Be aware of the tax treatment on restricted shares

Access to finance is one of the biggest concerns for most start-ups and when founders, directors or employees acquire shares or own shares in the company they need to be careful, as it could lead to tax consequences that are not favourable to them.

In the case of a start-up, the divide between being a shareholder and someone rendering services can be nebulous, says Beatrie Gouws, head of stakeholder management and strategic development at the South African Institute of Tax Professionals.

“The result is that in some instances, investors may receive tainted Section 8C shares, which will lead to them receiving income taxable at their marginal rate when the restrictions are lifted.”

Anti-avoidance provision
Michael Rudnicki, tax executive at law firm Bowmans, explains that Section 8C is an anti-avoidance provision that was introduced into the Income Tax Act in 2004. It has seen several amendments since then.

“If you acquire a restricted equity instrument in connection with employment, or even as a result of being an employee or director, it may fall into Section 8C,” he warns.

The section caters for instances where employees or directors are incentivised to stay in the company; instead of a sizeable bonus they are given shares, either for free or for less than the market share price.

In the typical start-up phase of a business where capital has not been raised, it may be that restrictions on shares do not exist and are only negotiated at a later stage when capital is raised.

Rudnicki says even if the “proximate cause” for acquiring the restricted shares is not employment, but to invest in the company as a co-founder, it can result in the director becoming liable for employees’ tax when the restrictions are lifted.

“This is terrible because an investor in a start-up certainly does not have in mind to be taxed as an employee.”

This was probably not the intention of the legislator, whose intention it was to prevent arrangements where employees and directors were trying to escape the provisions of Section 8C.

“The concern is that a founder of a business who acquires a restricted share could potentially fall foul of the provisions.”

Rudnicki explains that in cases where unrestricted shares are offered to a director or employee at a below-market price, a tax obligation will immediately be triggered.

They will be liable for tax on the difference between the market price and the actual price, at their marginal tax rate (which could be 45%). Any growth on the shares thereafter will be taxed at the capital gains rate (18%).

If the director pays the market price for the shares, there is no tax liability and growth thereafter will be taxed at the capital gains rate.

In the case of restricted shares, the tax liability is triggered when the shares are sold or when the restriction is lifted (even if the shares are not sold).

“This can be quite painful, because if you sold your shares you at least had cash to pay for the tax. The point is that when the trigger happens there is a tax-vesting event under Section 8C.”

Rudnicki warns that the employee’s tax liability remains with the company. This means the tax must be withheld from the director or employee’s income and paid over to the South African Revenue Service (Sars).

There is obviously an opportunity to make an arrangement with Sars to spread the liability, but technically the full amount becomes payable once the vesting event takes place.

“The idea is to impose commercial restrictions without imposing restrictions under Section 8C, but it is not so easy,” says Rudnicki.

He adds that there are options, such as locking the employee or director in for a year and restricting the selling of the shares to the company or co-workers or co-shareholders.

He says the sooner the restriction is lifted, especially for start-ups, the lower the potential tax liability could be. If the director or employee wants to stay because of the value proposition, it is better to lift the restriction as soon as possible so that future growth will be subjected capital gains tax only, and not to employees’ tax.