If taxpayers have been party to or are still party to a deferred delivery share incentive scheme, they should take notice of the judgment delivered on 14 September 2011 in the Tax Court, (Western Cape) (Cases No 12760, 12828 & 12756).
Section 8A of the Income Tax Act, No 58 of 1962 (the Act) was introduced in the Revenue Laws Amendment Act, 2004, and applies to any gain made by a taxpayer by the exercise of any right to acquire a share, if such right was obtained by the taxpayer before 26 October 2004. The Tax Court case related to a typical deferred delivery scheme and one of the questions was whether the gains realised under the scheme were taxable in terms of section 8A, section 8C or paragraph 2(a) of the Seventh Schedule to the Act.
A typical deferred delivery scheme involved a scenario where employees were granted options which were immediately exercised, with the purchase price only being payable on and the delivery of the share being deferred until after the expiration of a particular period (say three years) or on cessation of employment. Under these deferred delivery schemes, taxpayers generally argued that the initial exercise of the option triggered the section 8A gain (which was inevitably zero, unless exercised at a discount) and any gains realised going forward would not be subject to section 8A (ie the option had already been exercised).
The taxpayers in the Tax Court raised similar arguments: a party taking delivery of shares pursuant to the conclusion of an agreement for the purchase of shares does not thereby exercise a right to acquire shares for purposes of section 8A.
However, the South African Revenue Service contended that:
- the exercise by an employee of an option under the deferred delivery share scheme in question did not give rise to an unconditional sale, and that the employee's purchase of the shares was conditional at least upon the employee's employment having been terminated prior to the relevant anniversary dates and the market price of the shares being higher than the specified consideration payable by the employee;
- the true substance of the arrangement was that the exercise of the option would take place only if the employer remained in the employer's employ until the relevant anniversary date and only if it was to the employee's financial advantage to take delivery of the shares and to pay the specified consideration;
- the deferred delivery scheme was intentionally designed to ensure that there was no gain at the time of the exercise of the option and that the employee's material financial benefit would accrue only when the delivery of the shares occurred on the respective anniversary dates; and
- for the reasons mentioned above, the employee only acquired an unconditional right to delivery of the relevant shares upon the arrival of the deferred delivery date and at such stage the sale had become unconditional and subject to section 8A of the Act.
At paragraph 122 Judge Allie, with reference to SIR v Kirsch 2978(3) SA 93(T), notes that for purposes of section 8A of the Act, whether an employee accepts an offer for the sale of shares or exercises an option to purchase the shares, both would be the exercise of a right to acquire shares.
Importantly, he held at paragraph 117 that:
"in the context of section 8A, it is not the mere right but the acquisition pursuant to the grant of that right which brings with it the possibility of financial gain. Having regard to the environment in which section 8A was introduced, the clear purpose of section 8A was to tax employees who bought shares at less than market value by either accepting offers for the sale of the shares, or by accepting options to purchase the shares."
Accordingly, section 8A is triggered when a gain is made and in the case of deferred delivery schemes, the gain is only finally quantified once delivery occurs as this is when acquisition of the shares is complete. In other words, in the context of a deferred delivery scheme, section 8A may also be triggered on the delivery of the shares to the employee.
Taxpayers party to a deferred delivery scheme should therefore carefully analyse whether the gain realised on the actual delivery of the scheme shares are subject to tax in terms of section 8A or section 8C of the Act (which applies to shares not acquired by way of the exercise of any right granted before 26 October 2004 in respect of which section 8A applied).
The particular facts of the Tax Court case are helpful to appreciate the issues at hand. Share options had been granted to one of the taxpayers in August 1998 and December 1998 and the shares were only to be delivered on 14 August 2004 and 2 December 2004, respectively. The gain (if any) realised on the initial exercise of the option would have been subject to income tax in terms of section 8A. However, based on the finding that section 8A may be triggered on the deferred delivery of the shares it was held that:
- section 8A of the Act applied to shares delivered on 14 August 2004 (before 26 October 2004); and
- thereafter section 8C would apply to the shares delivered on 2 December 2004.
Taxpayers should therefore carefully analyse their historic or current participation in deferred delivery share incentive schemes to determine whether they have correctly disclosed any gains or potential gains in terms of section 8A and section 8C of the Act.