Many growing companies want key people to think like owners, but the shareholders are not ready to give away real equity. Issuing shares brings new voting rights, dividend entitlements, minority protections and, often, a difficult conversation when the employee leaves. A phantom share scheme offers a middle path.
Under a phantom scheme, an employee is promised a cash payment linked to the value or growth in value of the company’s shares, without ever becoming a shareholder. Done well, it aligns the employee with the company’s success and keeps the cap table clean. Done poorly, it creates uncertainty about how much is owed, when it is taxed and what happens when the employee resigns or is dismissed.
This article explains how phantom and other cash-settled schemes work, the main legal and tax issues, and what a well-drafted scheme should cover.
What a phantom share scheme is
A phantom share scheme is a contractual arrangement between the company (or a group company) and participating employees. The employee is allocated a number of notional or “phantom” units, each linked to the value of one ordinary share. When the units vest, or on a defined trigger event, the company pays the employee cash based on the share value at that time.
Common variations include:
- Full-value units, which pay the whole value of a share at the payout date.
- Appreciation units (sometimes called share appreciation rights), which pay only the growth in value above the value at the date of grant.
- Dividend-equivalent rights, which pay amounts equal to dividends declared on a real share.
- Performance units, where the number of units that vest depends on company or individual targets.
Because no shares are issued, the employee has no vote, no right to company information as a shareholder and no claim to dividends unless the scheme provides for dividend equivalents. The scheme is purely a contractual right to be paid.
Why companies use them
- No dilution. Existing shareholders keep their percentages and control.
- Simplicity on exit. There are no shares to buy back from a departing employee, only a contractual entitlement that the rules can limit.
- Flexibility. Vesting, performance conditions and payout events can be tailored to the business.
- Suitable for private companies where there is no market for shares and the shareholders do not want employees on the share register.
The trade-off is cash. The company must be able to fund the payouts, often at the same time as a growth event or sale. A scheme that promises large payments without considering liquidity can strain the business when it is most successful.
The valuation question
For a listed company, the share price provides an objective value. For a private company, the scheme rules must set out how value is determined. Options include a formula (such as a multiple of earnings), an annual valuation by an independent valuer or the board, or the price achieved on a sale of the company. Unclear valuation provisions are the most common source of disputes in these schemes.
How phantom payouts are taxed
A cash payout under a phantom scheme is taxable in the employee’s hands as remuneration, and the employer must withhold employees’ tax. The more difficult question is the timing and the provision under which it is taxed.
Section 8C of the Income Tax Act 58 of 1962 taxes gains on “equity instruments” acquired by virtue of employment, generally when the instrument vests. Its definition of an equity instrument is wide enough to include certain contractual rights whose value is determined by reference to a share. Section 7B, on the other hand, deals with “variable remuneration” such as bonuses, which is taxed when it is paid. Tax practitioners have debated which provision applies to phantom schemes, and the answer can affect when tax arises and whether a SARS directive is needed before withholding.
The employer’s deduction for the payout, and whether it can be claimed before payment, also depends on how the obligation is structured. Because of these points, the tax treatment of any scheme should be confirmed with a tax adviser before it is launched, and revisited if the rules are changed.
Accounting and employment law considerations
Cash-settled schemes are generally recognised as a liability in the company’s financial statements and remeasured as the share value changes. A rising valuation therefore increases the recorded liability, which can affect profit, covenants and the business’s attractiveness to lenders.
From an employment law perspective, scheme entitlements may be regarded as part of the employee’s remuneration or benefits. Where the board has a discretion, for example over allocations or good leaver status, it must exercise that discretion rationally and in good faith. Arbitrary decisions can lead to unfair labour practice disputes or contractual claims. The scheme rules should also be consistent with the employment contract, so that the employee’s entitlements are clear on resignation, retrenchment, dismissal, retirement, death or disability.
What the scheme rules should cover
- Eligibility and allocation: who may participate, who decides allocations and how they are recorded.
- Vesting: time-based, performance-based or both, including any cliff period.
- Valuation: a clear method for determining value at grant and at payout.
- Payout events: vesting dates, a sale of the company, a listing or other liquidity events.
- Leaver provisions: good leaver and bad leaver definitions, and what happens to vested and unvested units in each case.
- Malus and clawback: the circumstances in which unvested units can be reduced or paid amounts recovered.
- Corporate events: adjustments for share splits, restructurings, mergers and changes of control.
- Funding and caps: limits on the total payout in any period, and the company’s right to defer payments in defined circumstances.
- Tax: confirmation that the employee bears their own tax and that the employer will withhold as required.
- Amendment and termination: how the scheme can be changed, and protection for accrued rights.
- Disputes: a practical mechanism for valuation disputes, such as referral to an independent expert.
How O’Reilly Law can help
We design and draft phantom share, share appreciation and other cash-settled incentive schemes, including the scheme rules, award letters and board resolutions. We align the scheme with employment contracts and shareholders’ agreements, advise on leaver and clawback provisions, and work with your tax adviser and auditors on the tax and accounting treatment.
Contact us to discuss an incentive scheme for your key people.
Related reading: Retention bonuses and clawback clauses · Founder vesting, good leavers and bad leavers
This article is general information and not legal or tax advice. Correct as at November 2026.