Should phantom shares be taxed in terms of section 8C of the South African Income Tax Act, 1962, or should they be regarded as a bonus, to which section 7B of the Act applies?
This question is important firstly, because the timing of when the tax event occurs may differ depending on which provision is applicable and secondly, employers have certain compliance obligations with regard to section 8C gains, including the requirement to obtain a tax directive from the South African Revenue Service, which do not apply to bonuses.
In a typical phantom share plan, the participating employees are awarded "phantom shares" (or notional units) as an incentive arrangement, in terms of which they may receive cash payments based on dividends and/or growth in the share price of the employer company's shares.
Phantom share plan awards may be granted on a discretionary basis subject to performance or time-based conditions. If these conditions are met, in effect, the employee receives a bonus that is based on the employer company's performance calculated with reference to dividends and/or the share price.
The employer company's shares thus simply represent the basis of calculation of the bonuses paid to the employees, but the employees do not acquire any shares or any rights in or entitlements to such shares, nor are any shares held by an entity such as a share incentive trust for the benefit of the participating employees.
In principle, amounts paid to employees under a phantom share plan will be subject to tax in full.
For purposes of section 8C, an "equity instrument" includes, among other things, any contractual right or obligation, the value of which is determined directly or indirectly with reference to a share. As such, phantom share awards may constitute a contractual right as contemplated in this wide definition. However, it is arguable that section 8C should not be interpreted as including every contractual right which is valued with reference to a share.
In this regard, the rationale for extending the ambit of section 8C by widening the scope of the term "equity instrument" to include such contractual rights (as set out in the Explanatory Memorandum to the relevant legislation) was to address executive share schemes involving trusts where the executive obtains a right to the value of the shares held in the trust without obtaining any right to acquire the underlying shares themselves.
The Explanatory Memorandum stated that "Hence, section 8C now applies to an interest in a trust even if the employee has a right solely to the value of the shares in the trust (without any direct right in the shares themselves)." The intention of the legislature in making these changes seems to be directed specifically at incentive schemes involving shares held directly or indirectly for the benefit of the executive.
On the other hand, section 7B applies to "variable remuneration" which includes, among other specified amounts, a bonus contemplated in the definition of "remuneration" in the Fourth Schedule to the Income Tax Act. There is no definition of a "bonus" in section 7B of the Income Tax Act or in the Fourth Schedule.
The relevance of which provision should apply in relation to the timing of the tax event is that, in terms of section 8C the tax event occurs when the "equity instrument" is deemed to vest, which in the case of an equity instrument which is subject to restrictions may only occur, amongst other events, when all the applicable restrictions cease to have effect.
For example, if there is a "malus" and/or "clawback" provision applicable to a payment made to the employee under a phantom share plan whereby the employee may be required to repay the amount if certain conditions are not met, the equity instrument will not be deemed to vest for tax purposes until such clawback provision no longer applies, regardless of the fact that payment has been received by the employee.
However, in terms of section 7B, any amount to which an employee becomes entitled from an employer in respect of variable remuneration is deemed to accrue to the employee for tax purposes on the date on which the amount is paid to the employee by the employer. The bonus will therefore be taxable on the date of payment regardless of whether there are any clawback provisions applicable.
Accordingly, there are two different timing rules that could apply.
There are also different compliance obligations for the employer. In the case of any gains which are taxable in terms of section 8C, before withholding employees' tax the employer must apply for a directive from SARS to determine the amount of tax to be withheld. However, bonuses may be processed through the employer's payroll without the need to obtain tax directives.
On the basis that the amendment to the definition of an equity instrument in section 8C to include contractual rights within the ambit of the provision was introduced to counter tax avoidance in the context of share incentive trusts, it is arguable that this aspect of the definition should be interpreted more restrictively to exclude bonus payments which are simply determined using the employer's shares as a calculation methodology, without there being any rights or entitlements to shares themselves. Since section 7B specifically applies to bonuses, this provision should apply to bonus payments made under phantom share plans.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
