Equity-based compensation for employees, and its tax implications

It is not uncommon for companies to use or develop different incentive schemes for either motivating or retaining its employees. In order to ensure that top employees act in the long-term interest of the company employing them, companies may deploy equity-based compensation. By giving the employees a piece of the company, the employer ensures that there is an alignment of interests between the employee and the employer.

One of the most common incentive schemes is using share options. A share option is where the employee of the company is granted a right to acquire share(s) for either a non-cash consideration or a price that is discounted compared to valuation; subject to certain conditions. The conditions may be based on length of employment or meeting certain performance targets. Additional conditions maybe agreed depending on the structure of the scheme. Vesting periods may also be defined, which is a time at which the employee will be entitled to exercise his/her options. As such, the employee may only exercise the option to receive shares in the company on or after the vesting date, but before the option expiry date.

Contrary to the taxation of regular salary or bonus payments, share options have different implications in at least two ways:

Firstly, employment tax implications – Section 7(2)(f) of the Income Tax Act, Cap 332 [RE 2019] (“ITA”) requires all payments, including benefits in kind which are made in respect of employment to be included in calculating the individual’s gains or profit from an employment.

Offering share options to employees constitutes a benefit derived in the course of employment. However, the question will be at what time the share option will constitute a benefit for the purposes of employment tax (i.e. between when they are offered or when rights on shares are acquired / vested).

From a Tanzanian perspective, currently the legislation does not specifically address taxation of share option schemes and as such, a general interpretation is adopted. As a general rule, taxation of an amount is triggered when the person is entitled to receive an amount which in our case when the shares are vested.

Consequently, share options can be considered as a benefit derived in the course of employment when the employee acquires rights on the share and not when the share options are offered. The value of share options may be included in calculating individual’s gain or profit from employment when the person has acquired rights on the shares such as when the conditions under the scheme are met by the employee.

However, the value of share options to be included in calculating individual’s gain or profit from employment will depend on the vesting conditions that whether the employee will receive the shares at a non-cash consideration or at a discounted price.

Therefore, it is required for employer to account for employment tax at the time when the employees’ options are vested and remit the same to the revenue authority. As such, for cash flow and liquidity purposes for both the employer and employee, a share option scheme should take into consideration the tax implications.

Secondly, investment income implications – Section 9(2)(b) of the ITA requires net gains from realisation of investment asset to be included in calculating the person’s gains or profit from conducting an investment. Section 3 of the ITA defines investment asset to include shares. As such and in line with my comments above regarding timing of taxing the benefit, at the time when the shares are vested, the employee will acquire an investment asset.

Therefore, when the investment asset (i.e. vested shares) is realized through sale or exchange for other economic gains, gains resulted from such realization will be required to be included in calculating a person’s income from investment.

Further, section 39(a) of ITA defines realization of an asset to include when the asset is sold, transferred, exchanged, cancelled etc. Therefore, when a person subsequently sells the vested shares, gains resulted from such sale will be required to be included in calculating a person’s income from conducting an investment. As such, the employee should be aware of the tax implications which may arise when dealing with his/her vested shares especially when they are transferred.

At individual level, this will trigger tax return filing requirement in Tanzania as guided by section 91 of the ITA on the basis that the individual will have income other than employment income.

Although share option as an incentive scheme offers numerous advantages to both employer and employee, tax consideration should be taken into account when planning. Understanding of different tax implications arising out of share option scheme will help to manage expectations of all the parties involved. It will also enable all parties to avoid penalties and interest which may arise due to non-compliance of the tax laws.

Charles Kitali is a Tax Consultant with Deloitte Consulting Limited. He can be reached at ckitali@deloitte.co.tz. The views expressed herein are those of the author and do not necessarily represent the views of Deloitte.