Founder Shares: Do The Tax Rules Follow the Commerical Reality? 

29 May 2019

Founders of businesses will usually inject large amounts of intellectual capital into their ventures apart from economic capital from banks and seed capital from investment pundits.  Tax is hardly a consideration at the commencement stage of a business venture and if it is, the dream of capital growth is usually equated to a capital gains tax liability at some future date.

Not only will the founder of the business be a shareholder in the investment vehicle having injected limited economic capital, but usually will be a director of the company.  Could the directorship cause the founder’s shareholder interest to be tainted with an employees’ tax exposure?  Could a disposal among co-founders who are directors of the investment vehicle be taxed in a way other than qua shareholder?

The conundrum lies in the infamous section 8C of the Income Tax Act, 1962; the law that taxes so-called ‘restricted equity instruments’ which are acquired “by virtue of his or her employment or office of director of any company”.  The effect of these rules is to subject otherwise capital gains to income tax, and to defer the tax event until the said restrictions cease to have effect or the instrument is disposed of. If the share value grows, the amount subject to income tax at the later date is higher.

But the provisions go one step further and seek to bring within the net a ‘restricted equity instrument’ acquired during the period of his or her employment by any company or office of director of that company from either:

  • that company
  • or a related company
  • or any person employed by or that is a director of that company or a related company.

The key requirement for this element of the section to apply is that the instrument must be ‘restricted’.  This is defined to mean many things but is primarily focused on restrictions from transferability at market value as well as forfeiture restrictions other than at market value.  There is no requirement that the instrument had to be acquired by virtue of employment.  An objective test is applicable in this instance which includes a determination whether the shares were acquired after the person became an employee or director.

In a founder business, where the founder is also a director, the seed funder may require the founders to be locked-in to the business in such a way that the transferability of their shares is restricted for a period of time.  This may cause the shares to be ‘restricted’ and on the face of it the shares may constitute ‘restricted equity instruments’, subject to employees’ tax.  Not only could the founder that subscribes for the shares be subject to section 8C, but also the transferee of the shares that acquires the shares from the founder, provided both are either directors or employees of the company whose shares are transferred.

Albeit that this provision of section 8C was meant to deal with anti-avoidance considerations relating to employment shares,  the wording may cause so-called founder shares to be caught within the income tax net. 

Accordingly, consideration must be given to restrictions imposed on founder shares in shareholders agreements and incorporation documents so as not to be met with an employees’ tax liability.  Furthermore consideration should be given to the timing of the introduction of shareholder restrictions as well as contracts of employment and directorship arrangements in order to assess the application of the section.

Michael Rudnicki

+27 11 669 9314

+27 83 377 6492

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