Clear tax laws will boost employee ownership

A client carries out a transaction at a mobile bank in Kigali. Photo/FILE   Nation Media Group

By John Kuria and Charity Kamunya

In the past, employees have been planning for their retirement by making contributions to pension schemes and provident funds.

Lately, however, there has been the emergence of Employee Share Ownership Plans (ESOPs), which serve not only as retirement plans for the employees, but also as incentive plans for the employer.

An ESOP is a defined contribution benefit plan that invests in the stock of the employer company and is available to the employees of that company. The stock is pooled and held by a trust, which is managed by trustees.

Once an employee pays for the stocks or upon satisfaction of certain stipulated conditions, the allocated stocks vest in the employee.

Currently, we do not have detailed laws on the taxation of ESOPs. The main provision is that the difference between the market value per share and the offer price per share at the date the option is granted is the benefit to the employee if the ESOP is registered with the Commissioner.

Taxable benefit

This benefit should be taken into account when the employee is computing his/her personal tax. The provisions are not clear about taxation of benefits where the ESOP is unregistered. In practice, however, the taxable benefit is taken to be the difference between the market value of the share at the time of vesting, and the offer price per share at the date the option is granted.

Since the share price is likely to have appreciated during the vesting period, the taxable benefit will be higher for members of an unregistered ESOP.

For unregistered ESOPs, precedence dictates that any disputes arising due to such ambiguities should be determined in favour of the taxpayer. One may actually argue that there is no taxable benefit arising out of an unregistered ESOP.

Perhaps one of the reprieves that the taxpayer can still celebrate is the suspension of capital gains tax. Once the stocks are vested in the employee, any gains made after disposal of stocks at an appreciated value are not subject to tax. The difference between the selling price at the time of disposal of the shares and the vesting price is a capital gain that should be enjoyed tax-free by the investing employee.

In certain jurisdictions like the US, ESOPs thrive due to the tax incentives that are available to them. 

Contributions made to ESOP are tax deductible to the company, and it also receives full deduction for stocks contributed directly to the ESOP. 

By doing so, the employer actually increases its cash profits by the value of the taxes saved through the deduction.

In the case of a leveraged ESOP, the deductibility of contributions is even more attractive. Under this arrangement, an ESOP takes out a cash loan from a bank or other lender.

Debt financing

The ESOP uses these funds to acquire stocks either from the company or from existing shareholders. 

Subsequently, the company makes contributions to the ESOP and the ESOP repays the bank loan. In the US, these contributions made by the company to repay both the interest and the principal amount are tax deductible. 

This makes the ESOP an attractive form of debt financing for the employer from a cash flow perspective.

In comparison, Kenyan laws are still lagging behind in the regulation of ESOPs. However, the activities on the ground are growing at a very fast pace. Recently, we have seen the emergence of ESOP investment financing in Kenya but this has made the waters of ESOPs taxation even murkier.

Dividend payments

In ESOP investment financing, the company usually has the objective of giving loans to employees to buy stocks in the company. However, it is not good practice for the company to execute this disbursement directly to the employees.

However, companies deal with this obstacle by giving a loan to the trust, which in turn grants loans to the employees at a relatively low interest rate.

The employees can then pay off the loan by installments and by offsetting it against dividend payments.

This arrangement raises several questions, one being whether the loan should be considered as being provided by the company.

If the company is considered to be the lender, it is then accurate to say that the low interest loan should be subject to fringe benefit tax.

It is, however, difficult to prove that the company is the lender, since the legal instruments will specifically indicate that the lender is the trust. Such specific provisions should serve to extinguish any relationship between the employees and the company, making the provisions on fringe benefit tax inapplicable.

Since we do not have specific legislation dealing with these issues, the grey areas will remain until such time that legislators realise the need for them to make the sector vibrant.

—John Kuria is Tax Manager while Charity Kamunya is Tax Consultant, Deloitte Kenya.

The views expressed in this article are the author’s and not necessarily those of Deloitte Kenya.