EMPLOYEE SHARE OWNERSHIP
16.1 INTRODUCTION
16.1.1 In recent times, in many countries in the world, there has been a significant growth in employee share ownership.
16.1.2 The benefits of employee share ownership plans (ESOPs) are, in the Commission's view, rather well set out in a booklet published in 1995 by the ESOP Association in the United States, as follows:
The growth of employee ownership in recent decades has been a significant development in the areas of business competitiveness, employee compensation, corporate finance and business continuation. Though there are several forms of employee ownership, employee stock ownership plans, or ESOPs, have achieved the most widespread acceptance and support. The rapid and continuing growth in the number of ESOPs being established and the breadth of industries covered have important ramifications for employees, corporations and the economy as a whole.
16.1.3 In describing the historical background to the ESOP concept, the aforementioned booklet states as follows:
The ESOP concept is based on the theories of capital ownership developed by Dr. Louis O. Kelso. Kelso reasoned that only through widespread capital ownership could modern economies provide for more equitable distribution of wealth. According to Kelso, the concentration of wealth in the U.S. economy results from the fact that capital-producing assets are owned by a small minority of individuals. (Studies conducted by the Joint Economic Committee of Congress, the Federal Reserve and the General Accounting Office have confirmed that nearly 50% of the privately owned stock in the U.S. is owned by 1% of the population). In an economy in which capital is inexorably replacing labour as the means by which wealth is produced, Kelso emphasized the importance of providing the majority who do not presently own capital with a means of achieving substantial stock ownership. Only by sharing in the ownership of productive capital would workers be able to obtain through the market a second income to supplement the wages they earn through their labour.
Since the average worker does not have the financial capability to buy that capital with his or her own earnings, Kelso conceived of the ESOP as a means of providing employees with access to capital credit. By giving employees a stake in corporate financial transactions, their capital ownership could be paid for out of the future earnings produced by the corporation. Widespread application of the ESOP concept would thus promote broadened ownership of wealth through free-enterprise initiatives, rather than resorting to government redistribution through taxation.
Kelso put his ideas into effect by installing ESOPs in a number of companies during the 1950s, 1960s and early 1970s, but it was not until he attracted the support of United States Senator Russell Long of Louisiana that ESOPs began to attract increasing attention. Senator Long was a senior member and then the Chairman of the Senate Committee on Finance and he began to champion the ESOP cause on Capitol Hill.
The Employee Retirement Income Security Act of 1974 ("ERISA") was the first major bill that facilitated the establishment of ESOPs. In the ensuing 12 years, Senator Long promoted the use of ESOPs in a number of additional legislative initiatives, culminating in the ESOP incentives included in the Tax Reform Act of 1986. Because of their unique character as a method of providing employees with an ownership stake in their companies, and because of the tax incentives that exist to promote their use as a technique of corporate finance, ESOPs have assumed a separate identity from other employee benefit plans.
Due primarily to vigorous legislative promotion by the U.S. Congress, the number of ESOPs nationwide has increased from several hundred in 1974 to approximately 10,000 in the mid-1990s, with continued growth expected. Promoted as a means of broadening the ownership of capital and improving the productivity of the American workforce, ESOPs have been at the forefront of a movement for employee ownership that is having profound effects on methods of employee compensation, techniques of corporate finance and efforts to increase corporate America's performance and competitiveness.
16.1.4 The reasons advanced for the adoption of the ESOP concept in the United States are relevant to circumstances currently prevailing in South Africa. In fact there are added reasons why, in contemporary South Africa, the encouragement of employee share ownership has an even greater significance:
(a) first there is concern, which has been voiced by numerous public authorities and others, about the high degree of concentration in the South African economy and about the importance of taking steps to encourage deconcentration;
(b) second, and closely linked to the foregoing factor, there is a desire to democratise, to a greater extent, the ownership of assets, which entails the spreading of ownership among a greater number of individual shareholders in the private sector; and
(c) third, there is the desire to promote employee economic empowerment, which is clearly closely linked to the factor referred to in paragraph 16.1.4(b) above.
16.2 HISTORY OF TAX ASPECTS OF EMPLOYEE SHARE OWNERSHIP IN SOUTH AFRICA
16.2.1 Various amendments which have been made from time to time over the last 25 years to the Income Tax Act have had a significant impact on employee share schemes in South Africa.
16.2.2 The objectives of employee share schemes may be briefly set out as follows:
(a) to enable the employee to participate in the growth of the company thereby serving as an incentive to greater performance;
(b) to ensure that the growth referred to above is received by the employee as capital and thus free of tax (on the basis of existing principles in our tax system);
(c) to ensure that the basis on which the shares are acquired will not give rise to any ongoing fringe benefits tax in the hands of the employee; and
(d) to protect the employee against the so-called "downside" risk arising from a decline in the share price.
16.2.3 Clearly the grant of an option to the employee, which may be exercised over a fairly lengthy period of time, to acquire shares in the employer company at the price prevailing on the date when the option is granted, achieves most of the objectives referred to in paragraph 16.2.2 above. Thus it is no surprise that until 1969 options were overwhelmingly the most common form of employee share scheme in South Africa.
16.2.4 The position changed dramatically away from options when the Income Tax Act was amended in 1969 by the insertion of section 8A. In terms of this legislation essentially any gain received by, or accruing to, an employee on the exercise of an option is taxable.
16.2.5 From 1969 to 1974 the common form of employee share scheme consisted of the issue of shares by a company to its employees of shares on a partly paid basis, interest free.
16.2.6 When the Companies Act, No 61 of 1973, came into operation, the issue of shares on a partly paid basis became unlawful by reason of the provisions of section 92 of the Companies Act, and the common form of employee share scheme became the issue of shares to a trust (established in terms of section 38(2) of the Companies Act). The company lends money to the trust to acquire for cash shares in the capital of the company which are on-sold by the trustees to the employee on the basis that the employee enjoys interest free credit over a long term to pay the trust.
16.2.7 The common form of employee share scheme referred to in paragraph 16.2.6 above suffered a severe setback with the introduction of the Seventh Schedule of the Income Tax Act in 1984, or the so-called fringe benefits tax. In terms of this amendment, the extension of a loan or credit in favour of the employee (at a rate of interest which is less than the official rate of interest for fringe benefits tax purposes) to acquire shares in the employer constituted a taxable fringe benefit. The position in this regard was further exacerbated when dividends ceased to be subject to tax and thus there was no deduction of any portion of the aforesaid fringe benefit. Certain phasing-in relief was granted in recognition of the burden referred to above and the further burden arising from the consequence to share schemes of the abolition of tax on dividends.
16.2.8 Relief to protect against the downside risk of a decline in the share price was granted by the introduction of section 10(1)(nE) into the Income Tax Act in 1984.
16.2.9 The net result of the foregoing amendments to the Income Tax Act is that in South Africa today it cannot safely be said that there is a greater popularity enjoyed by the share option scheme as opposed to the share purchase scheme or vice versa. Different people have different preferences. Thus various types of employee share schemes are adopted in South Africa today, including:
(a) the share option scheme;
(b) the share purchase scheme;
(c) the so-called deferred delivery version of the share purchase scheme;
(d) a combination of the share option scheme and the deferred delivery scheme, designed to take advantage of the proviso to paragraph 2(a) of the Seventh Schedule, but subject to considerable doubt as to the efficacy of this scheme;
(e) the redeemable preference share scheme; and
(f) the debenture scheme.
16.2.10 Gains made by a trust responsible for an employee share scheme are generally not subject to tax.
16.2.11 The Margo Commission examined employee share schemes and its recommendations were as follows:
The exception recommended relates to approved share incentive schemes for employees of a company. The incentives provided by bona fide schemes of that nature are regarded as being of great economic value in encouraging productivity and a healthy relationship between employer and employee through the holding by the latter of an investment stake in the company, with the opportunity of increasing such holding each year. Commenting on employee share schemes in his budget speech for the 1985-1986 year, the Chancellor of the Exchequer said:
"The whole-hearted commitment of employees to the success of the companies in which they work is vital to our country's economic future."
The points on which Commission members are agreed are as follows:
(a) The tax relief allowed under the Seventh Schedule should be in respect of a "soft loan" granted to employees to acquire shares in the company.
(b) The benefits of the scheme should not be limited to senior executives but should be available to all permanent employees.
(c) Provision should be made for the voluntary sale of an employee's shares on leaving the company.
(d) Any capital profits on realization of the shares should be taxed or not taxed according to the ordinary principles applicable to profits on the realization of equity holdings.
(e) For the benefits under a share incentive scheme to qualify for exemption from tax, the scheme should be approved by the Commissioner.
With reference to (a), some Commissioners would extend the exemption from tax to the benefits of share option schemes in which the employee is granted an option to take up shares which, within limits, is exercisable at any time. However, by their nature these schemes protect the employee from a potential loss in the value of his or her shares. For this reason the Commission does not recommend the extension of the exemption from tax to the benefits of share option schemes. The majority of Commissioners, however, take the view that there should be a "downside potential" as well for an employee who takes up shares under an incentive scheme - which is not the case under the present treatment of stop-loss provisions in the Seventh Schedule. The employee should be in the same position as any other investor, although by his "whole-hearted commitment ... to the success" of his company he can contribute in greater degree to protect and enhance the value of his shareholding.
16.2.12 The foregoing recommendations were not implemented.
16.3 APPROACH OF THE COMMISSION TO EMPLOYEE SHARE SCHEMES
16.3.1 The Commission very much supports the objective of greater employee share ownership in South Africa. This objective is not only relevant in the case of conventional companies in the private sector, but also in the case of companies in the public sector which may be restructured with a view private ownership.
16.3.2 In expressing the sentiment set out in paragraph 16.3.1 above, the Commission wishes to emphasise that its references to employee participation in share ownership refer to the entire labour complement of a company, including, more particularly, employees at the lower level of the organisation. The Commission does not consider it necessary to provide additional encouragement or assistance to the relatively few wealthy executives at the top level of companies.
16.3.3 Following on the foregoing sentiments expressed by the Commission in favour of wider employee share ownership, the questions that arise are whether:
(a) there are at present any impediments that stand in the way of greater employee share ownership in South Africa;
(b) to the extent that there are found to be impediments, what measures should be adopted to eliminate those impediments; and
(c) even if impediments are not found to exist or are eliminated, should special encouragement be afforded to facilitate greater employee share ownership in the sense contemplated by the Commission?
16.3.4 From a non-tax point of view, the Commission is of the opinion that conceptually and with respect to legal considerations, structures exist in South African company law which will accommodate almost every scheme designed to broaden employee participation in share ownership. For example, the trust referred to in section 38(2) of the Companies Act, 1973, is sufficiently broad and flexible to accommodate almost any employee share scheme. No changes are needed in this regard.
16.3.5 From the point of view of taxation, the two impediments to employee share ownership at present are the following:
(a) in the case of share option schemes, the provisions of section 8A of the Income Tax Act, which taxes as ordinary income the gains of employees which arise on the exercise of an option to acquire shares; and
(b) in the case of share purchase schemes, the provisions of the fringe benefit legislation which are contained in the Seventh Schedule to the Income Tax Act, and which tax as ordinary income the difference between the rate of interest actually charged by employers to their employees on loans or credit granted and the official rate of interest which is currently 16 per cent.
16.3.6 In considering any recommendations which could result in changes to the Income Tax Act, the Commission has had to consider numerous policy factors, including the following.
(a) First, is it realistic or reasonable to isolate share schemes for a special tax dispensation? However meritorious share schemes might be, what about employees who wish to obtain credit from their employers for other meritorious purposes, such as the acquisition of a family home or provision for the education of their children?
(b) Secondly, the financial authorities in South Africa have, over many years, sought to discourage the use of non-cash remuneration. This was the reason for the introduction of the Seventh Schedule to the Income Tax Act. Non-cash remuneration creates distortions, is inequitable (unfairly discriminating against those who receive cash remuneration) and makes small business uncompetitive with big business in the ability to recruit and retain employees in that non-cash remuneration is capital intensive. The Commission supports the efforts that have hitherto been made to discourage non-cash remuneration and would not wish to recommend measures which would undermine those efforts.
(c) Thirdly, in the case of options, the employees are not exposed to any downside risk. There is only a potential benefit and there is no reason in equity not to subject a portion of this benefit to tax.
(d) Fourthly, by granting a special tax dispensation, either for employee share option or employee share purchase schemes, there would be a disadvantage to self-employed people. The tax system should not disturb the neutrality between self-employed and employed persons.
16.3.7 By not granting any special tax dispensation, it does not mean that wider employee share ownership cannot occur. Companies can provide assistance through the remuneration package; this would be deductible by the company and in the case of those employees for whom the Commission would wish to encourage share ownership, the tax burden would either be non-existent or negligible.
16.3.8 It follows from the foregoing that the Commission is of the view that no sound reasons exist for recommending any changes to the existing income tax principles relating to employee share schemes, subject to the observations set out in paragraph 16.3.9 below.
16.3.9 The Commission does wish to place two observations on record:
(a) The Commission understands that it is the practice at present in the case of employee share purchase schemes where the employee is not a dealer in shares, that any gain made by the employee is regarded as being of a capital nature. It is the Commission's view that this practice is sound and should be incorporated in a practice note to be issued by the Commissioner.
(b) It may be desirable, in the case of share purchase schemes where the scheme contains all the features suggested by the Margo Commission and, in particular, where the scheme applies to all levels of employees and is not designed solely for senior executives, that, although the fringe benefits tax provisions should continue to apply, the employees should be permitted to elect to pay the fringe benefits tax on the earlier of the expiration of five years or when the shares are resold by the employees. Interest should accumulate at the stipulated rate on the liability to pay fringe benefits tax from the date on which it arose in terms of the Seventh Schedule until the payment of such fringe benefits tax. Since there will be administrative problems in keeping track of the amount payable by the employee in terms of this recommendation it is suggested that the obligation be on the employer to keep records of the amount of fringe benefits tax payable by the employee and the interest thereon. If such records are not kept or if the employee fails to pay such tax then the employer should be liable for such tax, with the right of recovery from the employee.
16.4 BENEFITS OF ADOPTING THE COMMISSION'S RECOMMENDATIONS
16.4.1 It is the view of the Commission that if its recommendations are accepted and implemented, there will be meaningful encouragement of employee share ownership in South Africa whilst at the same time:
(a) not impairing the integrity of the tax system;
(b) not violating the objective of discouraging non-cash remuneration; and
(c) not disturbing neutrality between self-employed persons and those in the employ of others.
16.4.2 The encouragement referred to in paragraph 16.4.1 will take place in the context of share purchase schemes where the employee is at risk.
16.4.3 Gains derived from share option schemes will continue to be taxable in accordance with existing principles.
16.5 RECOMMENDATIONS
16.5.1 The Commission recommends that, in the case of employee share purchase schemes (where the employee is at risk), save where the employee is a dealer in securities (as determined by reference to ordinary income tax principles), any gain made by the employee on scheme shares be treated as a capital gain. This principle should be confirmed in an appropriate practice note. [para. 16.3.9(a)]
16.5.2 The Commission further recommends that, in employee share purchase schemes which have the features set out hereunder, although the fringe benefits tax provisions of the Seventh Schedule will continue to apply in respect of loans granted in terms of such schemes, the employees should be permitted to elect to pay the fringe benefits tax due either on the current basis or on the earlier of the expiration of five years as from the date of the granting of the loan or when the shares are resold. Interest should accumulate at the stipulated rate on the liability to pay fringe benefits tax from the date on which it arose in terms of the Seventh Schedule until the payment of the fringe benefits tax. As a matter of administration there should be an obligation on the employer to keep records of the amount of fringe benefits tax payable by the employee as well as the interest thereon. If the employee fails to pay such tax then the employer should be liable for such tax. [para. 16.3.9(b)]
16.5.3 The Commission recommends that the concession proposed in paragraph 16.5.2 should apply to employee share purchase schemes with the following features:
(a) the benefits of the scheme should not be limited to senior executives but should be available to all permanent employees;
(b) provision should be made for the voluntary sale of an employee's shares on leaving the company; and
(c) the scheme should be approved by the Commissioner for Inland Revenue. [paras. 16.3.9(b); 16.2.11]
MISCELLANEOUS
17.1 INCENTIVES FOR PERSONAL SAVING
17.1.1 The importance of encouraging personal saving in South African is generally recognised and widely supported. It was thus urged on the Commission by numerous parties that tax incentives be considered for personal saving.
17.1.2 As explained in Chapter 15 of the first Report, personal saving is largely motivated by the desire of individuals to provide for lifetime crises and eventual retirement, and to smooth consumption expenditure over time. Its level depends primarily on the level of after-tax income. It is not especially sensitive to the rate of return earned on the funds invested, as a high rate both increases the incentive to save and reduces the need.
17.1.3 The Commission remains convinced that the provision of tax incentives for personal saving would:
(a) do little more than result in a redirection of personal saving between the various instruments and vehicles that are available;
(b) call for a higher rate of personal tax to finance the incentives, which higher rate would, in itself, reduce the after-tax income out of which saving has to be made.
17.1.4 The deferment of tax on contractual saving made through the retirement industry is an established part of our system that the Commission does not wish to disturb. It is not, however, at this stage prepared to lend support to incentives designed to encourage other forms of personal saving.
17.2 MARKETABLE SECURITIES TAX
17.2.1 In the first Interim Report the Commission recommended the abolition of marketable securities tax.
17.2.2 The urgency of implementing this recommendation has been increased by numerous developments which have taken place since the publication of the first Report, including:
(a) the extensive restructuring that has occurred with regard to the Johannesburg Stock Exchange and other developments affecting the South African financial markets;
(b) the significant increase in the mobility of international capital;
(c) developments that have taken place in international financial markets;
(d) the relaxations that have occurred in the South African exchange control regulations; and
(e) active trading in instruments which are traded in accordance with the provisions of the Financial Markets Control Act, and which are not subject to any duties.
17.2.3 The consequence of the factors referred to above, coupled with the sensitivity of stock market dealings to transaction taxes, is that the failure to abolish marketable securities tax may result in either or both of the following:
(a) where a particular share is listed both on the Johannesburg and a foreign stock exchange, transactions in that share may take place on the foreign stock exchange to the exclusion of the Johannesburg Stock Exchange;
(b) even apart from the instances referred to in (a) above, the popularity of dealing on the Johannesburg Stock Exchange may decline and it could become uncompetitive with other stock exchanges.
17.2.4 Attention has been drawn to the fact that there are certain European stock exchanges where there is a transactions tax of 0,5 per cent. Questions have been raised why the relevant exchanges retain their popularity despite the existence of such transactions taxes. The response given to the Commission in answer to this query is that all relevant factors, including liquidity, technology, taxes and so forth must be taken into account cumulatively in determining the willingness of investors to deal on a particular exchange. Other stock exchanges have features which are absent in South Africa, such as liquidity, which compensate for the disadvantage of transaction taxes.
17.2.5 The abolition of marketable securities tax carries with it the requirement that various forms of stamp duty on share transactions should similarly be abolished.
17.2.6 The Commission recognises that the abolition of marketable securities tax and various stamp duties is a significant cost to the fiscus. Approximately R700 million was contributed by these duties in 1994.
17.2.7 In the formulation of a Budget that is subjected to severe strains, the abolition of any tax or duty can only occur within the context of a careful assessment of priorities. Whilst this assessment is the prerogative of Government, it is the duty of the Commission to point out the significance of the consequences referred to in paragraph 17.2.3, in the context of a world that is characterised by acute mobility of international capital. If transactions on the Johannesburg Stock Exchange were to be inhibited by transaction taxes, the cost to South Africa would be great. Conversely, the benefits of making the Johannesburg Stock Exchange more attractive to foreign and local investors and dealers are considerable. These benefits include a potential enhancement of the entire tax base which clearly redounds to the advantage of the fiscus.
17.3 TAXPAYER EDUCATION
17.3.1 In its submissions to the Commission the National African Federated Chambers of Commerce and Industry (NAFCOC) drew attention to the urgent need to provide education to taxpayers to facilitate compliance with the tax system. The Commission supports these submissions, which have informed the recommendations made in Chapter 12 of this Report regarding taxpayers' rights, and expresses the hope that the restructured tax administration will, as a matter of priority, take steps to provide such education to taxpayers and to make the offices of local receivers of revenue more accessible to South Africa's taxpayers.
17.4 RECOMMENDATIONS
17.4.1 The Commission reiterates the recommendation in its first Report that the marketable securities tax should be abolished, together with the various stamp duties on share transactions. [paras. 17.2.2; 17.2.5]
17.4.2 Initiatives to provide taxpayer education and to make local revenue offices more accessible to taxpayers are urgently needed. [para. 17.3.1]