The proposal is in respect of services rendered, with narrow exceptions, and would affect restricted equity instruments. These are usually units in a share incentive trust or shares that are subject to a restriction – usually that the employee may not dispose of his or her units or shares for a certain period.
Employers commonly place such restrictions on shares or units in order to align the economic interests of the employee with those of the employer in that the employee should contribute to an increase in the value of the company’s shares while he or she remains in employment.
The basic principle of income tax that applies in these circumstances is that the employee is subject to income tax on the market value of the shares or units at the point at which the restrictions fall away (which is referred to as the “vesting date”), with a reduction for expenditure incurred (if any) in acquiring the shares or units. For example, if on the vesting date a share has a market value of R100 and the employee paid R40 to acquire it, the gain of R60 is taxed at the employee’s marginal income tax rate in the tax year in which the vesting date falls.
It appears from the draft explanatory memorandum that the reason for the proposal is that there are concerns with certain arrangements in which the value of the shares or units is denuded prior to the vesting date, such that the shares or units have little value to tax at that point. This can occur by the declaration of dividends in the underlying company or, in the case of units in a share trust that are held by the employee, a share buy-back prior to the vesting date.
The proposal will hit dividends received by or accruing to the employee prior to the vesting date which will, as a result of the proposal, become taxable in the hands of the employee at marginal rates of tax. A related, but separate, proposal seeks to tax any amount other than a dividend received by or accruing to the employee prior to the vesting date at marginal rates, also with limited exceptions. Both proposals would take effect in respect of amounts received or accrued on or after 1 March 2017, if they survive the legislative process.
The general policy intent appears to be to equalise the tax treatment of employee benefits regardless of whether the benefits are in the form of cash remuneration or amounts arising from the holding of shares. However, the problem with the present proposal is that in the case of dividends, no cognisance is taken of the tax already suffered in the hands of the company.
An employee holds shares in the employer company that may not be disposed of for three years. During this period the company declares a dividend of R100, payable to the employee. Income tax at the rate of 28% would in most instances already have been suffered on the underlying profits in the company prior to the declaration of the dividend. Although dividends tax would not apply in the circumstances, the employee would, in terms of the proposal, be subject to income tax on the dividend at the marginal rate of income tax. If the marginal rate is 41%, the total effective taxes suffered by the company and the employee on the dividend would be 57,52% expressed as a percentage of the original profits that accrued to the company.
The position is even worse, relatively speaking, in the case where the employee is on the lowest marginal rate of tax of 18%. In these circumstances, the total effective taxes suffered would be approximately 41% which is more than double the effective rate of tax that would apply to cash remuneration received by the employee, which would be taxed at 18%.
The distortion arises because in a situation in which cash remuneration is paid to an employee, the employer usually obtains an income tax deduction for the cash remuneration paid, which results in the effective rate of tax being only that of the marginal rate of tax applicable to the employee. By contrast, in the case of a dividend paid, there is no income tax deduction for the employer.
If the tax treatment of employee benefits is to be equalised regardless of whether the benefits are in the form of cash remuneration or amounts arising from the holding of shares, then the proposal needs to be amended such that the company that declares a dividend may obtain an income tax deduction for the dividends declared if the amount would have been ‘in the production of income’ had it been paid as a cash award to the employee concerned.
Submissions have been made regarding the above proposal and the final version of the bill will most likely be released later this year.
