Employee Share Scheme
Employee Share Schemes (E.S.S) are becoming increasingly popular amongst large and even smaller corporate entities that want to incentivize and engage their workforce and recruit and retain key employees.
Although Employee Share Schemes are structured and implemented in various forms and for different reasons, certain key principles need to be adhered to at all times :-
- Substance should always take precedence over form. The scheme should provide organic benefits to the corporation by selecting the correct candidates for participation in such schemes and the schemes should be implemented to ensure growth and or improved profits for the corporation, and
- The scheme should, in general terms, be financially beneficial to the participant. Should dividends not be adequate to retain the participant, retention of the participant will require higher salaries and benefits, that may increase the anticipated cost to company beyond what can be regarded as profitable.
- The scheme should compliment and advance both the culture and long term goals of the corporate entity.
Employee Share Schemes are traditionally constructed according to various different models, being :-
- Outright Option to Purchase
- Share Options
o With interposing trust
o Without Interposing Trust
- Staggered Share Option
- Share Incentive trusts
o General Staff Incentive Trust
o Broad Based Black Economic Empowerment Trusts
o The Selected Employee Incentive Trust
- Phantom or Cash Settled Share Plan
An Outright Option to Purchase constitutes an agreement in terms whereof shares are offered for sale to either a single or multiple employees at either the market related value of the shares or at a discounted rate. The purchase price may even be financed by the corporation and may even be subject to certain conditions eg a minimum period of employment with the corporation or the performance of the employee. The shares will generally vest in the employee at the time of concluding the agreement.
Share Options, in turn, constitutes an agreement in terms whereof the shares will vest in the employee at a later stage, eg after five years. The shares will be offered to the employee at either the market related value thereof or at a discounted rate. The employee will be obliged to make payment of the purchase price, either after expiry of the period referred to or during the period or will be subject to certain performance requirements. This model does not make use of an interposing trust. The model can be implemente by making use of an interposing trust, where the allotted shares will be issued to a trust, which will hold the shares on behalf of the participant until the period expires and/or the other restrictive conditions have been met eg employment for at least 5 years.
Staggered Share Options can take the form of either a outright option or a share option. The major difference lies in the fact that shares are allotted to the employee as he/she made payment of the purchase price. To illustrate by way of example. Employee John will be allotted a maximum of 40 shares over 4 years in increments of 10 shares a year at a value of R1 per share. In year one John will have to make payment of R10 as payment for his shares. The bulk of john’s dividends, accruing from his 10 shares in year one, will be allocated towards repayment of the purchase price. In year two a total of 20 shares would have been allotted to John, the dividends of which, will still be allocated to John’s repayment with the exception that a small portion thereof will accrue to John as his dividends may now have exceeded his installments on repayment. John’s income will steadily increase over the following 4 years, after which he will be entitled to the whole of the dividends accruing to his shares.
Share Incentive Trusts (SIT) are based on the principle that shares are not allotted to either a selected employee (Selected Employee Incentive Trust) or all staff of a particular class (General Staff Incentive trust or Broad Based Black Economic Empowerment Trusts), but that such shares are kept in trust on behalf of such a selective or class of employees. The employees will as a general rule be entitled to elect a representative to represent them at board meetings and will further be entitled to dividends accruing to the trust.
Typically, a SIT model would involve the following steps:
- the employer would form the SIT, which in turn would subscribe for the shares in the employer;
- once the SIT has acquired the shares, the employees would be appointed as beneficiaries of the SIT to receive the benefits flowing from the shares (i.e. the dividends and voting rights) until the expiry of a specified lock-in period;
- at the expiry of the lock-in period the beneficiaries would receive the shares, either for market-related consideration, for a consideration which is less than the market value of the shares or for no consideration.
The formation of the SIT and the issue and subscription of the shares in the employer do not have any tax consequences in the hands of either the employer or the SIT. However, the manner in which the SIT model is structured (i.e. for all of the employees in general or only for a select few) will determine the tax consequences in the hands of such employees.
Phantom or Cash Settled Share Plan is not a true share incentive plan because no actual shares are issued to the employees. Units or “phantom” shares are allocated to employees by the company or by a share trust. These are not actual shares, and do not entitle the employee to any rights as equity holders. Instead, the scheme amounts to a contract between the company or share trust and each employee whereby the employee receives what is, effectively, a bonus. In most cases, each unit entitles the employee to receive an amount equal to the dividend declared in respect of an actual share. On the expiry of certain time periods, the holder of the unit is paid an amount equal to the market value of an actual share or the growth in the market value since the allocation date of the unit. Phantom scheme cannot be structured with a tax treatment more beneficial than simply payment of tax on the benefit at the employee’s marginal income tax rate.
Any share option scheme whereby an employee or a director acquires an option to purchase shares in the employer company by virtue of his employment, falls within the ambit of section 8C of the Income Tax Act No. 58 of 1962 (the Act). The effect of section 8C is that if the equity instrument (i.e. the option) generates a gain, the taxpayer is required to include such gain in his income for the tax year in which the instrument vests in him. The gain is calculated by subtracting from the market value of the equity instrument at the time that it vests in the taxpayer the sum of any consideration paid by the taxpayer in respect of the equity instrument.
Employees should further note that the acquisitions of shares at discounted rates may have certain tax implications especially in as far as Capital Gains Taxes are concerned.
Section 8B was introduced in 2004 to promote long-term, broad-based employee empowerment by allowing employees to participate in the success of their employer with minimal tax cost. In essence,
what section 8B does is to allow for the tax-free treatment of “qualifying equity shares” acquired by employees, even though these shares may be acquired at no cost or at a discount.
In order for a share to be a “qualifying equity share” for purposes of section 8B it must satisfy two requirements:
the employee must receive the share in terms of a ‘broad-based employee share plan’ (as defined); and
the market value of all the shares acquired by the employee in terms of that broad-based employee share plan in that year and the two immediate preceding years of assessment cannot in aggregate exceed R9 000.
In order to qualify as a “broad-based employee share plan” the following conditions must be met:
the employer must offer the shares to the employees for no consideration or at par value;
employees may not participate in the broad-based employee share plan if they participate in another equity share plan,
the employer must offer the plan to at least 90% of those other employees who have been permanent employees on a full-time basis for at least 1 year;
the employees must receive full voting rights and be entitled to all dividends; and
the plan may contain no disposal restrictions other than a restriction imposed by legislation, a right to acquire the shares at market value and a restriction on the employee to dispose of the share for a period of 5 years.
The effect of section 8B is the following:
the receipt of the qualifying equity shares is exempt from income tax in the hands of the employee;
the receipt of the qualifying equity shares is exempt from fringe benefits tax in the hands of the employee;
any loans by the employer to the employee to acquire the qualifying equity shares are free of fringe benefits tax; and
if the employee sells the shares after the 5-year period, the gains on the disposal would generally be capital in nature and be subject to CGT in the hands of the employee.
The previous Companies Act prevented any company to assist any person financially to obtain or acquire any interest in the company. The provisions of the New Companies Act alleviated this restriction by allowing such incentive schemes, subject thereto that :-
The board of the company may only authorize the financial assistance if:
the board is satisfied that the solvency and liquidity test will be satisfied;
the terms of the loans are fair and reasonable to the company; and
the share scheme complies with section 97 or the loans have been authorized by a recent special resolution of the shareholders.
To qualify as an employee share plan and claim the exemption from publishing a prospectus, the company whose shares are subject to the scheme must:
Appoint a compliance officer.
State in its financial statements the number of the shares that it has allotted during any financial year to the employee share plan.
The compliance officer must:
Be responsible for the administration of the plan.
Provide a written statement to any employee who receives an offer to purchase shares, setting out:
o the nature of the transaction, together with the associated risks;
o information relating to the company, including the latest annual financial statements, nature of the company’s business and its profit history for the last three years; and
o full particulars of any material changes which occur in relation to any information provided in respect of the above.
Ensure that copies of the documents containing this information are filed with the Companies and Intellectual Property Commission (Commission) within 20 business days of the establishment of the employee share scheme.
File a certificate within 60 business days after the end of each financial year certifying that the compliance officer has complied with the obligations set out above in the previous financial year.
The registrar of companies also needs to be formally informed of any such incentive schemes.
This documents does not intend to deal exhaustively with tax implications normally associated with share incentive schemes and should you contact our offices for more information.
Kindly contact us for further assistance.