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The down and dirty of executive share incentive schemes

Why should this elite class of taxpayer remain protected?

Employees, as compared to casual workers, get paid whether they turn up for work or not. On top of the salary are other benefits such as sick leave, annual leave and bonuses. Much time and energy is spent devising creative benefits that will escape the tax net, and the more an employee earns, the greater the motivation for lowering the tax rate. 

Many large companies have set up employee share schemes to enable their employees to benefit from positive growth in the company. The commercial rationales are various, and would range from incentivising employees to work harder and remain in the company’s employ, to meeting ownership requirements contained in the Broad-Based Black Economic Empowerment Act of 2003 (BBBEE). The fundamental objective of BBBEE is economic transformation and enhancing the economic participation of black people in the South African economy.

Share incentive schemes can be very complex, after all, they need to navigate the Income Tax Act, the Companies Act, and other provisions such as the JSE Listings Requirements. A well designed employee share scheme will ensure that the benefits of holding shares is passed to the employees in a tax efficient manner. The scheme will usually involve a Trust which has been established to administer the scheme, and a special purpose vehicle (SPV), which will either purchase shares in the listed company, or the listed company will issue shares to the SPV.

The company may also provide for a separate management or executive share scheme. I find it difficult to understand how someone who has reached managerial or executive level requires a carrot to induce them to work harder and remain in the company’s employ. Similarly, if executives are to align themselves with shareholder’s interests and share in the economic upside of the company, why do they not share in the downside? Or is an executive share scheme merely another way to reward an executive with a tax efficient incentive to be stored in the family trust?

If the company performs poorly, or if its share price tumbles for any reason, the company will rush to the rescue of any employee share scheme. Likewise, the company will justify any contribution to a share scheme as being tax deductible because there is a close connection between the contribution and the production of income. In short, the same reason will be used to justify any contribution made to the share scheme to recompense a share scheme for any loss. Maintaining a happy workforce will outweigh the interests of the shareholders who actually purchased the shares in good faith, and the company will endeavour to make up any shortfall.

Earlier this year, a company (SG Taxpayer) won a case against Sars in which it claimed that a R48 million contribution to its employee management share incentive scheme was tax deductible. Hopefully the only precedent this case will set is that Sars should take more care in supporting its arguments for any disallowance of deductions. In this matter, Sars omitted the key negative test contained in section 23(g) of the Income Tax Act, that “any moneys, claimed as a deduction … must be expended for the purpose of trade … ”.

Steinhoff Africa Retail (Star) was recently in the news when it made a R440 million provision in regard to a third-party debt related to a Pepkor management investment company, and a R60 million provision for an impairment of loans associated to the third-party debt. Concerned that the “legacy Steinhoff share incentive scheme” no longer adequately addressed the need to “retain, motivate and reward key senior employees” of the group, another R90 million was sunk into a cash retention scheme.

The Companies Act, 2008, mandates that a shareholders’ special resolution is required when the company provides financial assistance to various parties, which includes directors, related or inter-related companies, a member of a related or inter-related company, or any person related to these parties. Financial assistance includes a guarantee. However, there is an exception where financial assistance is given to a qualified share incentive scheme, in that the board may authorise the financial assistance.

It should be noted that a management investment company doesn’t necessarily qualify as an employee share scheme as provided for under section 97 of the Companies Act. And if it doesn’t, any financial assistance would have to have been provided in line with a special shareholders’ resolution adopted within the previous two years. This cannot be done after the fact.

There is another safeguard. Before the company’s board provides any financial assistance, it must ensure that the company has satisfied the solvency and liquidity test immediately after providing the financial assistance, and that the terms of the financial assistance to be given are fair and reasonable to the company. In my view, shareholders should carefully ascertain whether the board in fact did this.

National Treasury has been grappling with the taxation aspects of share incentive schemes for some time, and they should not let arguments setting out any possible detrimental impact on a broad based share scheme to obfuscate the necessity to deal harshly with executive share schemes. Perhaps it is time to set different tax rules for different share schemes. Why should financial assistance to “impoverished” executive share schemes not be taxed as ordinary income? Why should this elite class of taxpayer remain protected?

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How about making it a choice for such executives – if you opt for the share scheme, you forfeit your salary which gets paid to a charity of your employees’ choice. The executive is then truly married to the performance of the company.

However, you would need to ensure that such an executive does not introduce staff cuts under the guise of ‘restructuring’ or other tricks to inflate the share price at the expense of stakeholders.

The ANC is a socialist organization where “the accountability lies with the collective”. This implies that the people who attended the Nasrec congress of the ANC are actually indirectly responsible for the managerial decisions at Eskom. Therefore the people who are responsible for the management of Eskom, are themselves not aware of their responsibilities and the actions that are required. Forget that they are hopelessly under-qualified for this position.

Here we have the biggest utility in Africa being managed by nobody. The inefficiencies, the effect of bad management, the corruption and lack of accountability by everybody in the structure is forced down on the devastated and abused client. This is how socialism destroys an economy.

Replace this destructive system with a system that enforces accountability and ensures that all role-players accept responsibility. This is the free-market system.

The consumer of electricity, who also happens to be the taxpayer, foots the bill for the destructive mistakes made by this incompetent, reckless and ignorant government. The current trend clearly leads to the total implosion of Eskom. It is inevitable in south Africa that electricity will eventually be provided by the free-market.

Privatize it orderly now, before it chaotically privatizes itself later.

A simple route would be matching : company’s tax deduction is equal to the employee’s taxable gain.

That STAR arrangement should be a crime

Two matters need to be kept apart here: 1) The race for talent when it comes to executive skills and knowledge, which necessitates finding ways to retain key staff. To my mind there can be no cogent argument from shareholders against this as it is aimed at maximising shareholder value; 2) The implementation of these incentive schemes and the necessity for oversight by the board and, ultimately, the shareholders, including the institutional investors. Don’t throw the baby out with the bathwater. The problem is with 2) above, not with 1).

Louise:

I think what shareholders have a problem with is the one-way nature if these schemes : big rewards even with no out-performance. The STAR bailout is poster child for abuse.

I am fine rewarding when my share does 10% better than market. But, if market is up 25% and my share is up 15% the option scheme should be underwater.

Fair solution : relative stock options. So strike moves relative to a relevant basket of peers and index. If basket up 20% the strike goes up 20% If basket down 20% the strike also down 20% That also takes care of a wide correction sinking the scheme despite us doing better than market.

For some obscure reason most boards are not too eager to evaluate such an option scheme….

I think we agree – it’s not the what that is the problem, it’s the how.

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