Companies, particularly listed companies, offer employees so-called share options (also referred to as share incentive schemes or employee share ownership plans (ESOPs)) as a form of further remuneration and even as an employee retention mechanism. In unpacking and understanding the tax consequences linked to ESOPs, the provisions of section 8C of the Income Tax Act need to be considered. Section 8C replaced section 8A, which was previously the taxing provision in relation to ESOPs, in 2004. This article considers some of the more practical challenges when dealing with share schemes. 

The biggest challenge is usually the liquidity constraints that employees face as a result of the vesting of an equity instrument, irrespective of the fact that no cash has exchanged hands. It is for these reasons that companies typically encourage employees to dispose of a certain number of shares in the company (after vesting of the equity instrument) to create liquidity to pay the tax due to the South African Revenue Service. 

Following the vesting of the equity instrument, section 8C determines that the gain to be derived by the employees would be equal to the market value of the equity instrument at vesting (strike price), less the consideration paid for the equity instrument (grant price). The market value determination would, in the absence of a prescribed formula which would otherwise serve as an agreed proxy to consistently determine market value, be the arm’s length market value that may be attributable thereto. 

The gain determined is included in the taxable income of the employee and is subject to PAYE at the employee’s effective tax rate. It can also happen that the employee creates a potential loss on vesting. Should the ESOP Rules not cater to stop-loss provisions, this loss will be included in the income of the employee. 

Section 8C also finds application where an employee is not necessarily granted the share options, but rather a connected person in relation to the employee. This could be if share options, by virtue of the employee’s employment, are granted to his spouse or his trust. 

From a practical perspective, it is always important to consider the rules of the ESOP as they will be material in determining vesting for section 8C purposes. The courts will consider the rules and its actual application and not whether the company in question refers to the vesting of the equity instrument or not. 

Upon final vesting of the equity instrument, in terms of the rules of the ESOP, and upon the employee paying the necessary PAYE, the strike price becomes the new base cost for capital gains tax purposes, should the employee now hold the shares acquired on capital account. 

ESOPs can have complicated and sometimes unintended tax consequences and it is advisable to get professional assistance prior to the implementation of ESOPs. 

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)