Tax Amendments - 2011 - Capital Gains Tax

Once again, the Taxation Laws Amendment Bill (the Bill) is large and wide-ranging and deals with a number of important issues. Following the furore caused earlier this year by the proposed suspension of section 45 of the Income Tax Act (the Act), further draft legislation was published. The Bill now includes these contentious aspects. But there are other important changes as well.

This publication deals only with aspects that are likely to be of general interest and excludes comment on highly technical or esoteric amendments.

A number of the amendments have different effective or commencement dates, which will be detailed where appropriate. Except for these, the amendments to the Act are deemed to come into operation from the commencement of tax years ending on or after 1 January 2012 (i.e. they will apply, for example, for the years ending 29 February, 30 June, 30 September and 31 December 2012).

Amendments affecting corporates Corporate restructuring rules – domestic aspects

The announcement on 3 June 2011 (when the draft legislation was published for comment) that section 45 of the Act dealing with intra-group transactions was to be suspended for eighteen months while so-called abuses were considered and remedies designed, caused a furore. Following frenetic discussions and negotiations, a compromise solution was published on 3 August 2011 and, with some modification, the new rules have now been given effect to.

Section 45 of the Act will continue to apply, but subject to the provisions of a new section, being section 23K of the Act.

The major amendment to section 45 is that where an intra-group transaction is undertaken and, in general terms, the purchase price is left owing on inter-company loan account, that loan will have a zero base cost in the hands of the creditor company. The rule goes slightly wider than this, but this is the essence of it.

It follows that, in principle, any repayment will give rise to a capital gain, subject to capital gains tax (CGT), in the creditor company's hands. However, this capital gain will be disregarded provided that, at the time of payment, the debtor and creditor are still part of the same group of companies (for tax purposes).

Similar rules have been introduced where the purchase price is paid by shares which are not equity shares (i.e. typically redeemable preference shares).

There seem, however, to be errors in regard to the implementation date. It is probably the intention that it applies to transactions entered into between 30 August 2011 and 31 December 2012. Instead the Bill states that it will apply in respect of any tax year commencing on or after 1 January 2012 (which does not make sense).

Denial of interest deduction – section 23K

Allied to the amendment to section 45 of the Act is the introduction of section 23K which applies to any interest incurred in terms of a debt instrument issued on or after 3 June 2011 for the purpose of funding an inter-group transaction. In simple terms, the interest is disallowed as a deduction unless the South African Revenue Service (the SARS) issues a directive to the contrary.

In issuing the directive, the SARS must take into account the amount of interest incurred by the purchaser of the assets, as well as all amounts of interest incurred, received or accrued in respect of other debts used directly or indirectly to fund the purchasing company's debt. In other words the SARS will consider what the net effect on the South African tax base will be.

In addition, regulations will be issued prescribing criteria that the SARS must have regard to in considering the application for a directive, taking into account issues such as the purchasing company's debt: equity ratio, its interest cover, the terms of the debt instrument, and so on.

There are also specific rules relating to the timing of lodging of the application and the effect of changes to facts and circumstances. It is also not unusual that a company incurs debt to acquire shares in a target company, following which the target company distributes its business and assets to the acquiring company as a liquidation distribution. Roll-over relief is obtained in terms of section 47 of the Act, and the interest on the debt is allowed as a deduction against the business profits going forward.

Section 23K also applies to a transaction such as this where the liquidation distribution occurrs on or after 3 August 2011. To the extent any interest is disallowed under section 23K and the recipient of that instrument is another company in the group (but excluding a non-resident company), the interest received will be exempt from tax (see section 10(1)(hA) of the Act).

Hybrid equity instruments

The treatment of hybrid equity instruments (mainly in the form of redeemable preference shares) is well-known (see section 8E of the Act). In a nutshell the section deems a dividend to be interest in the hands of the shareholder either:

where (in the main) a redeemable preference share is redeemable, or could at the instance of the holder be redeemed, within three years of issue; or
where the holder had a put option in respect of that share which could be exercised within three years of issue.

Section 8E of the Act has had its ambit narrowed considerably, principally to deal only with redemptions of shares, while a new section – section 8EA of the Act – dealing with third-party backed shares has been introduced. This deals inter alia with put options.

Essentially section 8E now applies only where the issuer has the obligation to redeem the share in whole or in part within three years, or the holder has the right to have it so redeemed.

However, a new category of hybrid equity instrument has been introduced. This is any type of share if the dividend is to be calculated directly or indirectly with reference to any specified rate of interest or the amount of capital subscribed, and the share is directly or indirectly secured by a financial instrument other than an equity share. Thus if security has been given for the performance by the issuer and the security is in the form of a pledge of the issuer's assets (other than equity shares in other companies) the share will automatically be a hybrid. This aspect ties in with section 8EA.

The amendments apply to any dividends received or accrued on or after 1 April 2012. To the extent that there are existing shares in issue, where the parties are unable to amend the terms before then, the legislation is clearly retroactive.

Section 8EA – third-party backed Shares

If a share is a third-party backed share then here, too, the dividends are deemed to be income (i.e. taxable income) in the shareholder's hands.

In brief, a third-party backed share is one where:

there is a put option in respect of the share against any person other than the issuer, or
such other person has issued a guarantee, indemnity or similar arrangement in favour of the shareholder, or
such other person is obliged to procure, facilitate or assist with the acquisition or the making of the payment under the guarantee, etc.

In other words, if any person other than the issuer is at risk by reason of the existence of a put option or a guarantee, the share will be a third-party backed share.

But there are exclusions from this rule, thereby having the effect that the dividend retains its tax-exempt nature in the shareholder's hands. The main elements of the exclusions include:

The share must have been issued to fund an acquisition of equity shares in an operating company (being a company that carries on business in the course of furtherance of which it provides goods or services, or is a holding company of such a company).
Alternatively, the share must have been issued for the purpose of refinancing any debt incurred for that purpose, or to replace any previously issued shares issued for that purpose.
The put option must be against, or the guarantee, etc, must be issued by:

the operating company, or
any person that directly or indirectly holds more than 20% of the equity shares of the operating company, or
any person that directly or indirectly holds more than 20% of the equity shares of the issuer, or
any controlled group company (i.e. a 70% or more subsidiary) in relation to the operating company or the issuer of the shares.

Section 8EA applies in respect of all dividends received or accrued on or after 1 October 2012. Once again, there is the prospect of retroactivity, but here a longer period to rearrange terms is given.

Buy-backs of listed shares

In terms of amendments to the Act in 2010, the definition of "dividend" excluded the repurchase by a company of its own securities listed on the Johannesburg Stock Exchange (JSE) in accordance with the JSE's requirements.

Thus no part of the buy-back consideration would be seen as a dividend - attracting secondary tax on companies (STC) in the hands of the listed company, or dividends tax (from its effective date of 1 April 2012) in the hands of a taxable shareholder, such as an individual or trust.

The effect of the amendment was that the full buy-back consideration would be included in gross income (for share dealers) or be treated as CGT proceeds (for capital investors). This change was intended to simplify the tax implications for shareholders of listed companies, who are often unaware of the composition of the buy-back consideration received, and the consequential STC and income tax/CGT implications.

However, as a result of the manner of drafting of the provision, specific listed buy-backs implemented off market were also affected, because the amendment applied both to general and specific listed share buy-backs.

With effect from 1 April 2012 the provisions will be amended so as to narrow the scope only to general repurchases of listed shares. This will allow a listed company to fund a specific repurchase otherwise than out of contributed tax capital (i.e. out of profits only), which is regarded as a dividend. Corporate shareholders will thus receive a dividend free of withholding tax as purchase consideration, without incurring any CGT as would be the case in a general repurchase.

Local return of capital

Essentially, a local return of capital is an amount paid by a South African tax resident company as a distribution or as consideration for a share buy-back, which results in a reduction of the company's contributed tax capital (for example share premium).

Specifically excluded from the definition of a return of capital are two of the exclusions to the dividend definition, namely those relating to issues of the company's own shares (e.g. capitalisation shares) and share buy-backs by way of certain general repurchases of listed shares (see above). Broadly speaking, the concept of a return of capital is similar to a "capital distribution", dealt with in paragraphs 74 and further in the Eighth Schedule to the Act.

The tax treatment of a capital distribution / return of capital now sees its third major overhaul.

At first, a capital distribution did not have an immediate tax implication, but upon disposal of the shares in respect of which a capital distribution was previously received, the previous capital distributions had to be added to the actual disposal proceeds to determine the capital gain or loss.

This regime was then replaced by rules in terms of which a capital distribution triggered a deemed part-disposal of the shares in respect of which the distribution is received.

The deemed part-disposal treatment is now being replaced by a regime in terms of which a return of capital will firstly serve to reduce the base cost of the shares in respect of which the distribution is made, and only when the base cost of the shares has been exhausted will any excess amount distributed result in a capital gain for the recipient.

For example, if the base cost is R100 and a return of capital of R30 is received, the base cost is reduced to R70. If a further return of capital of R80 is received, the capital gain will be R10. If thereafter the share is sold for R150, the full proceeds will be subject to CGT.

For returns of capital on pre-valuation date shares, a different dispensation applies. A return of capital accruing on or after 1 April 2012 on pre-valuation date shares triggers certain deemed rules for purposes of the date of acquisition of the relevant shares as well as their base cost going forward.

In particular, a return of capital on or after 1 April 2012 will result in the share being deemed to have been acquired at the time of the return of capital (i.e. it will no longer be regarded as a pre-valuation date asset), and the base cost of the share will be set as the market value on the date of the return of capital:

less an amount equal to the notional capital gain had the shares been sold then; or
plus an amount equal to the notional capital loss had the shares been sold then.

Even more complicated than the various tax implications flowing from a capital distribution / return of capital are the effective dates of all these major amendments.

The second (deemed part-disposal) regime was phased in from 1 October 2007, so that capital distributions which occurred on or after 1 October 2007 triggered the deemed part-disposal treatment. For capital distributions which occurred prior to 1 October 2007, the first regime (addition to disposal proceeds) remained effective, unless the shares in question were not actually disposed of by 1 July 2011. On 1 July 2011 all shares in respect of which capital distributions were received prior to 1 October 2007 and which were not disposed of, were deemed to have been part-disposed of, so that the previously untaxed distributions become taxable.

The current amendments override the 1 July 2011 date retrospectively, so that no part-disposal on 1 July 2011 will be deemed to have occurred.

Rather, the position for pre-1 October 2007 capital distributions is now as follows:

The first regime (addition to disposal proceeds) will continue to apply if the shares, in respect of which the distribution was received, are actually disposed of on or before 31 December 2011. This provision comes into operation on 1 April 2012, which raises a question as to how the amendment will, practically, apply to override positions on 1 July 2011 or 31 December 2011 – both dates being prior to 1 April 2012!
Where the shares are not disposed of before 1 April 2012, the return of capital will be treated under the new rules, namely it will serve to reduce the base cost of the shares, and a capital gain will arise only to the extent of the return of capital exceeding the base cost.
The position relating to a pre-1 October 2007 return of capital on shares which are disposed of between the period 1 January 2012 and 31 March 2012 seems to be unregulated.

A return of capital during the period 1 October 2007 to 31 March 2012 is subject to the rules in terms of which a deemed part-disposal of the shares in respect of which the return is received, is triggered.

The latest regime applies to any return of capital accruing on or after 1 April 2012. The effective date for the new regime is stated to be 1 January 2012, and applicable in respect of a return of capital received or accrued on or after that date. The body of the legislation, however, applies only to a return accruing on or after 1 April 2012.

The various references to a capital distribution are replaced by a reference to "return of capital" throughout the legislation dealing with the capital gains tax implications for these distributions. Although the two concepts are broadly similar, there may be instances where a distribution that qualified as a "capital distribution" would not constitute a "return of capital".

Companies are, with effect from 1 April 2012, required to issue written notices if a distribution constitutes a return of capital.

Debt without set maturity dates

Section 24J of the Act contains specific rules that taxpayers must use to calculate the incurral and accrual of interest, which, in essence, determines that interest must be calculated on a "yield to maturity" basis.

The concern is that taxpayers have been altering these rules by manipulating the maturity dates of the debt, thereby ensuring that the interest receipt of the lender coincides with the payment by the borrower (often found with shareholder loans which are payable on demand).

Specific sets of rules were therefore proposed to deal with debt without a maturity date (perpetual debt - this was under the draft Bill released in June 2011), debt instruments with uncertain maturity dates, and so-called demand instruments.

However, as a result of the anticipated impact of treating perpetual debt as shares (with the interest as a result being taxed as dividends) on the property loan stock sector, this provision has been deferred until a new regulatory regime is established for property loan stock companies.

As regards debt with uncertain maturity dates, section 24J will now be amended so that the date of redemption of an instrument will be:

the date on which all liabilities to pay amounts in terms of the instruments is specified provided such date is not subject to change (whether as a result of a fixed or contingent right of the instrument holder); or
if there is no date specified or it is not subject to change, the date on which, on a balance of probabilities, all liabilities to settle all amounts in terms of the instruments will be discharged.

Demand instruments (being an instrument which provides the holder with the right to require redemption at any time before the specified redemption date) will be regarded as maturing within one year (365 days from date of issue or transfer of the instrument), and therefore the yield to maturity calculation must be based on this annual maturity date.

The proposed amendments will come into effect 1 April 2012, and will apply to amounts received by or incurred by taxpayers on or after that date. Therefore current debt instruments will also be affected.

Dividend cessions and borrowed Shares

Concern has been voiced by Treasury that the recipient of a ceded dividend merely receives another form of income distinct from the distribution of the underlying dividend, as in the case of a bona fide shareholder. Put differently, where the dividends are separated from the underlying shares the cessionary acquires dividends purely for their tax-free nature and the dividend recipient is no longer the party with the beneficial interest in the shares in question. Furthermore, in many cases these cessions seem to be financed by tax deductible funds.

The Bill addresses this perceived abuse by limiting the tax free nature of dividends in prescribed circumstances, effective from 1 April 2012. In terms of proviso (ee) to section 10(1)(k)(i) of the Act any dividend received by or accrued to or in favour of a company in consequence of:

any cession; or
any right that company acquired in consequence of any cession

will render such a dividend taxable going forward.

It should be noted that although this proviso has substantially been simplified from the previous draft of the Bill, its ambit is much wider as it now applies to any dividend received subsequent to a cession. However, it only applies to companies receiving ceded dividends and does not apply to trusts as previously drafted, or to other taxpayers.

Furthermore, in terms of provisos (ff) and (gg) to section 10(1)(k)(i) the exempt status of dividends on borrowed shares will no longer be enjoyed. The aim of these changes is to deny exempt status to the dividends where the borrower, which in carrying on its scheme of profit-making also has a corresponding obligation to pay, say, manufactured dividends on identical shares, also often attempts to manipulate a tax deduction.

The Minister had announced the intention to close down the arrangements where collective investment schemes invest in money market instruments but investors receive tax-free dividends, but the legislation does not seem to have given effect thereto.

Amendments affecting individuals New medical credit system and expenses treatment

In the 2011 Budget speech the Minister of Finance announced the intention to reform the current medical tax deduction allowance by replacing it with a new medical tax credit system. The Bill now includes the new section 6A which seeks to give effect to these proposals.

Parity between the tax deductions available between higher and low income taxpayers is sought, as previously up to 40% savings could be attained by higher income individuals.

With effect from 1 March 2012 the deduction system for medical scheme contributions will convert to a tax credit system. This will provide taxpayers with a tax credit for monthly medical contributions, i.e. the amount will be deducted from the tax liability and not from taxable income. These monthly credit amounts are set at R216 each for the taxpayer and his / her spouse (or first dependant), and a further R144 for every additional dependant.

However, if one's contributions exceed four times the tax credit, one will be able to claim the excess as a deduction from taxable income at the marginal rate. Credits will be non-refundable and operate in the same manner as the primary, secondary and tertiary rebates.

Effectively lower income taxpayers will gain from the new dispensation, whereas higher income earners will benefit less than at present. Taxpayers aged 65 and over will (for the time being) not fall within this new system and will still be able to claim the full deduction for medical scheme contributions.

What the section does not address is the current deduction of out-of-pocket medical expenses. Treasury released a discussion document in June 2011 requesting comment from the public, not only on the proposed conversion, but also on the way forward on the tax treatment of out-of-pocket medical expenditures.

Even though the second round of comments on the out-of-pocket expenses issue was requested by end of October 2011, the Bill currently does not address this issue fully, and, as such, outof- pocket expenses will still be claimable as a deduction.

Changes to the tax free dispensation of moving homes from companies and trusts

Paragraph 51A was inserted into the Eighth Schedule to the Act with effect from 1 October 2010 to provide taxpayers with an opportunity to move, on a tax neutral basis, their homes from companies, close corporations and trusts, with the subsequent termination of these holding vehicles. The paragraph has undergone various changes since its introduction, and has not escaped further amendments under the Bill.

The amendments seek to clarify that the property must be transferred to persons connected to the company or trust at the time of disposal (such as family members, or beneficiaries of the same trust), and those connected persons must have used the residence mainly for domestic purposes.

Also, in line with the provisions for companies, steps must be undertaken from the date of disposal of the residence to terminate the trust (what these steps entail is not specified, but it would appear a six month period is envisaged - similar as for companies and close corporations).

Moreover, the requirement that the donor and all beneficiaries must agree to the termination, failing which a court order must be obtained, has been dropped, so that the trust can be terminated as provided for in the trust deed.

CGT – foreign exchange gains and Losses

Generally speaking, natural persons and trusts were not subject to tax at ordinary rates on foreign currency gains and losses on debt instruments in terms of section 24I of the Act. But they were subject to CGT thereon in terms of the Eighth Schedule to the Act.

There were lengthy and complex rules relating to the determination of capital gains and losses on currency movements in respect of debt instruments, and it is likely that those rules were very rarely observed in practice. And if they were, the tax yield did not justify the cost and inconvenience of the record-keeping and computation.

With effect from 1 March 2011 those rules are repealed in toto. This means that any currency gains on debt instruments will be completely exempt from tax, and any losses completely disregarded, as far as most individuals and trusts are concerned.

Insurance benefits

The capital or revenue nature of the proceeds of long-term insurance policies has been subject to uncertainty for some time. There is also no clear differentiation between the proceeds of risk policies compared to investment policies. A number of significant amendments have thus been made in this regard. All amendments are due to come into operation on 1 March 2012 and will apply in respect of premiums paid or proceeds received on or after that date.

Long-term insurance treated as a fringe Benefit

In terms of an amendment to paragraph (d) of the "gross income" definition, the proceeds received by a person or his/her dependant or nominee, where the person was an employee or director of the policyholder, will be included in gross income.

The provision will also apply in relation to the cession of any policy (other than a pure risk policy) to the person or his / her dependants or nominees or to any pension, provident or retirement annuity fund for the benefit of the person or his / her dependants or nominees.

An exemption is however granted on such proceeds to the extent to which the premiums on such policy were taxable in the hands of the recipient as a fringe benefit (section 10(1)(gG)), provided the premiums were not deducted under section 11(a) of the Act by the recipient.

The provisions of the Seventh Schedule, dealing with fringe benefits, have been extended to include a new paragraph 2(k) which includes as a taxable benefit any premium paid for the benefit of the employee, his / her spouse, child, dependant or nominee. The cash equivalent of the benefit will be the premiums paid – paragraph 12C of the schedule.

The net result of the above is that, to the extent that the premium paid is taxable as a fringe benefit, the proceeds on the policy will be exempt from tax in the hands of the employee.

A further prohibited deduction has been added in the form of section 23(p). In terms of this, no deduction is allowed in respect of the cession of any policy by a taxpayer to an employee, director, dependant or to any fund for the benefit of the employee, etc.

Capital gains tax will continue to apply to owners of second-hand policies.

Disability insurance

An amendment is made to paragraph (m) of the "gross income" definition to include the proceeds of a policy on death, disablement or severe illness of the policyholder, including any loan or advance in respect of such policy.

The tax rules relating to policies providing for benefits arising as a result of illness, injury, disability or unemployment have also been amended to treat any premium which is paid by an employer and taxable as a fringe benefit, to be deemed to be a premium paid by the employee under paragraph 12C of the Seventh Schedule.

The premium will thus qualify for a deduction by the employee under section 11(a), which will offset the fringe benefit, and will not be a prohibited deduction under section 23(m) of the Act. Proceeds on such a policy will be included in the income of the employee, as noted above.

Key man insurance

Amendments have also been made to the tax treatment of so called "key man" insurance policies.

An exemption in respect of the proceeds will apply under a new section 10(1)(gH) of the Act where it is specifically stated in the policy document that the provisions of section 11(w) will not apply. This is effectively an elective provision in terms of which the employer can elect to:

deduct the premiums – in which case the proceeds will be included in its gross income with no exemption (a conforming policy), or
not deduct – in which case the proceeds will be exempt (a non-conforming policy).

An endorsement will need to be added by 31 August 2012 to existing insurance policies to cover this election.

Severence benefits

A number of technical changes have been made to the definition of "severance benefit" which will have no significant practical implications.

Any severance benefit received will also be treated in the same manner as other lump sums received from retirement funds for purposes of the rating formula in section 5(10); the determination of normal tax payable under section 6(1); and the deduction of retirement annuity fund contributions under section 11(n).

A severance benefit is now specifically excluded from also constituting a taxable benefit under the Seventh Schedule.

Retirement benefit provisions

Various technical changes have been made to provisions dealing with retirement benefits, including the definition of a "living annuity" and the treatment of lump sum withdrawal benefits.

As a consequence of the replacement of the source provisions contained in section 9 of the Act, the provision dealing with pensions or annuities received in respect of services rendered in the Republic has also been amended.

The most significant implication is that the provision that requires that the services must have been rendered in the Republic for at least two years during the ten years immediately preceding the date on which the pension or annuity first became due in order to fall into the section, has been removed.

The amount to be included will thus be based solely on the period of services rendered in the Republic over the total period. This provision applies in respect of years of assessment beginning on or after 1 January 2012.

International aspects

New foreign dividend regime

New definition

Dividends and foreign dividends are now two completely separate concepts. It can no longer be accepted that a distribution by a foreign company (which would have constituted a dividend had that company been a South African company) constitutes a foreign dividend.

A dividend will, with effect from 1 April 2012, by definition be limited to certain distributions by South African tax resident companies.

So, what constitutes a foreign dividend?

In terms of existing legislation a foreign dividend is defined as an amount payable on or after 1 January 2011 by a foreign company, which is treated as a dividend in terms of the income tax laws of the country of incorporation of the foreign company. Failing applicable income tax laws, an amount will be regarded as a foreign dividend if it is so characterised by the company law in the jurisdiction of incorporation.

In terms of the current set of amendments the above rules were amended retrospectively to 1 January 2011, so that the characterisation of the payment in terms of the tax laws of the jurisdiction where the company has its place of effective management, as opposed to place of incorporation, will determine whether the payment constitutes a foreign dividend. In the absence of applicable tax laws, the characterisation given by the company law of the jurisdiction of incorporation will determine the nature of the payment by the company.

The definition also now excludes (retrospectively) redemptions of participatory interests in foreign collective investment schemes in bonds and securities, as well as distributions which the foreign company is eligible to deduct in terms of the law in which the company's place of effective management is located.

Tax rate

The tax treatment of foreign dividends is now regulated separately in a new section 10B of the Act, and these provisions will apply to foreign dividends accruing on or after 1 March 2012 to natural persons, deceased and insolvent estates and special trusts, and on or after 1 April 2012 to all other taxpayers.

Generally, the new foreign dividends regime is a positive amendment for taxpayers.

Apart from one exception, the maximum tax rate applicable to taxable foreign dividends is now well below the normal tax rate applicable to other forms of income. For taxpayers other than normal trusts, the effective tax rate on taxable foreign dividends is equal to 10%. For trusts (other than special trusts), the effective tax rate is 14%.

Considering the stated rationale for the amendment, namely for the tax rate applicable to foreign dividends to correspond with the dividends withholding tax rate on local dividends, the 14% rate applicable to trusts appears out of step, and hopefully is just an oversight.

Other exemptions

The required equity holding to qualify for the participation exemption has been dropped from 20% to 10%. Probably the biggest relief from an administrative point of view, is that the foreign financial instrument holding company (FFIHC) exclusion from the participation exemption falls away. Due to the effective dates, there is a window period between 1 October 2011 and 1 March / April 2012 during which certain distributions may be subject to the FFIHC exclusion, thereby rendering the dividend to be taxable.

The participation exemption remains subject to the existing exclusion relating to dividends which are linked to tax-deductible payments by another person, and is also not available for foreign dividends from foreign collective investment schemes in securities and bonds.

Apart from the participation exemption, the following exemptions from foreign dividends tax will apply:

Dividends declared to a companyshareholder which is tax resident in the same country as the payor company (also subject to the exclusion for dividends which are linked to tax-deductible payments and from foreign collective investment schemes and securities);
The existing exemption available to dividends declared out of profits that were effectively included in a resident's income under the controlled foreign companies (CFC) rules (subject to the existing additional provisions applicable to this general rule); and
Dividends, other than in specie dividends, in respect of JSE listed shares (as these will be subject to dividends tax).

Foreign tax credit on SA source Income

If a foreign country taxes (usually in the form of a withholding tax) a South African tax resident on income generated from services rendered in South Africa, a tax credit for the foreign tax will be afforded to the resident.

This deals with a problem where (particularly) African countries deduct tax on payments to non-residents on service fees, even though the fees are foreign source income and thus outside the foreign (i.e. African) country's tax net.

This amendment is a move away from the general rule that foreign tax credits are only available for foreign-source income.

The tax credit is limited to the lower of the foreign tax and the South African tax on the amount. Consequently, no excess credits can be carried forward. The foreign amount needs to be translated to rand at the average exchange rate for the tax year during which the foreign tax is withheld.

The foreign tax credit is available for all foreign taxes withheld on or after 1 January 2012. With effect from a date to be announced, a taxpayer will be required to submit, within 60 days of the date on which the foreign tax is withheld, a declaration in a prescribed form to SARS.

Corporate restructuring rules

The corporate restructuring rules are extended, in certain instances, to include transactions involving CFCs which remain under the control of the same South African group of companies.

For purposes of these provisions, the definition of "group of companies" reverts to its normal meaning in terms of which foreign companies can form part of the group (which is contrary to the specific meaning of a group for purposes of the rollover relief provisions).

The asset-for-share relief in section 42 of the Act will be extended, in principle, to include the disposal of equity shares in a foreign company to another (recipient) foreign company, in exchange for equity shares (amounting to a qualifying interest) in the recipient foreign company, where the recipient foreign company is a CFC in relation to any company that forms part of the same group of companies as the disposing entity. If, within eighteen months of the transaction, the disposing entity ceases to hold a qualifying interest in the recipient foreign company, or the foreign company ceases either to be a CFC or a group company in relation to the disposing entity, the same anti-avoidance rules applicable to local asset-for-share transactions will be triggered (i.e. there is a deemed sale at market value of the balance of the shares).

Amalgamation relief contemplated in section 44 of the Act could, in principle, include a disposal by a foreign company of all its assets to a foreign resultant company, if the two companies form part of a 95% chain (i.e. more than the normal 70% required for a group) of companies and the resultant company will be a CFC in relation to a South African tax resident company in the 95% chain of companies.

Unbundling relief, in terms of section 46, will extend to transactions where the unbundled company is a CFC and the unbundling company is either a resident or another CFC, which unbundling company must hold more than 50% of the equity in the unbundled company, and provided the shares in the unbundled CFC are distributed in accordance with the shareholding in the unbundling company. If these requirements are met, the unbundling relief could apply to the extent of the shareholder(s) forming part of the same group of companies as the unbundling company.

Rollover relief provided under section 47 of the Act for liquidation distributions is also extended to liquidation distributions to CFCs that form part of the same group of companies as the liquidation company, provided the resident in relation to which the holding company is a CFC forms part of the same group.

The above rules apply to transactions entered into on or after 1 January 2012, except for the amendments to the unbundling relief, which apply to transactions entered into on or after 1 January 2013 (although it is not clear whether the date for the unbundling relief is a typographical error in the Bill).

Headquarter companies

Last year the concept of a headquarter company was introduced as part of the strategy to make South Africa the "Gateway to Africa". The benefits of a headquarter company are principally that it is not subject to STC or dividends tax, so that dividends passing through the company will not be taxed. Similarly when the withholding tax on interest is introduced it will be exempt; the CFC rules do not apply; and the thin capitalisation rules and certain transfer pricing rules do not apply.

In addition, if the company is a South Africanincorporated company which qualifies as a headquarter company under the exchange control criteria (which are slightly different) the company will be treated as if it were a foreign company (i.e. it will be completely free of all South African exchange controls).

Unfortunately there were certain difficulties with the legislation enacted last year, as section 9I of the Act, and it was feasible that certain pre-existing companies could qualify for the benefits of headquarter companies. Treasury also has the view that if a concession is given by way of an incentive, there ought to be some control exercised, principally in the form of reporting obligations, which are now introduced (though the Explanatory Memorandum to the Bill indicates that these obligations are not onerous).

The main criteria to qualify as a headquarter company are the following:

Each shareholder in the company must hold a minimum of 10% of the equity shares and voting rights in the company (which means that, in effect, there can never be more than ten shareholders). The minimum shareholding used to be 20%.
At the end of the tax year at least 80% of the cost of the total assets must comprise equity shares in, or loans advanced to, or intellectual property licensed to, a foreign company, in which the headquarter company holds at least 10% (previously 20%) of the equity shares and voting rights. As a concession, in determining the total assets, one must not take into account any cash, or bank deposits payable on demand.
Both these criteria must apply for all previous tax years as well.
Additionally, if the gross income exceeds R5 million, then at least 50% of the gross income must consist of rental, dividend, interest, royalty or a service fee paid by the foreign company in which shares are held, or proceeds from disposal of that interest (though such proceeds could never constitute gross income by definition!).
And, finally, the company must make an election on an annual basis to be a headquarter company (and this would preclude any company from claiming headquarter status in prior years as it would not have made the election in those years).

These new rules apply from 1 January 2011, from when the previous rules applied, so that, effectively, they substitute for the pre-existing rules retroactively.

CFC s – special rules for insurance cell captives

The concept of a CFC will, for the financial years of CFCs commencing on or after 1 January 2012, include individual cells within a protected cell company, the principal trading activities of which constitute insurance business. The fact that a protected cell company is, in terms of the law applicable to it, considered to be one indivisible entity, does not prohibit the SARS from treating an individual cell as a separate foreign company for CFC purposes.

Consequently, even if 99% of a protected cell company is owned by non-residents, but residents hold more than 50% of the participation rights in one cell, that cell could constitute a CFC, so that the income and gains attributable to that cell could be attributed to the residents for South African tax purposes.

The original announcement was that the new rules would apply to all cell companies, but it is clear that the new rules are limited (for the moment anyway) to insurance captives.

Transfer pricing

Two aspects of the current amendment to the transfer pricing rules deserve mentioning.

First, transfer pricing adjustments used to impact only the taxable income of a taxpayer. Consequently, taxes which are levied outside of the normal structure of the Act were not affected by transfer pricing rules. Of specific relevance here are the withholding taxes. In terms of the current amendments, transfer pricing adjustments are extended to all taxes, and could thus, in principle, serve to increase withholding taxes as well.

Secondly, as the STC charge which could arise for companies on transfer pricing adjustments will fall away with the advent of the new dividends tax in April 2012, a different secondary transfer pricing mechanism is being introduced. This mechanism entails the deeming of the transfer pricing adjustment amount as an interest-free loan, which, in itself, triggers a transfer pricing adjustment on the deemed interest charged.

For example, if in terms of a primary transaction a transfer pricing adjustment of R1 million is made, tax will be levied on the R1 million, but it will not stop there. The R1 million will be deemed to be an interest-free loan, so that the deemed interest on the interest-free loan will, once again, trigger a (secondary) transfer pricing adjustment. So if an arm's length interest rate is, say, 10%, there will be additional taxable income of R100 000 per annum.

It appears possible that the above treatment could cause a spiralling tax effect, in that the adjustment under the deemed interest-free loan will, again, trigger a deemed interest-free loan, and so on (i.e. in the following year the loan will be deemed to be R1,1 million).

The new provisions become effective for tax years commencing on or after 1 April 2012. A new transfer pricing provision was scheduled to become effective on 1 October 2011, but the new amendments override (retrospectively) the October 2011 effective date so that the previous set of amendments will, effectively, never come into effect and the pre-1 October 2011 position will continue to apply until it is replaced by the new provision in tax years commencing on or after 1 April 2012.

Change of residence or becoming a headquarter company

There has, since CGT was introduced on 1 October 2011, always been a rule that the giving up of South African residence triggers CGT (except in the case of certain assets). This is achieved by the persons who give up residence being deemed to dispose of their assets at market value on the date immediately before the day on which they cease to be residents.

These rules have now been collected in section 9H of the Act, and also apply to a company which becomes a headquarter company. Typically this will occur where it was not previously a headquarter company and it made the election to be such. This will also act as a disincentive to existing companies to try and move into the headquarter company regime. The effect will thus be that it triggers CGT if the market value of its assets exceeds their base cost.

The main exemptions from CGT in these circumstances continue to be in respect of a direct or indirect interest in immovable property in South Africa, and in respect of assets attributable to a permanent establishment in South Africa.

Foreign return of capital

Distributions from foreign companies which do not meet the defi nition of a foreign dividend, as described above, are foreign returns of capital, unless they are tax-deductible in the jurisdiction where the company has its place of effective management. The defi nition of foreign return of capital is also retrospective to 1 January 2011.

It is not clear what the tax status or treatment of the tax-deductible distributions are supposed to be – it appears that their accrual to a South African tax resident would be taxable in the normal course.

The accrual of foreign returns of capital to South African tax residents on or after 1 April 2012 will result in the reduction of the resident's base cost for the foreign company's shares, and once the base cost has been exhausted, the excess will trigger capital gains. Accruals of foreign returns of capital prior to 1 April 2012 do not have any stated tax implications.

It is relevant to mention that the concept of "return of capital", which is limited to distributions by South African tax resident companies, is introduced into the Act, also retrospectively, with effect from 1 January 2011. Returns of capital essentially inherit (also retrospectively) the tax implications that used to apply to capital distributions.

As a result of foreign returns of capital being excluded from the concept of (local) returns of capital, and because the old capital distribution rules are being made applicable to (local) returns of capital only, accruals of foreign returns of capital between 1 January 2011 and 31 March 2012 appear to escape any South African tax consequences (i.e. it is arguably a non-taxable capital receipt and there is also no disposal triggering a capital gain).

Vat

Treasury has recognised that due to the current market conditions many property developers are forced to rent the residential properties which they hold as inventory, as they are unable to sell them immediately. Technically, these properties undergo a vAT change in use when rented out (even if only temporarily). The developer must then pay vAT on the deemed supply (calculated on the open market value) of the property, an unenviable position for developers already under fi nancial stress.

The Bill contains relief (albeit temporarily) for developers (as defi ned) by regarding the event of supplying of rental property as not being in the course or furtherance of the vendor's (vATable) enterprise. There is still a requirement that it must be the intention of the developer to on-sell those developments (i.e. it cannot hold it for rental).

The property itself will only be regarded as a taxable supply on the earlier of 36 months from the date of conclusion of the rental agreement, or the date on which the developer applies the property permanently for a purpose other than that of making taxable supplies.

Developers must note that in order to qualify for the relief, they are required to advise the SARS of their position within 30 days of commencing the rental supply (in a form or manner to be prescribed).

The relief will come into operation on promulgation of the Bill and will cease to apply on 1 January 2015.

Other amendments

various other amendments were also made. These are too technical to describe in any detail, but are still worth mentioning and include:

the re-writing of the rules relating to the allowance on research and development expenditure;
the codifi cation of the source rules;
amendments to the rules relating to deductions for investments in venture capital companies;
the termination of the deduction for investments in fi lms and the substitution therefor of an exemption provision; and
certain changes to the dividends tax rules.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

South Africa: Tax Amendments - 2011