Section 8C of the Income Tax Act No. 58 of 1962 (“ITA”) is directed at taxing employees and directors on the gains derived from “equity instruments” or share options as they are commonly referred to. Generally, this section seeks to ensure that the value derived under a share scheme attracts the correct (income) tax treatment, where the acquisition of the shares is linked to an employment relationship. But there are instances where the operation of section 8C creates this link fictitiously, in which case a lack of planning could result in an immensely expensive tax event.
The genesis of section 8C and its predecessor, section 8A, can be drawn back to when South Africa did not have a capital gains tax (“CGT”) regime. There was an incentive for employees to structure components of their remuneration that would attract CGT treatment. Where the design of a share incentive scheme could achieve this, the resultant gains would effectively be tax free. The same incentive remains after the introduction of CGT, on account of the arbitrage between the CGT rate and the rate of personal income tax.
Fundamentally, section 8C, as with its predecessor, is concerned with the causa that underlies the acquisition of the equity instrument i.e., if it was acquired “by virtue of employment”. But the Legislature, in its attempts to keep up with the creativity of tax advisors, continuously amended section 8C. It now comprises several subsections, carved out over time to subvert any mischaracterisation of gains on share options.
These carve-outs include provisions directed at schemes where an equity instrument is acquired in terms of a disguised arrangement from persons other than the employer or where it is granted to a person other than the employee, or where the scheme is designed to prematurely trigger the tax event to artificially fix a deflated value. This piece, however, is focused on the implications of section 8C(1)(a)(iii).
Subparagraph (iii) dictates that the gains on an equity instrument will be taxed as income where it was acquired as a “restricted equity instrument” during the period of employment or directorship. For discussion purposes it serves to note that a restricted equity instrument will be classified as such if it is subject to a restriction (not imposed by legislation) that prevents the taxpayer from freely disposing of the equity instrument at market value.
Subparagraph (iii) deviates from the position that the equity instrument must be factually linked to the taxpayer’s employment. The Explanatory Memorandum issued by National Treasury and SARS on the Taxation Laws Amendment Bill, 2010 (“EM”) clearly explains the application:
“There is a strong possibility of collusion as it is extremely difficult to determine when an employee acquired a restricted equity instrument from a co-employee or director or directly from an employer. In light hereof, there is a presumption that there is an automatic inclusion in section 8C without regard to a factual test.”
In other words, where the acquisition of a restricted equity instrument coincides with the period of employment or directorship, subparagraph (iii) deems the acquisition to be linked with that relationship or office, irrespective of the true causa. The potential ramifications can be explained by way of practical example.
As a matter of course, at inception, founding shareholders would also be appointed as the directors and / or the employees of that company. It is not uncommon in these instances for the founding shareholders to impose certain restrictions inter se, be it in terms of a shareholders agreement or the company’s Memorandum of Incorporation. Typically, to protect their investment, these covenants would prevent the founders from disposing of their shares for a specified period, or at least, the remaining shareholders will be granted a pre-emptive right to acquire the shares at a reduced or nominal value. In either event, in the context of section 8C, where the restrictions apply upon subscription (acquisition), as they often do, the shares will constitute “restricted equity instruments” upon issuance.
The problem arises where the founders are appointed as directors and / or employees before or concurrently with the issuance of the shares. Factually, it is not intended to grant the shares qua director or employee; it is simply a result of secretarial practicalities or inadvertent drafting. Be that as it may, the shares will fall within the ambit subparagraph (iii). It follows that where the restrictions are lifted, the shares will “vest” for purposes of section 8C, and the shareholder will be subject to income tax on the growth of their shares.
It may also happen that private equity investors approach the founders while the initial restrictions are still in place. Based on the same commerciality, the new investors may insist on the imposition of similar restrictions, to ensure that the essential human capital remains with the company. The outcome is the same, albeit the classification of the shares as restricted will simply be perpetuated. The upshot is, again, that where the restrictions are lifted, or where the founders decide to cash out, the notional or actual gains will be subject to income tax.
Take No Chances
Intrinsically, this cruel eventuality can be ascribed to the Legislature’s overly zealous intervention over the years. One would be inclined to argue that substance (and sanity) should prevail in these cases. But the EM is clear that SARS may adopt a formalistic approach. The Commissioner need not concern himself with the factual or commercial reality of the matter. The taxpayer will somehow have to convince SARS that a deviation from the tenure of the underlying agreements is warranted. Unfortunately, arguments of fairness will not win the day.
The only way to avoid this calamity is for shareholders and investors to be painfully meticulous in formulating the constitutive documents and agreements when they establish or invest in a company. Otherwise, their return (notional or otherwise) on investment could very well be erased.