If your employer has offered you shares in the company, it's important that you understand the type of scheme the shares fall into, and what the tax consequences will be if you accept the offer. We spell out what you need to know about the taxation of share incentive schemes.
In 2004, the South African Revenue Service introduced significant changes to the taxation of share incentive schemes. There has been much confusion about these changes. Before you get your head around the rules, it helps to understand the old rules.
Basically, if you were a party to a share scheme, in terms of which you were awarded an option to acquire shares, or you were offered the shares themselves, before October 26, 2004, the scheme would be taxable in terms of the old legislation. This applied even if those shares could only be disposed of at a later date, or would only be delivered and paid for at a later date.
On October 26, 2004, things changed dramatically with regard to share schemes: Any option to acquire a share or an instrument convertible into a share (hereafter collectively referred to as a share, unless the type of share is specified) acquired on or after that date, is subject to the new rules.
There are now two different methods of taxation for two different types of schemes. The first is known as the "broad-based employee share plan", and the other taxes any scheme that does not fall into this category.
In simple terms, the broad-based scheme applies where the employer is giving equity shares to its employees, and at least 90 percent of the employees are employed on a full-time basis and have been with the employer for at least a year, are entitled to participate in the scheme. In addition, for the scheme to qualify, no employee may receive, in terms of the scheme, shares worth more than R9 000 in total within any three-year period.
If you receive shares that qualify as broad-based scheme shares, you will not be taxed on the value of those shares, provided that you keep them for at least five years. In addition, if your employer gives you an interest-free loan to pay for the shares, you will not be subjected to fringe benefits' tax on the interest-free benefit arising from the loan. However, if you sell the shares within five years, you will be taxed on the amount for which you dispose of the shares.
If the shares you receive do not qualify as broad-based scheme shares, they will be taxed under the "other schemes" rules.
The principal difference between the new rules and the old rules for these "other schemes", is that the market value of the shares you receive as a consequence of your employment, is taxed in your hands when those shares become vested - that is, when you are able to freely dispose of the shares.
An example
Let's use an example to illustrate the difference between the old (pre-October 26, 2004) rules and the new rules: Your employer offers you 1 000 shares at the current market price of R10 less a discount of, say, 20 percent, on condition that you do not dispose of those shares for the next three years. Your employer gives you an interest-free loan to pay for the shares. After three years, the shares are worth R50, and you decide to sell them all.
- The old rules.
Under the old rules, you would have been taxed on the market value of the shares when you took up the offer (R10 000), less what you paid for them (R8 000) - that is, R2 000. But, you could elect to pay the tax after the restriction to sell the shares had expired. If you sold the shares at that point (in this case, after three years), you would be taxed on the R2 000 rolled over, and you would have paid capital gains tax (CGT) on R40 000 (R50 x 1 000 shares less R10 000). The rules allowed the base cost to be the market value at the date of vesting.
It should be noted that CGT would only have been payable when the shares were sold, so if you held on to them for another three years and then sold them, the CGT would only be payable at that point.
Individuals pay CGT on 25 percent of a capital gain. So, assuming you were on a marginal tax rate of 40 percent, and have used up your CGT-exempt amount (R10 000), your income tax would be R800 (R2 000 x 40 percent), and your CGT would be R4 000 (R40 000 x 25 percent at 40 percent) - a total of R4 800.
Also, bear in mind that you would have paid fringe benefits tax on the interest-free loan until it is repaid.
- The new rules.
Under the new rules, the shares only become vested (that is, unrestricted) when the three-year period is over and you are able to sell them.
At that point, you will be immediately subjected to income tax (your employer will be required to deduct employees' tax) on the full proceeds less the amount you paid for the shares - that is, R42 000 (R50 000 less R8 000). If your marginal rate is 40 percent, this amounts to R16 800, which is considerably more than under the old rules. In addition, you will pay fringe benefits tax on the interest-free loan until it is repaid.
Under the old rules, many share incentive schemes were designed to use the fact that vesting of the shares could be delayed, even though you may have "bought" them upfront, giving rise to very little income tax, and leaving the growth of the shares to be taxed under CGT (or, before CGT was introduced, not at all).
The new rules prevent this from happening, and are designed to ensure that you are taxed on the full value of the shares when you finally own them in an unrestricted manner.
The legislation has many nuances and complexities, and I have summarised the basic principles for you. The moral of the story, of course, is that if you are offered shares by your employer, make sure you know which scheme the shares fall into and what the tax consequences will be.
Definition
Share options
give employees an opportunity to buy a certain number of shares in their employing company. A share option is designed to encourage employees to stay with their employer. The price at which employees can buy the shares is fixed when the option is granted, and is favourable at the time. But there is no guarantee that it will remain that way. Instead of buying and selling the shares, the employee may choose to buy and hold on to the shares, and thereby become a shareholder.
- Deborah Tickle is partner in tax services at KPMG.
This article was first published in Personal Finance magazine, 4th Quarter 2005. See what's in our latest issue