Income tax on restricted and unrestricted equity instruments

On 30 May 2014, Binding Private Ruling No. 170 was released by SARS, which dealt with the question of whether the conditions imposed on an employee in respect of an employee share scheme would result in the shares constituting restricted equity instruments for purposes of s8C of the Income Tax Act, No. 58 of 1962. It is clear from the Ruling that there is often a fine line between whether or not one is dealing with a restricted equity instrument.

In terms of s8C of the Act, an employee will be subject to income tax on any gain (or loss) determined on the date of vesting of a restricted equity instrument. With reference to the Ruling, if the employee held a restricted equity instrument, he would be subject to s8C of the Act on the date of vesting, which would have income tax consequences (as opposed to capital gains tax consequences) for the employee concerned.

A restricted equity instrument is defined in s8C(7) of the Act, and includes a share:

• which is subject to any restriction (other than a restriction imposed by legislation) that prevents the taxpayer from freely disposing of that equity instrument at market value;
  
• which is subject to any restriction that could result in the taxpayer:
  
• forfeiting ownership or the right to acquire ownership of that equity instrument otherwise than at market value; or -
  
• being penalised financially in any other manner for not complying with the terms of the agreement for the acquisition of that equity instrument.

Against this legislative background, SARS had to consider in the Ruling whether, in the following circumstances, the shares held by the employee constituted restricted equity instruments:

• The employee was not a resident of South Africa. At all material times, the employee resided in Country X and rendered services in Country X.
  
• As part of an employee share scheme, the employee acquired shares in his employer company, which was also resident in Country X.
  
• The employee was the beneficial owner of the shares, which could be sold at any time subject to the approval of the management of the board of his employer. However, the employee was required to sell the shares if he ceased to be employed by the employer group.
  
• In terms of a put and call option agreement:
  
• the shares could, at any time, either be sold by the employee to his employer company (or another company in the group) or acquired by the company at market value;
  
• all the shares could not be disposed of immediately. The sale had to be spread over a period of four years and the market value for the shares was fixed for the four-year period.
  
• The employee's employment with his employer had terminated and some of the shares were sold in terms of the agreement. The remaining shares would therefore be sold over the next four years at the predetermined price.

The employee was contemplating relocating to South Africa with his family, and would most likely become a resident of South Africa before the remaining shares were sold to the company.

Taxed on worldwide income

If the employee became a resident of South Africa, he would in future be subject to tax in South Africa on his worldwide income and no longer only South African sourced income. It follows that, if the shares were restricted equity instruments for purposes of s8C of the Act, the employee was presumably concerned that any gain on the subsequent disposal of the shares could be subject to income tax in South Africa in terms of s8C of the Act. If, however, the shares were unrestricted equity instruments, the employee would establish a base cost for those remaining shares equal to their market value when he became a resident.

Having regard to the definition of a restricted equity instrument above, the important consideration was whether the restrictions on the disposal of the remaining shares over a four-year period at a predetermined price 'prevents the taxpayer from freely disposing of that equity instrument at market value.

Despite the employee being forced to sell the shares over a four-year period at the market value determined and fixed at the time of termination of his employment, SARS ruled that these remaining shares constituted unrestricted equity instruments as defined in s8C(7) of the Act. On this basis, s8C of the Act would not be applicable to the subsequent disposal of the shares by the employee once he became a resident of South Africa.

If s8C of the Act had been applicable to the subsequent disposal of the remaining shares by the employee, it would have been interesting to see whether SARS would consider any s8C gain as being exempt from normal tax in terms of s10(1)(o) of the Act.

Exemption from tax

S10(1)(o) of the Act provides an exemption from normal tax for remuneration earned by an employee for services rendered outside of South Africa for a designated period of time. If the employee in the Ruling is entitled to apply the s10(1)(o) exemption over the period that the services were rendered to his employer (without regard to any subsequent periods of time spent in South Africa), the employee would be exempt from normal tax on any s8C gain realised on the disposal of the remaining shares, as he was outside South Africa for the entire time the services were rendered. In other words, if s10(1)(o) of the Act is applicable, it may be irrelevant whether the shares constituted restricted equity instruments.

However, if one has regard to SARS's Income Tax Interpretation Note 16 and Binding Class Ruling No. 25, it is not clear whether SARS would adopt this interpretation and application of s10(1)(o) of the Act.

The Ruling illustrates the fine line between those situations where taxpayers would be regarded as holding a restricted equity instrument and an unrestricted equity instrument, which could have a material impact on the tax consequences triggered on the subsequent disposal/vesting of the equity instruments concerned.