This article is a continuation of last week’s article (Kibuuka, Paul. “A primer on employee share option schemes in TZ”. The Citizen. 8 June 2019), and it is based on current Tanzanian tax legislation.
In that article, we learnt that the initial step in selecting an appropriate share option scheme is to define the employing company’s motive and objective of launching such a scheme and then, the company, as founder or settlor, together with the chosen trustees, create a trust under the Trustees Incorporation Act, Cap 318 (R.E. 2002).
We also learnt that the trust created acquires and holds shares in the company, and the employees become the beneficiaries of the trust with rights to exercise their share options.
Further, we learnt that the dividend payment made by the company to the trust from the company’s after-tax profit is paid out to the employees by the trust based on the option exercised by the individual employee.
Against this background, in this week’s article, we explore the Tanzanian income tax aspects of employee share option schemes. However, the accounting aspects thereof are outside the scope of the article.
Section 52 of the Income Tax Act, Cap 332 of 2004 (“ITA 2004”) provides for the legislative footing on taxation of trusts in Tanzania. Specifically, it states that a trust shall be liable to tax separately from its beneficiaries.
Thus it follows that the income of the trust is subject to tax. For ease of reference, section 52(1) of the ITA 2004 is reproduced here: “A trust or unit trust shall be liable to tax separately from its beneficiaries and separate calculations of total income shall be made for separate trusts regardless of whether they have the same trustees.”
In our view, however, a trust that is launched for the purpose of facilitating an employee share option scheme receives no income in its ‘own person’ and thus it is not liable to pay income tax.
This view is based on the firmly established ‘conduit principle’ of which, if income accrues to that trust and the trustees distribute it to one or more beneficiaries in the same year, the income retains its nature, resulting in the income being taxed in the hands of the beneficiary and not in the trust.
The resulting tax advantage is that if the trust is a resident trust the beneficiary who receives a distribution from the trust qualifies for an income tax exemption in terms of section 52(2)(a) of the ITA 2004, which states that - and I quote here - “Distributions of a resident trust or unit trust shall be exempt in the hands of the trust’s beneficiaries...”
And although section 7(2)(f) of the ITA 2004 brings to charge other payments made in respect of employment including benefits in kind (also, called fringe benefits) as it charges “gains or profits from the employment of the individual, a reading of section 52(2)(a) cited above, together with section 7(3)(a) of the ITA 2004, which provides that exempt amounts shall be excluded when calculating an individual’s gains or profits from an employment for the year of income, suggests that distributions made by the trust to employee beneficiaries are not subject to tax.
This is surely a good argument, but would it discharge the trust established as a vehicle for the employee share option scheme from its duty to file tax returns to the TRA?
As with any taxation authority in the world, the TRA has a keen interest in monitoring trusts and employee share option schemes more closely, by monitoring the submission and accuracy of income tax returns of trusts.
The TRA has also been too ardent in treating distributions from trusts as income from employment in the hands of the employee beneficiaries and consequently subjecting the distributions to pay-as-you-earn (Paye) tax.
Tanzania’s narrow income tax base gives us a striking glimpse into the attitude of the TRA about employee share option schemes as tax avoidance arrangements used by companies, yet the tax law as articulated above refutes this attitude.
Paul Kibuuka (email@example.com) is a tax and corporate lawyer, tax policy analyst and the chief executive of Isidora & Company.