can be regarded as received from “equity shares” or from the trusts as beneficiaries, which will affect the tax position.