Monday, August 13, 2012

Using taxes for Employee share schemes.

Questioning the wisdom of giving tax breaks on Employee Share Options.

Sometimes politics can generate some curious suggestions. Despite its likely overall merits, the Democratic Alliance’s master plan to increase employment includes a proposal “to introduce tax breaks to help ordinary South Africans get shares in the companies they work for.” It is a bit like dishing up a wholesome plate of pasta with a spoonful of peanut butter on top of the serving.

Employee share options really do sound like a great-to-have – employees owning a stake in the company and working their tails off to ensure top dividends. But unless the ESOP is designed for employee control of or a significant say in the company, the merits of conventional programs have still not been clearly demonstrated globally. As I wrote in an article last year: they have “as many champions as detractors. The accounting conventions are still not fully understood, polished or even universally supported.” As a concept in organisational theory it certainly deserves on-going scrutiny. But to take it to a point where we should consider sacrificing part of our tax income in its wider promotion is putting the cart very far in front of the horse. In the United States, there have been some serious efforts to roll back tax breaks for ESOPs

One of the puzzling contradictions in the DA proposal is that it is clearly going to be of benefit mainly to employees (or more likely employers) of listed companies. It is then proposed to have “an employee bonus scheme for unlisted firms that replicate existing share incentive regimes for listed entities”. It suggests that “bonuses would be partially tax-free, in a ratio that is linked to growth in an appropriate share index over the five-year period”. Apart from a rather nebulous measure, it still means that the tax break will in practice only apply to larger companies, putting smaller and medium enterprises at an employee recruitment disadvantage.

Employee Share Option Schemes have been around for some time. But it has only been since the mid-seventies that wooing labour into the shareholder camp has gained momentum and has given rise to a whole array of schemes with some of the most complex, costly and imaginative forms of accounting targeted at the whole spectrum of employees from executives to the general workforce.

Despite their growing popularity in employee reward systems, particularly executive rewards, they have had inconsistent outcomes at best and apart from some anecdotal research I have not been able to find credible scientific global evidence to prove any real discernible difference in staff motivation, loyalty and productivity, between those that have and do not have them. While it has been argued that they tend to work better at a more senior level in an organisation, a PWC study has concluded that they are deeply flawed even at that level. Recent history is also increasingly questioning the behaviour of many executives in exploiting short term performance at the expense of longer term company health to gain maximum benefit from their options. Do we really want to add general staff into that collusion?

What is already clear from both the number of collapses of these schemes and the overwhelming number of participants who cash in their shares at the first opportunity, is that the schemes themselves seldom enjoy much loyalty. Of course, most employees will express willingness to be part of such a scheme, especially if they have heard about Kumba employees getting up to nearly R600 000 in share option pay-outs. But even here, given the opportunity to reinvest, less than 20 of the more than 6200 did so. Loyalty to an ESOP will be severely tested, and probably fail, if it hints in any way at flexibility in regular pay.

Minority holding ESOPs may eventually prove their value, but at this point their rationale is suspect. Their growth is rooted in the agency theory which seeks to align the interests of managers with the interests of owners. This became popular organisational thinking in the past 3 decades or so with the emphasis on shareholder value. Unfortunately, there has also been a coincidence of customer neglect over this period, leading to the question whether the pursuit of shareholder value itself is not to blame for a growing gap between shareholder and customer interests.

If the primary purpose of ESOPs is to encourage employee involvement in their companies and pave the way for flexible pay structures, then there are far easier and more effective ways of achieving this than through complex share ownership schemes. It is difficult at the best of times in any collective to align a common interest around rewards. It is especially so in companies where we simply cannot get away from the inherent conflict between profits and pay in the way our accounting formats are structured. And it is even more difficult in a confrontational labour environment such as in South Africa, despite its BEE benefits.

A common, unifying purpose is still best achieved through a focus on what everyone is there to contribute – service to others. Not only is this the only way of ensuring improved rewards for all, but it is the foundation of competitiveness, which in turn creates jobs and attracts capital. Once common purpose is forged, it becomes a lot easier to introduce common fate instruments such as profit-, gain- or fortune sharing. Only then will an ESOP make sense.

Giving credit where credit is due, the DA plan comprehensively and imaginatively tackles the problem of income disparities at one of its key sources – that of executive pay. Page 54 of its document says: “measures to reduce inequality will also have to tackle high-powered corporate insiders who extract salaries that are often out of proportion to the shareholder value they create by abusing remuneration committees that are not independent and shareholders who are not sufficiently informed.”

But as far as employee share ownership is concerned, and if I were asked to sacrifice some of my tax Rands, I would much rather do it on ensuring that employees are willing, contented and productive workers before being shareholders.

So far, there has been no substantiated link between the two.


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