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Employee share incentive schemes – Income tax implications by Stacy-Lee Dennis

Stacy-Lee Dennis

INTRODUCTION

It is important for taxpayers who claim deductions in respect of contributions to share incentive arrangements for employees, particularly where trusts are involved, to consider the potential impact of Commissioner for The South African Revenue Service v Spur Group (Pty) Ltd (the Spur Case).

Section 95(1)(c) of the Companies Act 71 of 2008 (“Companies Act”) defines an employee share scheme as:

a scheme established by a company, whether by means of a trust or otherwise, for the purpose of offering participation therein solely to employees and officers of the company or a subsidiary of the company, either—

(i) by means of the issue of shares in the company; or

(ii) by the grant of options for shares in the company

The section therefore allows participant employees to benefit from the growth in value of the shares of the company by giving employees the option of acquiring shares in the company or rights associated with shares.

There are many different forms that share schemes can take and it is important to note that the scheme must comply with the abovementioned definition for it to be classified as such for tax purposes.

The Income Tax Act 58 of 1962 (“Tax Act”) entitles taxpayers to deduct certain losses and expenses incurred by them from their taxable income if the losses and expenses comply with the requirements of (among other deduction provisions) section 11(a) of the Act.

Section 11(a) states:

For the purpose of determining the taxable income derived by any person from carrying on any trade, there shall be allowed as deductions from the income of such person so derived-

(a) expenditure and losses actually incurred in the production of the income, provided such expenditure and losses are not of a capital nature…”

SOUTH AFRICAN REVENUE SERVICE V SPUR GROUP (PTY) LTD

In the Spur Case the central question was whether a contribution of R48 million made by Spur Group (Pty) Ltd (Spur), to a trust established in furtherance of its employee management share incentive scheme, was sufficiently closely connected to Spur’s income earning operations so as to qualify for a deduction under s 11(a) of the Tax Act.

 The trust

Spur implemented an employee share incentive scheme to incentivise its employees.  Eligible employees of Spur were afforded an opportunity to participate in the scheme.

Spur’s holding company (“Spur HoldCo”) established the “Spur Management Share Trust”, a discretionary trust of which Spur HoldCo was the sole capital and income beneficiary.

Spur contributed an amount of R48 million to the Spur Management Share Trust.

Spur Holdco then used the funds to acquire preference shares in a newly incorporated company (“NIC”) and the Spur employees purchased ordinary shares in the NIC for a nominal value.

The Spur employees benefited from the value created in NIC by the appreciation of the Spur HoldCo shares held by the NIC.

Subsequently, the NIC used the subscription proceeds in respect of the preference shares to acquire shares in Spur HoldCo.  The preference shares were eventually settled by the NIC and the NIC sold the remaining Spur Holdco shares and used the proceeds to declare a cash distribution to its ordinary shareholders (Spur employees).

The Contribution (R48 million) in effect moved from Spur to Spur HoldCo and never left the Spur group of companies.

section 11(a)

Spur claimed a deduction under section 11(a) of the Tax Act in respect of its contribution to the share Spur Management Share Trust.

After conducting an audit in 2011, SARS disallowed these deductions claimed by Spur on the basis that “the expenditure was not incurred in the production of [the taxpayer’s] income in that there is no direct, causal link between the contribution and the production of income”, as “S Holdco was the only party to have benefited directly from the contribution” and the “participants were […] not the beneficiaries of the contribution”.

The SCA held that employees were incentivised by, and benefited from, the arrangements implemented by the Spur group via their separate investment in NIC shares, as opposed to the contribution made by Spur to the Spur Management Share Trust which funded the preference shares and was always intended to be returned to Spur Holdco, as the sole beneficiary.

 CONCLUSION

The facts in this case are unique and differ from more common incentive arrangements. Nevertheless, it is a true wake-up call and the essential issue is whether the connection between the contribution and the taxpayer’s production of income is close or immediate enough to justify the deduction in terms of section 11(a) of the Income Tax Act.

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