10 October 2011

Employees' tax implications of share scheme losses

The ongoing turmoil and miraculous turnaround every other week of the share market could have mixed fortunes not only for individual investors, but also those participating in the various employee share schemes (ESS). It is therefore not uncommon for an ESS to go ''under water'' and trigger losses on vesting for the various participants. The question arises as to how an employer should deal with ESS losses upon vesting in relation to its monthly employees' tax withholding obligation.

Section 8C of the Income Tax Act (the Act) deals with the taxation of directors and employees in relation to the vesting of equity instruments. More specifically, section 8C(2) of the Act deals with the amount to be included in and the losses to be deducted from the income of a taxpayer upon vesting of an equity instrument. Generally, a loss will arise on vesting where the consideration paid for the equity instrument exceeds its market value.

The definition of "remuneration", read with paragraph 11A of the Fourth Schedule, makes it clear that any gain made from the vesting of an equity instrument will be subject to the deduction of employees' tax. A further requirement, and one which employers conveniently disregard in many instances, is that paragraph 11A(4) of the Fourth Schedule requires a directive to be obtained from the South African Revenue Service (SARS) before employees' tax is deducted. The position many employers take by withholding a flat 40% (being the highest marginal rate), without obtaining a directive first is therefore technically incorrect, although SARS would never be out of pocket, so to speak, in terms of employee's tax collections.

Although the employees' tax consequences of gains under section 8C are dealt with sufficiently in the Fourth Schedule, it is silent on the treatment of losses and whether these could be taken into account in the month that it arises or only on assessment of that employee's individual income tax return. Obviously, it is more beneficial for SARS to delay the deduction of losses arising from an ESS, which would be in line with the "tax now deduct later" theme prevalent in the Fourth Schedule, for example travel allowance claims, company car claims and medical aid deductions. Advance tax rulings have also not dealt with ESS losses in any detail, apart from Binding Class Ruling 30, but this only confirms the deduction and not the timing thereof.

An argument could be made, based on the structure of the Fourth Schedule, that losses upon vesting should be deducted from remuneration in the month that it arises and not only upon assessment of an employee's individual income tax return. As stated before, section 8C(2) of the Act provides that the loss must be "... deducted from the income of the taxpayer ...", a term which is also contained in the definition of "remuneration". The definition of "remuneration" in the Fourth Schedule is wide and means "... any amount of income which is paid or payable to any person by way of salary ..." and includes various other amounts, such as any gain determined under section 8C of the Act.

An employer could arguably deduct the loss upon vesting from the employee's income, which is paid by way of salary, forming part of remuneration from which employees' tax must be withheld. Employees' tax would then be calculated on a reduced "remuneration" amount and places the employee in a better off position by not having to claim the loss only on submission of a tax return. The net tax position however remains the same, although the timing of the deduction may not be to SARS's liking.

An employer could also be faced with the scenario where an employee participates in various schemes, some triggering gains and others triggering losses in the same period. The question arises as to whether an employer is able to only deduct employees' tax in a specific month on the ''net amount''? The structure of the Fourth Schedule does not appear to support an employer only taking into account the ''net gain'' made upon vesting. Section 8C of the Act clearly distinguishes between gains and losses, and so does the Fourth Schedule having regard to the wording of paragraph 11A and the definition of "remuneration". It may not necessarily be the most practical solution but an employer would seemingly have to apply for a directive, under paragraph 11A(4) of the Fourth Schedule, in respect of the gain (not the ''net gain'') in isolation and deduct any losses from income as a separate entry. This will likely result in an over-deduction of employees' tax for that specific month.

An option for Treasury would be to possibly amend paragraph 2(4) of the Fourth Schedule to specifically allow the deduction of losses triggered under section 8C(2) of the Act in determining the balance of remuneration subject to employees' tax.

Ruaan van Eeden

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