Is your share incentive scheme benefiting mainly you, or you and the taxman?
The option of developing a share incentive scheme is becoming more attractive to many employers as a result of a tendency to empower employees; the need to provide incentives to work to develop businesses through employee participation, and the reduction in the number of effective fringe benefits.
Consequently, as an employee, you may be offered the opportunity to participate in such a scheme. The question is: Is participation in the scheme worthwhile or not?
The answer to this question depends, first and foremost, on your perception of the company's future. However, it also depends on how tax efficiently the scheme has been structured.
Although there are many ways in which share incentive schemes may operate, I will refer to a couple of the more conventional ones as examples.
It is essential, however, that you understand the tax effects of the scheme you participate in up-front, so that there are no nasty surprises later.
The first scheme operates as follows:
* The company sets up an Employee Share Incentive Trust;
* The company sells the designated shares to the trust;
* The selected employees are given the option to buy shares at the current market price.
These employees are entitled to exercise this option at any time after a specified period (say five years) and until a specified point in time, as set out in the trust deed.
The second scheme operates as follows:
* The company sets up an Employee Share Incentive Trust;
* The company sells the designated shares to the trust;
* The selected employees may buy the shares at the current market price at the date the offer is made to them;
* The employee is allocated the shares but does not pay for them immediately. The employee may not, however, take possession of the shares until he has paid the loan account in full. (He may also be prohibited from taking possession of the shares for five years, for example).
Let's assume that the shares, on the date they are offered in both examples, have a market value of R3. In five years' time, the market value is R15. Let's also assume the employee is offered 5 000 shares.
In the first example, if the employee exercises the option after five years he will receive shares worth R75 000, but will only have to pay R15 000 for them.
As a consequence, the taxman will want his share of the benefit and will require the employee to be taxed on R60 000. This amounts to tax of R27 000 if the employee is on the marginal 45 percent tax rate.
In the second example, the employee will buy the shares for R15 000 immediately, but will only be required to pay for the shares at a later date.
If the loan is interest free he will pay tax on the fringe benefit value of the interest. This is currently the difference between interest paid and 16 percent our employee in this example would, therefore, pay tax on R2 400 a year for as long as the R15 000 remains outstanding ie R1 080 (at the 45 percent marginal rate) a year, to the taxman.
In the meantime, however, he may receive tax-free dividends from the shares.
After five years, the employee will repay the loan account and take possession of the shares. At that point he will own shares worth R75 000.
The growth will represent a capital growth of shares he has owned for five years, and capital growth is not taxable. What he does with the shares later will determine whether that growth ever becomes taxable, but that is another issue.
Clearly then, there is a big difference between the two schemes. In the first, the employee has had to give the taxman R27 000. In the second, the employee has given the taxman R5 400 over a period of five years, and the dividends he received may, in any event, have been sufficient to cover this cost.