Executive ‘clawbacks’ may have unfair tax implications

Excessive executive pay and ‘perverse incentives’ are hotly debated topics and concerns have been raised about ‘inappropriate remuneration practices’ which create unacceptable risk-taking.

In an effort to curb these practices clawback provisions are becoming more prevalent in executive share schemes. These provisions create an obligation on an employee to repay the cash amounts they should not have received.

However, the South African Institute of Tax Professionals (Sait) is concerned that these clawback provisions create adverse tax consequences that are contrary to the policy of good governance. 

Sait CEO Keith Engel says these clawback provisions are treated as a ‘technical’ restriction for income tax purposes.

Impractical

In a submission to National Treasury and the South African Revenue Service (Sars) the institute says if included in the definition of a restricted equity instrument such provisions would have an “impractical, unbusinesslike or oppressive consequence”.

Sait proposes that the section dealing with restricted equity instruments be amended to clarify that a clawback provision is not a restriction in terms of the definition of a restricted equity instrument.

Under normal circumstances, the independent sale of bonus shares by an executive triggers tax. This tax trigger should end the matter. However, if a clawback provision exists, the executive can be taxed on the shares for the value associated with the share even after the sale, explains Engel.

If the share price was R300 after three years at the time of sale, the tax normally falls on the R300. If a clawback provision exists, Sars could argue that tax applies upon the falling away of the clawback requirement arising a few years later when the value of shares increases further (to say R500). The net result is a tax on value after sale that never accrues to the executive.

Executive accountability

Jaco la Grange, head of Sait’s personal tax work group, says clawback provisions are not driven by tax structuring considerations. “There is no desire to artificially influence the tax vesting date, but rather by consideration of executive accountability.”

The clawback is triggered by a specific event such as financial misstatement or fraud and entitles the company to demand an amount in cash from the employee who participated in the scheme.

He says in the submission that clawback provisions have been introduced into foreign legislation and governance codes over the past few years.

They have only started to make their way into the South African market since about 2016. The legislature cannot have had clawback provisions in mind when drafting the definition of ‘restricted equity instrument’ in 2008.

They are designed to deter executives from pursuing inappropriate strategies that would enable them to benefit from short-term increases in the company’s value, but which could potentially undermine the sustainability of the company in the long term.

Clawback policies are recommended in most European Union jurisdictions, as well as the UK, and are mandated in the US and the Netherlands.

La Grange says the South African regulatory system does not provide for mandatory remuneration clawbacks, but certain guidelines are set out in the King IV report on Corporate Governance.

Two Dawn executives voluntarily repaid their bonuses in 2105 when the company changed its remuneration policy to reflect the performance of the company and not of the executives.

‘Not a tax matter’

PwC tax partner Gerald Seegers says clawback provisions are not a tax matter. They could be a criminal matter or a common law matter between the employee and the employer.

If an employee receives a bonus that must be returned, Seegers is of the view that they  should be entitled to a reduction on the amount of tax paid on the bonus which was included in their income.

He said the issue is not to penalise such employees, but to put them in a position they would have been had the bonus or shares not been issued erroneously.

He does foresee some issues with the enforceability of the provision. “Business sees clawback provisions as a necessity, but there are still many legal questions.”

Is this a criminal or common law matter, and what rights do the employee have?  “Globally it is not a slam dunk to recover the money from employees. There are a lot of speed bumps and headwinds facing the company,” says Seegers.