Are contributions made to ESOP trusts by mining companies tax deductible?

By Norman Kerslake

On 16 February 2016, the South African Revenue Service (“SARS”) issued a binding private ruling (BPR 220) (“Binding Ruling”) in accordance with section 78(1) of the Tax Administration Act, 28 of 2011, in respect of contributions made by mining companies to trusts founded for establishing employee share ownership plans (“ESOPs”).

In terms of section 15(a) of the Income Tax Act certain “capital expenditure” (as defined), is deductible from the income derived by a taxpayer from mining operations. The pertinent issue dealt with in the Binding Ruling is whether a contribution made to a trust founded in order to establish an ESOP, would constitute a “capital expenditure” under section 36(11)(e) of the Income Tax Act (“Capital Expenditure”).

“Capital Expenditure” includes any expenditure incurred in terms of a mining right pursuant to the Mineral and Petroleum Resources Development Act, 28 of 2002, as amended (“MPRD Act”), other than expenditure incurred in respect of infrastructure or environmental rehabilitation. The Binding Ruling specifically determines whether a contribution to a trust created for the specific purpose of establishing an ESOP is considered to be expenditure incurred in terms of a mining right and, therefore, can be deducted as Capital Expenditure from the income derived by a taxpayer from mining operations.

In practice, many mining companies create trusts for the specific purpose of establishing an ESOP (“ESOP Trust”), where the permanent and longstanding employees of mining companies are appointed as the beneficiaries of such ESOP Trusts.

The most common purpose for a mining company to establish an ESOP Trust is to, inter alia, ensure and enhance compliance with the Black Economic Empowerment ownership obligation (“the BEE Obligation”) under the various Mining Charter documents.

In order to acquire shares in mining companies, in most cases, the trustees of ESOP Trusts will either –

– obtain funding from the existing shareholders of the mining companies for purposes of acquiring the shares;

– obtain funding from third party financiers for purposes of acquiring the shares; or

– enter into subscription and other agreements with the mining companies whereby the subscription price is repaid to such mining companies from dividends received,

pursuant to which the mining companies shall allot and issue shares to the trustees of the ESOP Trust (“ESOP Shares”), which ESOP Shares are to be held in favour of the beneficiaries of the ESOP Trusts.

Despite ESOP Trusts acquiring ownership in mining companies and mining companies enhancing their compliance with the BEE Obligation, the beneficiaries of the ESOP Trusts often fail to recognise any value of such ownership upfront and until the ESOP Shares have been repaid in full to the abovementioned financiers, which often takes many years.

The Binding Ruling determines that any monetary contribution made by a mining company to an ESOP Trust for purposes of enabling the trustees of the ESOP Trust to subscribe for ESOP Shares on behalf of the ESOP Trust (“Share Acquisition Contribution”) is a Capital Expenditure (as expenditure incurred in terms of a mining right), which Capital Expenditure is deductible from the income derived by a mining company from mining operations.

In addition to the beneficial tax implications for mining companies, the Binding Ruling stands to reduce the prolonged period over which the beneficiaries of ESOP Trusts do not realise the benefits of ownership of the ESOP Shares, by encouraging companies to make Share Acquisition Contributions in order to enable ESOP Trusts to acquire and immediately fund the acquisition of such ESOP Shares, as opposed to the alternative funding mechanisms.

The broad interpretation adopted by SARS in its reading of paragraph (e) of the definition of Capital Expenditure, whereby a Share Acquisition Contribution is considered as “expenditure incurred in terms of a mining right” can also be attributed directly to the importance of the legal obligation imposed on a holder of a mining right to comply with the BEE Obligation. In simpler terms, compliance with the BEE Obligation is of such importance to a mining right that expenditure incurred in respect of compliance with the BEE Obligation can be considered as expenditure incurred in terms of the actual mining right in certain instances.

It must be borne in mind that the Binding Ruling was made in respect of a particular set of facts and that legal and tax advice should be obtained in order to ensure that any Share Acquisition Contribution made to an ESOP Trust would be tax deductible.