Employee Incentives and Phantom Share Schemes In South Africa Explained

Esmerelda Erasmus
16 January 2023

With increasing competition for quality employees, companies throughout South Africa are redefining methods to retain and incentivise their employees. It has therefore become a regular occurrence for employers to offer shareholding to key employees of the company. The most recent and popular alternative method of incentivising key employees is referred to as Phantom Share Schemes. This alternative presents compelling options for both employers and employees as it seeks to strike a balance between traditional equity-based compensation and non-equity returns. The increased interest in Phantom Shares is primarily based on employee retention, motivation, and performance prospects.

What is a Phantom Share Scheme?

A Phantom Share Scheme is primarily a contractual right granted to an employee. In terms of Regulation 81(s) of the Companies Act a Phantom Share Scheme is defined “as a company plan or scheme in terms of which employees are granted a right to receive an amount of cash at a certain time, based on the performance of the share price of the company”. With a Phantom Share Scheme, no actual shares are issued to an employee in the way that they are issued to a company shareholder. Instead, employees receive shares or units which are linked to the market value or growth of the company value. The allocation of the units to the employees is commonly regulated by way of a contractual agreement between an employer and the employee. Phantom Share Schemes are flexible and easily manageable and it is therefore an effective mechanism to consider for employees who associate their success with their financial goals and in turn also with the success of their employer.

Phantom Share Schemes may be granted on a discretionary basis subject to performance or time-based conditions.

How are Phantom Shares valued and when are they paid out to the employee?

The value of the allocated units, as specified above, is linked to the value and growth of the actual shares of the company. Therefore, as the value of the company grows, the value of the units grows simultaneously. The contractual agreement between the employer and employee makes provision that the employee will be entitled to receive a cash payment equivalent to the market value of the actual shares of the company when the company declares its dividends or at any other event which may be specified in the contract.

The payout from a Phantom Share Scheme can be equated to a cash bonus that is received by an employee at the time specified in the contract and will thus be treated as normal income in the employee’s hand and taxable at the employee’s taxable rate.

Because the cash payment received from a Phantom Share Scheme is similar to a cash bonus on the company’s performance, employees are incentivised to contribute to the company’s success.

How does Phantom Shares vest?

A specific number of shares (units) are granted to an employee. Besides the number of shares, other important things, such as the type of payout and the vesting schedule, are also disclosed in the agreement.

Phantom Shares are subject to a vesting schedule. Vesting happens when the shares are distributed to an employee, the first batch usually after one year.

After this “vesting cliff” has been reached, the remaining shares typically vest on a monthly or yearly basis until all the shares have vested. In other words, the vesting schedule indicates when different “batches” of shares vest.

For example, an employee may receive 25% of their phantom shares after one year of service, and the remaining 75% over the next three years.

When Phantom shares vest, the recipient gets a specific amount of money equal to the value of the shares, depending on the type of plan, it is, however, also possible that the company distributes actual stock/shares instead of cash.

How are Phantom Share Schemes taxed?

The tax implications of a Phantom Share Scheme depend on whether it is classified as an equity instrument under section 8C of the Income Tax Act, 1962, or as a bonus under section 7B of the same Act. This may affect the timing and rate of taxation for the employee and the employer.

For purposes of section 8C an “equity instrument” includes any contractual right or obligation, the value of which is determined directly or indirectly concerning a share.

On the other hand, section 7B applies to “variable remuneration” which includes a bonus contemplated in the definition of “remuneration” in the Fourth Schedule to the Income Tax Act. This means any amount to which an employee becomes entitled from an employer will therefore be taxable on the date of payment.

What are the different types of Phantom Share Schemes?

  • Full value Phantom Share Scheme: The employee receives the full value of the share price at the time of vesting or payment.
  • Appreciation only Phantom Share Scheme: The employee receives only the increase in the share price from the time of grant to the time of vesting or payment.
  • Dividend equivalent Phantom Share Scheme: The employee receives a cash payment equivalent to the dividends that would have been paid on the actual shares.
  • Performance-based Phantom Share Scheme: The employee receives a cash payment based on the achievement of certain performance criteria, such as revenue, profit, or market share.

Why should an employee invest in Phantom Shares?

Phantom Shares can provide increased incentives as the value of the company increases. This can also help ensure employee retention, especially in times of internal volatility, such as ownership change or a personal emergency.

It provides a level of reassurance to employees since Phantom Share Schemes are generally backed in cash.

Employees do not have to pay any upfront costs or taxes to acquire Phantom shares. Additionally, employees do not have to deal with the legal and administrative complexities of owning and transferring actual shares, such as shareholders’ rights and responsibilities, voting, dilution, etc.

What are the main advantages of Phantom Share Schemes?

Main advantages:

  1. Flexibility and customisation: Employers can tailor Phantom Share Schemes to accommodate individual or team-specific objectives.
  2. Mitigates value dilution: Phantom Shares circumvent the dilution of existing shareholder stakes, avoiding potential negative effects on ownership structure.
  3. Simplifies contractual and legal processes: Unlike actual equity ownership, Phantom Shares easily navigates legal complexities, streamlining the paperwork and administration.
  4. Empowers employees: The cash pay-out mechanism enables employees to reap the benefits of a company’s success.

With these distinct advantages, potential for growth offered to companies, and employee engagement, Phantom Shares are emerging as an attractive tool for companies aiming to retain a thriving workforce, with drawbacks of actual share ownership. They offer flexibility, cost-effectiveness, tax efficiency, and employee empowerment.

FOR LEGAL SUPPORT ON PHANTOM SHARE SCHEMES IN SA, CONSULT WITH BURGER HUYSER ATTORNEYS

It is always advisable for employers to give due consideration to future incentives to retain quality workforces and to make decisions that will ultimately be in the best interest of their company and their employees.

Contact Burger Huyser‘s commercial lawyers for legal guidance and support about Phantom Share Schemes as a method of promoting growth within a company and enhancing productivity.