by Joon Chong, Partner, Webber Wentzel
There have been a number of binding private rulings providing for the deductibility of contributions made by employer companies to share incentive trusts for the purpose of acquiring shares in the former. Although a binding private ruling is only binding on SARS and the applicant, published rulings can be relied on to provide an indication of the interpretation of law. In our interactions with SARS officials, we have found that this interpretation has generally been accepted, ie that contributions made to trusts for the purpose of acquiring shares in the employer company are deductible over the vesting period of the scheme.
In S G Taxpayer v Commissioner for the South African Revenue Service, the Tax Court was faced with the issue of whether there was a sufficiently close connection between the contribution made by the employer/taxpayer to the trust in respect of the share scheme to enable the employer to claim a section 11(a) deduction for the contribution.
The employee share scheme was structured in three layers with a trust at the top, a special purpose vehicle in the middle and the holding company of the employer/taxpayer at the bottom.
The employer/taxpayer was the wholly owned operating subsidiary of a listed company (Holdco). The taxpayer made a contribution to a trust which was then claimed as a section 11(a) deduction. Holdco was the only beneficiary of the trust. The trust acquired a shelf company (Newco). The trustees used the contribution from Holdco to subscribe for preference shares in Newco. The employees of the taxpayer were offered Newco ordinary shares at par value in proportions determined by Holdco. Newco used the subscription proceeds from issuing preference shares to acquire Holdco listed shares from the market. Newco's sole asset was the Holdco shares.
The Newco preference shares were redeemable after 5 years and carried a cumulative coupon of 75% of prime. However, Newco paid no dividends in the 5 years, with the result that the employees/ordinary shareholders in Newco were entitled to the incremental value of their ordinary shares by virtue of Newco holding Holdco's listed shares. Upon expiry of the 5-year period, Newco redeemed the preference shares and paid the cumulative preference share dividend to date by transferring the equivalent value of Holdco shares to the trust. Newco also declared ordinary cash dividends to the employees from the proceeds of disposal of the remaining Holdco listed shares. Holdco was never repaid the contribution to the trust.
The crux of SARS additional assessments was on the basis that a direct, causal link between the contributions paid by the taxpayer and its production of income was required before the taxpayer could claim a section 11(a) deduction. Holdco, as the sole beneficiary of the trust, was the only recipient which could benefit from the investment in Newco preference shares by the trustees, and any distributions of redemption proceeds and preference dividends by the trustees. The participants/employees did not benefit from the contributions made by Holdco. SARS further argued that if the taxpayer's sole purpose had been to incentivise its employees, then these employees should also have been beneficiaries of the contribution itself.
The Tax Court accepted the testimony of the taxpayer's witnesses that the contribution was a funding mechanism to protect the employees from the downside risks of Holdco's share price or the scheme becoming insolvent. The employees would have been exposed to volatility in the share price had they received funding directly from the trust to acquire shares. The Tax Court also accepted that the contribution enabled the taxpayer to retain key dedicated employees, and resulted in these employees making decisions which generate long-term profit for their employer.
The Tax Court held that what is required is an assessment of the closeness of connection between the expense and income. The test is not a direct, causal link between the two as initially argued by SARS (but later conceded by SARS during proceedings). The causal connection is established by referring to the incurring of the expense and initial use to which it is put. One must also consider the purpose of the expenditure from the taxpayer's perspective and the impact of such expenditure.
The Tax Court referred to a number of decisions on the meaning of "in the production of income" and held that the dominant purpose in the establishment and implementation of the scheme was to protect and enhance the business of the taxpayer and its income by motivating its key employees to be efficient and productive and remain in the taxpayer's employ. The mere fact that Holdco would also potentially benefit from the redemption of Newco preference shares (as the sole beneficiary of the trust) cannot negate the taxpayer's purpose and intention which was for the contribution to fund the incentive scheme. There was a sufficiently close causal link between the contribution and the taxpayer's income producing operation.
We submit that it is also probable that amounts contributed to a trust which is used by the trustees for the administration expenses of the share scheme or the incentive trust would also be deductible in terms of section 11(a). It would be proper, natural or reasonable to regard such expenses as being incurred for the incentive scheme.