Preferred Compensation Agreements for Key Personnel

yoren-chetty-profile-picArticle by Yoren Chetty

We are now familiar with the fact that since 1 March 2016, The South African Revenue Services allowed the following annual tax concession for persons making use of a retirement fund/s to save for their retirement:

27.5% of total remuneration or taxable income subject to a cap of R 350 000 per annum.

Whilst the majority of South Africans will not exceed this threshold, there are the exceptional few (those earning in excess of R 1 272 727.27 per annum) who will not benefit immediately by contributing more than R 350 000 per annum towards all their retirement funds put together (based on current legislation) as any excess will not be tax deductible, but will be carried forward to when they retire whereby they will be able to take a higher tax-free cash amount from their retirement funds than they would ordinarily be allowed to (currently the maximum tax-free amount that can be taken in cash from retirement funds at retirement is R 500 000).

Based on the above, our observation has been that some employers have reduced the allocation to their employees retirement funds accordingly so that they do not exceed the R 350 000 annual contribution cap. So how does an employer then make-up for the contributions that would have exceeded this amount?

One such mechanism would be to introduce a Preferred Compensation Agreement between the employer and employee – a tax-approved arrangement whereby the business owner (employer) is afforded the opportunity to pay a tax-favourable gratuity to key personnel over and above conventional retirement funds already in place. This gratuity is payable as a salary increase over and above the employee’s salary factoring in the income tax applicable as well so that the employee’s net salary is unaffected. The employer would set the rules in terms of the rendering of service required from the employee over a certain period of time in exchange for the employee receiving this additional compensation from the employer after that said period of time (usually exercisable at retirement).

The product choice would be an endowment with the employee being the life assured and policyholder, who will cede the policy as collateral to the employer over the lifetime of the contract. Should the employee meet their obligations in terms of the Preferred Compensation Agreement, the employer will then cancel the cession and the employee can then cash out the entire accumulated lump sum without any further taxes applied on that capital (the funds would have been taxed accordingly within the endowment structure at 30% on income and 12% on Capital Gains Taxes during the lifetime of the contract, which is attractive for individuals in the higher income tax brackets).

Should the employee not meet their obligations in terms of the contract, the employer would withhold the funds as the policy would be ceded to them and the employee would forego this benefit (either partially or entirely depending on the rules set out by the employer at the outset of the agreement).

Table 1 below summarises the basic concepts of the Preferred Compensation Agreement from both the employer’s and employee’s perspective.

Table 1: Key Concepts of a Preferred Compensation Agreement

As can be seen from the table above, the tax implications are quite favourable for both the employer and employee in this arrangement.

Should your employer wish to set up an arrangement of this nature for key personnel, or if you consider yourself to be a key employee and would like to engage with your employer in establishing such an arrangement, please contact your NMG Personal Wealth Financial Planner to assist you further.

Happy Investing!

Yoren Chetty, CFP®

Senior Financial Planner

NMG Personal Wealth