Gimme hype, Jo-anna!

Gimme hype, Jo-anna!

*Disclaimer – of course, a legal document needs to start with a disclaimer: our firm has a Slack channel called the #unlawyerzone, where we post adventures that team members get up to that are slightly less serious. This blog post comes from the hidden ether of our #unlawyerzone and should be read in that context. Also, I couldn’t resist butchering the title of that most famous and brilliant song (with apologies to Eddy Grant) to sugar up this rant.

I’ve been working as a commercial attorney for about 10 years and something that we inevitably see a lot of is how most of the business world seems to go into crazy mode whenever a new hyped idea comes along.

Any honest lawyer will admit that hype in the business world is to lawyers’ what blood is to sharks (with apologies to sharks). Hype does create work for us, but like that hairstyle you were so proud of in varsity: you may just be investing time and money in something that will be redundant (at best) and scary (at worst) a couple of years down the line.

Remember when the new Companies Act came into effect and you just had to adopt a new MOI for your company by midnight or the world would go up in flames? It was long before I joined our firm, but I’m glad to see that my partner Adrian Dommisse put things into perspective for our clients at the time with a slightly less Armageddonesque view on the situation.

Our firm has always been hesitant on hyped subjects (without being stuck in the past), but we’ve found that even if you don’t run towards the noise whenever there is an air of excitement in the business world, the party inevitably tends to move to your doorstep after a while.

I’m thinking of all the queries from people who wanted to put everything they ever owned into a Section 12J fund and how hyped that was a few years ago. People with no investment experience at all wanted to start Section 12J funds on every corner, until they learned about all the rules and red tape!

When every millennial with an online Python course in the bag started their own crypto fund from their garage, the queries took a different shape (often the misplaced shape of pyramids). Then there was the period when it was almost frowned upon not to refer to your start-up company as “the Uber of this or that…” or “the Spotify of organic vegetables”, but I see that we’re (mostly) past that now.

My goal is not to be the Grinch who stole hype – I have just been reflecting a lot over the years about what the best position is to take when the next best thing arrives. Our approach as a firm is simple: use hype to learn, but only spend your time and exert your energy on ideas or businesses that have substance.

For example, I think some of the hype around Section 12J has died down a bit over the last few years, with mostly only the serious players (who genuinely want to invest in exciting scalable businesses in the way that the Tax Man intended) still plying their trade in this way. Similarly, with the crypto world having come down to earth over the last year or two (read: the quick buck barbarians have left town), we can now focus on the amazing possibilities offered by blockchain technology.

Even though the dust has settled on the hype around topics like these, we are wiser on these topics now than we were before the circus came to town, so we can now use our tricks for real-world solutions. And how fulfilling it is to work with clients who are using blockchain technology to build or invest in real-world businesses that will improve the lives of people and take the friction out of exchanging and growing value.

Key-man insurance policies vs buy and sell agreements: Which is more appropriate for your business?

Key-man insurance policies vs buy and sell agreements: Which is more appropriate for your business?

INTRODUCTION

There is an important distinction between a key-man insurance policy and a buy and sell agreement. While they are both used in the context of ensuring the ongoing profitability and sustainability of a business in the event of the untimely death, severe disability or critical illness of a key business partner, their underlying purpose is different. We briefly unpack these differences below.

KEY-MAN INSURANCE

The value of a business is largely dependent on the input of key employees or partners in the business. The sudden loss of a key individual may put the business at serious risk. As such, a key person can be seen as someone whose absence (through death, disability or critical illness) will have a material adverse effect on the future of the business. What a key-man insurance policy seeks to do, is to protect the business in the event of the premature death of a key individual or if such key individual becomes disabled or critically ill. Such a policy is taken out and paid for by the company and upon the death, disability or critical illness of the key individual (who may or may not be a shareholder), the policy proceeds are paid to the company (rather than to the deceased estate in the case of a death of the individual). This provides the company with cash flow to enable the business to continue operations while a suitable replacement is found.

BUY AND SELL AGREEMENTS

A buy and sell insurance policy is typically used to fund a buy and sell agreement. The buy and sell agreement itself contains several important provisions to facilitate the orderly transition of ownership of the business, should one of the owners die prematurely, become disabled or critically ill, which provisions may include (amongst others):

  • What events may trigger a buy-out by the remaining shareholders – will it only be the death, disability or critical illness of the shareholder concerned, or will it include other events such as retirement or bankruptcy?
  • What shares each of the remaining shareholders are entitled or required to purchase – all shares or only shares of a specific class?
  • In what proportions the remaining shareholders will purchase the shares – pro rata or in a specified proportion?
  • How the buy and sell agreement will be funded – by way of an insurance policy or other method?
  • How the shares of the company will be valued.

Where a company has numerous shareholders, a buy and sell agreement provides the mechanism to provide for the funds that the remaining shareholders will need to acquire the deceased shareholder’s shares. This has an important bearing on the sustainability of the business as it may not always be a good idea for these shares to be passed on to the heirs – they may not necessarily have the skill set nor the desire to work in the business.

TAX IMPLICATIONS OF KEY-MAN POLICIES

The tax implications relating to the treatment of premiums paid and the proceeds received from a key-man policy are often overlooked. We discuss the various tax consequences briefly below.

Income Tax:

In terms of the Income Tax Act, 58 of 1962 (ITA), a company may be able to claim certain insurance premiums paid on the life of the key-person as a deduction. Whether the premiums could be deducted, will depend on whether the conditions and requirements as set out in the ITA have been met and in each case the particular policy wording will need to be reviewed in order to determine whether it is likely that a deduction will be allowed.

Estate Duty:

Section 3(3)(a) of the Estate Duty Act, Act 45 of 1955 (Estate Duty Act), includes the proceeds from a life insurance policy on the life of the deceased as “deemed property” of the deceased estate, if it meets the requirements of this section, irrespective of who the owner of the policy was or who paid the premiums. However, the full proceeds are not always included in terms of these deeming provisions. The section further provides that where the policy proceeds are not recoverable by the estate, but by the company, and the company also paid the premiums, only the amount by which the proceeds exceeds the total premiums paid plus interest thereon, is deemed to be the property of the deceased estate. However, section 3(3)(a)(ii) of the Estate Duty Act contains an estate duty exemption for these policies, resulting in them not being included as the deemed property of the deceased estate, provided all the requirements listed for the exemption to apply, have been met. If this is the case, no estate duty will be payable on the policy proceeds.

Capital Gains Tax (CGT):

In terms of paragraph 55 of the 8th Schedule to the ITA, the proceeds of key-man policies are exempt from CGT in the following instances:

  • where the person is the original beneficial owner of the policy;
  • where the person, whose life is insured, is or was an employee or director and any premiums paid by the person’s employer were deducted in terms of section 11(w) of the ITA;
  • where the policy is a risk policy with no cash or surrender value;
  • where the policy’s proceeds are exempt from income tax under section 10(1) of the ITA.

TAX IMPLICATIONS OF BUY AND SELL AGREEMENTS

Income Tax:

If the policy to fund a buy and sell agreement meets the requirements of section 11(w) of the ITA, the premiums payable may be deductible and the proceeds may be subject to income tax, again depending on the nature of the receipt.

Estate Duty:

The insurance policy to fund a buy and sell agreement must have been taken out for the purpose of buying out the interest of the deceased person, or a part of the interest – otherwise the policy will not be exempt from the “deemed property” and will be included in the deceased estate.

The deceased must not have paid any of the premiums of the policy. If a deceased has paid premiums on a buy and sell policy, it is likely to be regarded as the deemed property of the deceased and in which case it may not qualify for the exemption referred to earlier.

CGT:

If risk policies are used to fund the buy and sell agreement, the proceeds are exempted from CGT in terms of paragraphs 55(1)(a), (c) and (e) of the 8th Schedule to the ITA.

Any life insurance payments to the original beneficial owners and where no premiums were paid by the deceased, have always been exempted from CGT in terms of the 8th Schedule to the ITA.

If a deceased shareholder cedes his or her policy to a new shareholder, the policy ceded is a 2nd hand policy and historically gave rise to CGT consequences when the ceded benefit is eventually paid out, which is now alleviated by paragraph 55(1)(e) of the 8th Schedule to the ITA, subject to the policies being pure risk policies.

CONCLUSION

Replacement of a key individual or ensuring the orderly transition of ownership of a business (as the case may be) can take time. Although the memorandum of incorporation (MOI) or the shareholders’ agreement of the company may contain provisions on what should happen to the shares on the death or disability of a particular shareholder, they often do not take into account, the practical aspects involved. Additional funding and/or a separate buy and sell agreement is therefore required to ensure that all the necessary requirements and relevant processes are carefully set out and planned for. It’s important to note that, in terms of the Companies Act, 71 of 2008, no other agreement may supersede the shareholders’ agreement or MOI, so the company will need to ensure that if it is a buy and sell agreement they want to enter into, such agreement is properly aligned with the MOI and shareholders’ agreement.

SOURCES:

Vehicle finance “Extra fee”: strip it or bill it?

Vehicle finance “Extra fee”: strip it or bill it?

The National Consumer Tribunal (“NCT“) recently came out guns blazing and caused a stir in the motor vehicle industry. The application by Volkswagen Financial Services SA (“VWFS“) for the review and setting aside of a compliance notice previously issued against them by the National Credit Regulator (“NCR“), was dismissed by the NCT during the month of April 2019.

First, some background: the NCR issued compliance notices against VWFS and BMW Financial Services in 2017. In terms of these compliance notices, the NCR held that the “on the road” fees (colloquially termed as “Service & Delivery Charge” or the like) by the respective vehicle financiers constitute prohibited charges in terms of the National Credit Act, 34 of 2005 (“NCA“) and ordered each of these financiers to refund consumers who paid such fees. VWFS subsequently applied to the NCT to review and set aside the compliance notice issued by the NCR against them. The NCT however rejected their application and confirmed the decision taken by the NCR in their compliance notice (in a somewhat amended form, but in principle the same). The NCT ruled that VWFS were to: (i) refund all affected consumers; and (ii) cease adding any such or similar fees on their (vehicle finance) credit agreements as from 10 April 2019.

VWFS have since indicated that they will appeal the decision of the NCT, the effect of which then suspends enforcement of the ruling until the appeal has been finalised by the relevant court. Simply put, VWFS need not to comply with the compliance notice until the matter has been settled by the relevant High Court.

Please follow the link below to access a copy of the relevant NCT ruling:

https://www.thenct.org.za/wp-content/uploads/2019/04/Volkswagen-Financial-Services-South-Africa-pty-Ltd-v-National-Credit-Regulator-NCT-94937-2017-5612.pdf

Incentivising employees: Phantom scheme or esop?

Incentivising employees: Phantom scheme or esop?

As we receive more requests from entrepreneurs who want to incentivise valued employees in an optimistic effort to either attract top talent, retain top talent or even benefit their business’ BEE status profile, we realised that the motive behind such incentives are not always aligned to the type of incentive instrument that entrepreneurs request. In this blog, we aim to provide you with a basic distinction between two popular incentive instruments, namely the phantom share scheme (“Scheme“) and the employee share ownership plan (“ESOP“) to assist you in electing the best instrument for your valued employees.

PHANTOM SHARE SCHEME

Beneficiaries of a Scheme are awarded notional shares or units (not real shares but rather units giving participant employees the right to certain cash bonuses). The notional shares are linked to the issued shares in the share capital of the company. The Scheme is essentially a cash bonus plan under which the amount of the bonus is measured by reference to the increase in value of the shares in the issued share capital of the company. Such notional shares ordinarily grant the holder the same economic rights and privileges equal to all other actual issued shares in the company on a 1:1 ratio.

Therefore, instead of issuing authorised shares in the share capital of the company, notional shares are created and then awarded to participating employees (with or without vesting conditions). No shares are factually issued or transferred to the employees. Employees do not become actual shareholders of the company. This is illustrated in the fact that  they do not receive rights such as ownership rights in the company; rights to inspect records of the company; rights to attend shareholder meetings, nor voting rights – which would result in less control or decision-making influence from beneficiaries. Employees do however, have the opportunity to receive cash bonuses in the actualisation of certain events, such as when profits are declared by the company or any other “liquidity event”.

A Scheme is an excellent tool for attracting top talent and motivating employees who do not have a particularly long serving history with the company. In this respect, the Scheme allows shareholders to retain complete control and ownership of the company. The flexibility of the Scheme ensures that an employee receives a cash-in-hand benefit without enjoying other shareholders rights.

EMPLOYEE SHARE OWNERSHIP PLAN (ESOP)

An ESOP structure allows participating employees to acquire actual shares in the share capital of the company. By virtue of holding actual shares, such employees will become part owners of the company, they will have voting rights in the company (involving them in decision-making) and they will benefit financially when dividends are declared, as well as during an exit or other liquidity events. An ESOP, as opposed to a Scheme, is potentially an excellent instrument for incentivising long standing employees who have material interests in the growth of the company. Our recommendation is that ESOP shares should only be awarded to trusted individuals as holders acquire much more extensive rights, for example, the right to inspect sensitive company documentation and records.

CONCLUSION

While other complexities may influence your election of setting up and implementing either an ESOP or a Scheme, we recommend that the instrument selected should be guided by each entrepreneur’s true intentions.