The tax consequences of Section 40(5)(b) of the new Companies Act
12/11/2010

Section 92 of the current Companies Act, 1973, prohibits a company, save in the context of a public offer, from issuing or allotting shares unless they are fully paid up. This position has been altered by the new Companies Act, 2008 (New Companies Act) which is due to become effective on 1 April 2011. Section 40(5) of the New Companies Act provides that:

“If the consideration for any shares that are issued or to be issued is in the form of an instrument that is not negotiable by the company at the time that the shares are to be issued, or is in the form of an agreement for future services, future benefits or future payment by the subscribing party –

(a) …
(b) upon receiving the instrument or entering into the agreement, the company must –

(i) issue the shares immediately; and

(b) cause the issued shares to be transferred to a third party, to be held in trust and later transferred to the subscribing party in accordance with the trust agreement.”

From the wording of the New Companies Act, both in section 40(5) and elsewhere, it is clear that what is meant by “to be held in trust” is that a trust deed must be entered into and a trust must be established in which the shares should be held (the Trust).

Accordingly, the New Companies Act allows for shares to be issued without having being fully paid up, provided that the shares are transferred to a third party to be held in trust until the company has received full consideration for the shares, paid by way of services, benefits or money. For companies wishing to issue shares to transferees who may not immediately be in a position to settle the full consideration for the shares, such as companies planning to embark on empowerment or employee share incentive scheme transactions, which typically involve minimal cash and are often structured on an earnout basis, the provisions of section 40(5) are a welcome departure from the current regime. However, before taking advantage of these provisions, it is important that a company fully understands the tax consequences of setting up an arrangement contemplated in section 40(5).

In terms of the Securities Transfer Act, 2007 (STT Act), securities transfer tax (STT) is payable on all transfers of shares where the transfer results in a change in the beneficial ownership of the shares. Accordingly, STT consequences of the transfer of the shares to the Trust and from the Trust to the transferee must be considered. The STT rate is 0.25% of the taxable amount of the value of the shares. Depending on the circumstances of the transfer, the taxable amount of the shares may be the purchase consideration paid for the shares or the market value thereof.

From a capital gains tax (CGT) perspective, the transfers of the shares from the company to the Trust and from the Trust to the transferee will constitute disposals for purposes of the eighth schedule of the Income Tax Act, 1962 (ITA) and any capital gain realised pursuant to those disposals will be subject to CGT. Capital gain is defined in the eighth schedule as “the amount by which the proceeds received or accrued in respect of that disposal exceed the base cost of that asset”. Base cost is in turn defined to include, amongst other things, “the expenditure incurred in respect of the cost of acquisition or creation of that asset”. One would expect that the base cost of shares at the time that they are transferred from the subscriber to the Trust would be fairly low, which will result in a significant capital gain. Further, should the value of the shares increase significantly while they are held by the Trust, this will also result in a significant gain.

When the shares are transferred to the Trust, it is unlikely that the Trust will pay any consideration in exchange thereof. In that instance (and in the event that the consideration is in fact paid but the subscriber of the shares is a beneficiary of the Trust and therefore a connect person in respect thereof), the provisions of paragraph 38 of the eighth schedule to ITA will come into force and the subscriber will be liable for CGT at the market value of the shares.

In terms of paragraph 20 of the eighth schedule, transfer costs, transfer duty or other similar duties must be included in the base cost of an asset. Accordingly, the subscriber and the Trust will be able to utilise the STT to increase the amount of the base cost and therefore decrease the capital gain in respect of their transfers.

Where a transaction is set up using the provision of section 40(5), it may be advisable that the provisions of paragraph 80(1) of the eighth schedule are utilised. Paragraph 80(1) provides for the attribution of any capital gain realised by a trust pursuant to the vesting of an asset in a beneficiary to such beneficiary. Accordingly, in order for the Trust to benefit under the provisions of paragraph 80(1), the ultimate transferee of the shares must be a beneficiary of the Trust. In that instance, any gain that is realised by the Trust at the time that the shares are transferred to the transferee will be disregarded in the hands of the Trust and taken into account for purposes of calculated the transferee’s CGT liability.
Any and all dividends declared by the company while the shares are held by the Trust will accrue to the Trust and will be subject to secondary tax on companies (STC) at a rate of 10%. In terms of section 64 B(5)(f) of the ITA, a company may elect to be exempt from STC in respect of dividends declared in favour of a resident shareholder forming part of the same group of companies as the company declaring the dividend. However, the provisions of section 64 B(50)(f) do not apply to trusts and therefore this exemption will not be available to a company declaring dividends in favour of a trust. In term of section 40(6)(c)(ii) of the New Companies Act, unless the parties agree otherwise, any dividends declared in respect of the shares while the shares are held by the Trust may be paid or credited against the remaining value at the time of any outstanding consideration due to the company. It is anticipated that the current STC system will be replaced by a dividend tax system during the course of next year. While the tax rate under the dividend system will remain at 10%, dividends will be taxed on a different basis. It will now be taxed in the hands of the shareholder as opposed to the current position where the dividends are taxed in the hands of the company declaring the dividends.

From an employee incentive perspective, the relationship between the provisions of section 40(5) of the New Companies Act and those of section 8C of the ITA must be considered. Essentially, section 8C of the ITA provides that a taxpayer must take into account, for tax purposes, any loss or gain arising out of the vesting of an equity instrument (which includes shares) in the taxpayer, if that equity instrument was acquired by the taxpayer by virtue of his or her employment or office. The gain to be included in the income of the taxpayer for purposes of section 8C of the ITA is the amount by which the market value of the equity instrument determined at the time of vesting exceeds the sum of any consideration paid by the taxpayer in respect of the equity instrument. Accordingly, in the event that shares are issued to a Trust to be held in trust on behalf of a taxpayer’s employees, in terms of an employee incentive scheme, in exchange for an amount less than the market value of the shares, the provisions of section 8C will apply and the employees must account for income tax on the amount which represents the difference between the consideration paid for the shares and the market value of the shares. However, where any restrictions are imposed on the shares (other than those imposed by legislation) or where the shares have not vested on the employees, the provisions of section 8C will not apply and therefore the employees will not be obliged to account for the gain under section 8C. However, should the shares subsequently vest or should the restrictions be lifted, the provisions of 8C will be triggered and the employees will have to account for STC.

Currently, employee incentive scheme structures usually involve the setting up of a trust. In light of section 40(5) of the New Companies Act, the question arises as to whether we will begin to see two trusts being set up side by side in order to give effect to an employee incentive scheme (one to give effect to the usual provisions of an employee incentive scheme and the other to the provisions of section 40(5)) or the objects of the two trusts will be combined into one trust. From a practical perspective, the latter may be more worthwhile.

Accordingly, while the provisions of section 40(5) provide some welcome flexibility, and should therefore be welcomed, the potential tax consequences of its implementation must be carefully considered before these provisions are applied.