Innocuous binding private ruling or perhaps not
We often comment that the tax legislation applicable to share incentive schemes is complex and, as a result, a number of advance tax rulings have been published by the South African Revenue Service (SARS) dealing with the issues.
Another Binding Private Ruling, No 199 (Ruling), was released by SARS this week which dealt with the questions of whether:
- the participation rights held by beneficiaries of a share incentive trust constituted "restricted equity instruments" for purposes of s8C(7) of the Income Tax Act, No 58 of 1962 (Act); and
- the dividends received by the beneficiaries by virtue of these participation rights will be tax as income or exempt from normal tax in terms of s10(1)(k)(i) of the Act.
The Ruling once again illustrates the difficulty that taxpayers face in determining whether the particular equity instruments concerned constitute "restricted equity instruments" and whether any dividends received by them will be exempt from normal tax. In particular, recent amendments to subparagraphs (dd) and (ii) of s10(1)(k)(i) of the Act have created some uncertainty whether dividends received in respect of the relevant equity instruments will
be exempt from normal tax.
The facts of the Ruling are common in a number of share incentive schemes where:
- An incentive trust (Applicant) is established for the directors / employees of a private company.
- The Applicant acquires ordinary shares in the private company, which are held for the benefit of the directors and designated employees (Beneficiaries).
- The Beneficiaries are awarded participation units (Units) which entitle them to, amongst others things, a portion of the dividends received by the Applicant. However, in this particular scheme, the Units do not entitle the Beneficiaries to receive any shares held by the Applicant.
Importantly, for purposes of analysing the attendant tax consequences arising from the scheme, the Units in the Ruling were subject to the following restrictions:
- if a Beneficiary ceases to be a Beneficiary, the Beneficiary will be deemed to have offered their Units for sale to parties (Offerees) specified in the trust deed who shall be entitled (but not obliged) to purchase the Units;
- the purchase price payable for the Units is an amount equal to the fair market value which will either be determined (i) in terms of the trust deed or (ii) with reference to the ultimate underlying investments in which the shares, held by the Applicant, are invested;
- the Offerees are not obliged to purchase the Units; and
- no Beneficiary may dispose of a Unit without permission of the board of directors of the company, who may not unreasonably withhold its permission.
It is difficult to analyse the Ruling without all of the detailed facts and circumstances of the scheme. However, it is anticipated that the uncertainty has been created as a result of the recent amendments to s10(1)(k)(i) of the Act. The provisions of s10(1)(k)(i) of the Act are subject to differences of interpretation. However, it appears that the generally accepted interpretation of these provisions is that:
- if one is dealing with a "restricted equity instrument", the dividends will be exempt provided one complies with the provisions of s10(1)(k)(i)(dd) of the Act. In this case, all of the shares held by the Applicant had to be equity shares to qualify for the exemption; and
- if one is dealing with an "unrestricted equity instrument" or other arrangement, one has to carefully consider whether "any dividend received by or accrued to a person in respect of services rendered or to be rendered, or in respect of or by virtue of employment or the holding of any office", otherwise it may not be exempt in terms of s10(1)(k)(i)(ii) of the Act. The provisions of subparagraph (ii) are certainly less clear than the provisions of subparagraph (dd).
In the context of the Ruling it is likely that the Applicant and the Beneficiaries were concerned that if the Units were "unrestricted equity instruments", any dividends received by the Beneficiaries would be "in respect of services rendered or to be rendered, or in respect of or by virtue of employment or the holding of any office" and therefore no longer exempt in terms of the new s10(1)(k)(i)(ii) of the Act.
However, SARS confirmed in the Ruling that the Units constituted "restricted equity instruments" and, presumably on the basis that all the shares held by the Applicant were equity shares, any dividends received by the Beneficiaries would be exempt from normal tax in terms of s10(1)(k)(i)(dd) of the Act.
The Beneficiaries in the Ruling will take comfort from the certainty that any dividend distributions received by them will be exempt from normal tax, although any dividend distributions will be subject to the dividend withholding tax imposed at a rate of 15%.
However, the Ruling may give other taxpayers some cause for concern as to whether their particular equity instruments may be regarded as "restricted equity instruments" for the purposes of s8C of the Act. In particular, we note that:
- It is not clear from the Ruling, which of the restrictions imposed on the Units resulted in the Units constituting "restricted equity instruments" or whether it was the restrictions viewed collectively. For example:
- Is the fact that the Beneficiaries may not dispose of the Unit without prior approval from the board of the company alone sufficient for the Units to constitute a "restricted equity instrument", bearing in mind that the approval may not be unreasonably withheld?
- Do the other restrictions result in the Units becoming "restricted equity instruments" in circumstances where the Units can be disposed of at fair market value?
- Many of the restrictions referred to in the Ruling are common in a private company scenario where there is not a readily available market for the sale of the shares in the company and the board or other shareholders need to pre-approve the transfer of shares to any other person. If in a private company scenario, the shareholders of the company who also happen to be employees of the company are required, upon ceasing to be an employee, to offer their shares to designated transferees at fair mark value and/or obtain prior approval from the board to dispose of their shares (at fair value value), does this mean that these shares will be regarded as "restricted equity instruments"?
On first reading, the Ruling appears innocuous without much cause for concern. However, on closer analysis it does raise interesting, and often difficult, questions on when an equity instrument will be a "restricted equity instrument" and an "unrestricted equity instrument".
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