Originally published June 2011
A recent decision of the Cape Town Tax Court highlights uncertainty surrounding the application of the double tax agreement between South Africa and Luxembourg in relation to South Africa's so-called exit charge.
In terms of this rule a South African resident, on ceasing residence, is deemed to dispose of, with certain exceptions, the resident's worldwide assets at market value, thereby triggering a capital gain. The exceptions apply, first, to immovable property in South Africa (because, contrary to the general principle that non-residents are not liable for capital gains tax (CGT) on assets located in South Africa, non-residents are liable for CGT on disposals of immovable property); and, secondly, to assets attributable to a non-resident's permanent establishment in South Africa (because such an asset is subject to CGT in the hands of the non-resident on disposal). Under the exit charge rules, the resident is deemed to have disposed of the asset at market value on the day immediately preceding the cessation of residence, no doubt in order to avoid the argument that otherwise there would be no liability for CGT, i.e. the deemed disposal occurs while the person is still a resident1.
The facts, briefly, were as follows: The taxpayer was an investment holding company, incorporated in South Africa and listed on the JSE. Its sole asset comprised a 100% interest in another company2, which, in turn, owned 100% of a Guernsey company, which itself owned 65% of a UK based company. In July 2002 the taxpayer's board of directors met in Luxembourg and resolved that all future meetings would be held in that country. Notwithstanding that one of its executive directors remained in South Africa to perform certain functions on behalf of the taxpayer, it appears to have been common cause that the taxpayer transferred its residence to Luxembourg3. Thus the company was resident both in South Africa and Luxembourg – the former by reason of incorporation and the latter by reason of management. Nothing is stated in the judgment that the tie-breaker article in the South Africa / Luxembourg double tax agreement4 rendered the company to be a resident of Luxembourg, but this seems to be implied by the fact that it appears to be common cause that the company was resident in Luxembourg under the treaty.
The executive director then left South Africa at the end of January 2003, at which time the permanent establishment ceased. With effect from 26 February 2003 an amendment to the definition of "resident" in section 1 of the Income Tax Act, became effective, and that amendment states that a person, otherwise meeting the tests of residence, will not be a resident if that person is deemed exclusively to be a resident of another country for the purposes of the application of any double tax agreement. Thus notwithstanding the fact that the company remained a resident by reason of incorporation up until that date, the court acknowledged that this status changed with effect from the date the amendment took effect5.
The SARS applied the so-called exit charge and taxed the company. It is evident from the judgment that various arguments were raised by counsel for both the taxpayer and the SARS, but the court refrained from dealing with the various concepts, each of which, in the words of the judgment, "bristles with difficulties of interpretation, as became apparent during the hearing before this court"6. The court, instead, chose not to deal with any of these issues and instead found in favour of the taxpayer based on article 13(4) of the double tax agreement, which, in effect, grants sole rights to Luxembourg to tax any capital gain arising on the alienation of any property in South Africa (other than certain enumerated types of property which are not relevant here).
Counsel for the SARS argued that article 13 refers to the alienation of property, and here there was no such alienation – merely a deemed disposal. The court did not accept this argument, given that the South African legislation stated that, upon cessation of residence, the person, "will be treated for the purposes of [the legislation] as having disposed of an asset". The court could not see any reason why a deemed disposal of property should not be treated as an alienation of property for the purposes of the double tax agreement, and the judge agreed with the taxpayer's counsel, who argued that it would be absurd if a taxpayer were to be protected in terms of the article from liability for tax resulting from a gain arising from an actual alienation of property, but not a deemed alienation.
Counsel for the SARS counsel argued that if the taxpayer was correct, it would mean that the deemed disposal would never apply if a party were to migrate to a country with whom South Africa has concluded a double tax agreement. The judge's response was that the same might be said in respect of an actual disposal, but this is not a reason for concluding that the article in the agreement would not apply.
It is clear that a number of questions remain unanswered (or, at any rate, not dealt with by the court). For example, if it was common cause that the taxpayer gave up residence in July 2002, what prevented the exit charge from being triggered given that the deemed disposal is deemed to occur on the day before? Was the reason because an executive director remained in South Africa to tie things up before he, too, departed seven months later, and thus the asset was attributable to a permanent establishment in South Africa and therefore exempt from the exit charge? Was the executive director's presence in South Africa sufficient to create a permanent establishment in the circumstances? And, if it was, were the shares in the subsidiary attributable to the permanent establishment (given that the taxpayer was a pure investment-holding company whose sole asset comprised shares in another company, it is difficult to envisage how there could be a permanent establishment or that the shares are attributable thereto – after all, one would expect that all of the management functions would be exercised by the board of directors in circumstances such as this; and one would ask what business could be carried on7; and if there was an office, were the functions not auxiliary8)? If there was permanent establishment to which the shares were attributable, was the termination of that permanent establishment considered in the light of the exit charge? If there was indeed a permanent establishment, and the shares were indeed attributable thereto, and the deemed disposal took place the day before the termination of the permanent establishment, why would the gain not be taxable in South Africa? After all, article 13(2) of the treaty does permit South Africa to tax a gain from the alienation of movable property forming part of the business property of a permanent establishment in South Africa9. What relevance did the amendment to the definition of "resident" with effect from 26 February 2003 have on the matter? After all, would not the company in any event be deemed to have been exclusively a resident of Luxembourg under the double tax agreement?10
It is regrettable that the court, with respect, went no further than to raise various legal issues without analysing them, and, instead, fell back on what appears to be an easy option, even though its own finding "bristles" with uncertainties.
It will therefore come as no surprise that the SARS has noted an appeal.
1. None of these aspects appears in the judgment itself, and are set out as background information. No doubt these issues were canvassed during the course of the hearing and argument, but this article is based purely upon a reading of the judgment.
2. Which, it is assumed, was not a South African-resident company.
3. The test for residence of a South African company is either that it is incorporated in South Africa or it has its place of effective management here. The continued presence of the executive director in Johannesburg, does not, from the judgment, seem to have caused the SARS to contend that effective management remained in South Africa.
4.See article 4(3).
5 One would have thought that this was the situation in any event by reason of the application of the double tax agreement, and that this status arose in July 2002 and not only in 26 February 2003, but the court refrained from dealing with these issues.
6 The court hearing took place over four days in October 2010.
7 Which is a requirement for a permanent establishment.
8 Which results in there being deemed to be no permanent establishment.
9 And if the court has concluded that a deemed alienation must be treated the same way as an actual alienation in finding for the taxpayer, then the taxpayer cannot complain when the same logic is used here.
10 I should not be construed, by these questions, as having formed the view that the SARS ought to have succeeded. It is just that there are so many factual and legal questions that have not been dealt with in the judgment.
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