Legislation needs to be aligned with fiscal incentives

Source: Pexels

Employee share ownership has been a successful element of Black Economic Empowerment (BEE) and almost universally accepted by all political parties and stakeholders, including the DA, the ANC and labour. The rationale is clear: more workers owning production aligns with economic growth with extensive research backing its benefits.

Internationally, countries like the US, the UK and Singapore have implemented policies that promote employee ownership through tax incentives. In South Africa, the two government departments that should be spearheading this policy are Treasury and the Department of Trade and Industry (DTIC) with Treasury responsible for driving the tax and fiscal regime, and DTIC providing the empowerment and legislative regime to encourage employee ownership.

The number of employee share ownership plans (ESOPs) in South Africa has grown in recent years, enhancing employee participation in the corporate sector and becoming a pivotal element in Competition Commission approvals.

Companies are increasingly adopting long-term, or "evergreen" share schemes that allow employees to benefit across business cycles and promote long-term participation in company growth rather than linked to volatile share prices and funding structures.

The current tax framework, however, has not evolved to effectively support these share schemes. Section 8b of the South African Income Tax Act has limited effectiveness for BEE ownership purposes.

Taxation and reform

The key requirements include that at least 80% of all permanent employees must participate, employees must be fully entitled to dividends and voting rights and there can be no restrictions on the disposal of shares except for a lock-in period of up to five years. Unfortunately, unworkable bad leaver provisions, limited benefits and a lack of revisions have hindered its adoption and effectiveness​.

Section 8c of the Tax Code offers limited relief by linking the taxation date to vesting. It treats gains from ESOPs as taxable income at the time of vesting, often resulting in a significant tax burden for employees and a lack of deductibility for companies. However, it does not accommodate the newer, more dynamic ESOP structures.

Ramaphosa signs Procurement Bill into law: A new era for SA supply chain

25 Jul 2024

Internationally, there is a move to create tax environments that encourage ESOPs by offering tax incentives to both companies and employees. A complication locally is the integration of ESOPs with BEE initiatives with the need for leveraging placing undue financial risk on employees, underscoring the necessity for perpetual share ownership schemes that provide sustainable benefits without the disproportionate tax implications currently in place.

The current tax situation - where employees might pay up to the top marginal tax rate on dividends - can be excessively burdensome. What we need is a revised legislative framework that allows for dividends paid to employees to be deducted and which moderates the tax impact on employee beneficiaries.

Revising tax legislation to support perpetual share schemes and providing tax relief for both dividends and capital gains under these schemes could make ESOPs more attractive and feasible, in the process aligning South Africa more closely with global best practices.

Global tax incentives

Globally, many countries have successfully implemented tax incentives for employee share ownership schemes. In the UK, for example, a number of different policies have been introduced including enterprise management incentives aimed at smaller, high-growth companies; share incentive plans allowing employees to purchase shares, often at a discount, with tax-efficient benefits; and save as you earn (SAYE), a savings-related share option scheme that permits employees to save and then buy shares at a predetermined price.

Companies are allowed to deduct corporate tax for the difference between the exercise price and the market value of the shares at exercise for enterprise management incentive schemes. Employees are not charged income tax or national insurance contributions on grant or on exercise, provided the exercise price is at least the market value at grant. Capital gains tax benefits apply on sale.

Presidency signs Pension Funds Amendment Bill into law

22 Jul 2024

In the US, corporate contributions to ESOPs are tax deductible and the loans used to buy company stock can be repaid with pre-tax dollars. Employee contributions to ESOPs are not taxed until distribution and the rollover into an IRA is possible to defer taxes.

There is no tax deduction for incentive stock options (ISOs) unless there is a qualifying disposition. Employees are not charged tax on grant or at exercise, and capital gains tax only applies on the sale on the stock options, provided the shares are held for over a year after exercise and two years after grant.

The IRS allows businesses to deduct expenses related to setting up and administering ESOPs and other incentive schemes as business expenses. This includes legal, consulting and administrative costs directly associated with the maintenance of the plan.

Singapore has introduced ESOPs and employee share ownership (ESOW) which offer tax exemptions or deferrals to make it easier for employees to participate in share ownership, aiming to align their interests more closely with the business.

Australia has encouraged employee share schemes (ESS) by providing tax concessions for startups, aiming to help them attract, retain and reward employees with shares or options. The policy includes deferred taxation points and reduced tax rates under certain conditions.

Equity and engagement

The underlying motivation for all these countries is similar: improving corporate performance, aligning interests between employees and employers, fostering a sense of ownership and engagement and distributing wealth more equitably. Each country has tailored its policies to fit its specific economic and social context, with tax incentives being a common tool to encourage participation in these schemes.

The majority of countries have adhered to the principle that if the expenses are incurred wholly and exclusively for the purposes of the trade or business and are not of a capital nature, they are likely to be deductible.

South Africa needs to be led by global best practice and ensure its fiscal policies reflect and support our socioeconomic objectives. Not only is a re-evaluation and adjustment of ESOP-related tax legislation overdue, but it’s time for policymakers to take decisive action to ensure these schemes are as beneficial in practice as they are in principle.

Ideally, our tax legislation should be amended to encourage long-term ownership in broad-based employee schemes. We need to incentivise companies with tax deductions on the economic costs they incur, and only tax employees for capital gains if the scheme meets certain criteria. These criteria might include shares being held for longer than five years, setting upper limits to address income inequality and ensuring the schemes are broadly allocated to more than 70% of the company's employees.

Implementing the right legislation will encourage more companies to adopt ESOPs, fostering a forward-looking approach to economic development, corporate governance, inclusive growth, and social equity. Ultimately, this will contribute to a more equitable and prosperous economy.