Now that most applicants who sought amnesty under the Amnesty Act (or, to give it its full name, The Exchange Control Amnesty and Amendment of Taxation Laws Act No. 12 of 2003) have received their amnesty approvals, many will be turning their attention to the tax-efficiency of their offshore structures, which would also be viewed in conjunction with the costs of maintaining them.
The purpose of this Tax Werks is to give an overview of the tax consequences of the more common structures that are in place, with particular reference to the differing treatment of foreign exchange gains and losses which would apply to them. And with the current volatility in both the rand and the major hard currencies in which South Africans typically invest, this could be a significant factor going forward.
This publication is not geared towards amnesty applicants who hold assets in their personal names, but rather those who hold them through offshore structures. In all but the rarest of cases, the structures are in one of two forms. The first is an offshore trust upon which the applicant would have settled (donated) funds from time to time, with the trust then making investments (bank accounts, bonds, collective investment schemes, listed shares, etc) in its own name. The second is where the trust owns an offshore company, typically a British Virgin Islands (BVI) company, to which it lent, or otherwise invested in, the proceeds from the settlements or donations, and all the investment activity takes place within the BVI company. Very rarely would the trust hold other assets, though this is not unknown.
With this in mind, it is useful now to get an understanding of the various treatments for income tax and capital gains tax (CGT) purposes in general, and also when factoring in the relevant provisions of the Amnesty Act.
The following are the general rules under the Income Tax Act where a person has donated funds to an offshore trust.
- Where the trust holds the assets directly, the income of the trust is deemed to accrue to the donor in South Africa and will be taxed in his or her hands in terms of section 7(8) of the Income Tax Act. (For the purpose of this publication I will assume that no distributions are ever made by the trust during the periods in question.)
- Where the trust has derived capital gains, those gains are deemed to accrue to the donor, and be subject to CGT in his or her hands, in terms of paragraph 72 of the Eighth Schedule to the Income Tax Act. (For the sake of convenience, henceforth I will usually refer only to section 7(8), and not paragraph 72 as well, on the basis that any reference to the treatment of income will have (virtually) the same treatment for CGT purposes.)
- Where the trust does not hold the assets directly, but all the assets are held in a BVI company wholly-owned by the trust, conventional wisdom is that the income of the company is still earned by reason of the donor's donation to the trust, and therefore the company's income is similarly taxable in the donor's hands in terms of section 7(8) of the Income Tax Act.
- For the donor to claim amnesty, he or she had to elect, in terms of section 4 of the Amnesty Act, that the trust’s assets be deemed to be his or hers. As a consequence, the income earned on those assets is taxable in the donor’s hands, not under section 7(8) of the Income Tax Act, but because the assets "belong" to the donor applicant.
- Where the trust's assets comprised only the shares in and claims against the BVI company, because the applicant is deemed to own 100% of the BVI company, it is, according to consensus opinion, a controlled foreign company (CFC) so that all of its income and capital gains are taxable in the hands of the applicant under the CFC rules in section 9D of the Income Tax Act.
- Section 4 of the Amnesty Act goes on to state that section 7(8) of the Income Tax Act does not apply "while" the assets of the offshore trust are deemed to belong to the applicant. If the trust itself sells an asset, then the applicant is deemed to have disposed of the relevant asset for proceeds equal to market value. This will have the effect of triggering a capital gain in the applicant’s hands (though with the strengthening of the rand against other major currencies since 1 March 2002, the date the applicant was deemed to have acquired the assets of the trust, there is more likely to be a capital loss than a gain).
- It is clear that the use of the word "while" in section 4 of the Amnesty Act is intended to mean that the suspension of the application of section 7(8) of the Income Tax Act will be only temporary. Thus if the trust does sell any of its assets, clearly the proceeds will no longer be deemed to belong to the applicant in which case the income thereon (or on their reinvestment) can no longer be earned by the applicant. But because section 7(8) was only temporarily suspended, it does mean that, after any sale of an asset by the trust, the income will continue to be taxed in the donor’s hands – not by reason of the donor electing the asset to be his or hers under section 4 of the Amnesty Act, but by reason of the ordinary rules applicable under section 7(8) of the Income Tax Act, ie income of an offshore trust arising by reason of a donation made by a South African resident is taxable in the resident’s hands.
- Where the trust itself does not own the assets but they are held indirectly through a BVI company, it is clear that any change in the company's assets will have no affect on their treatment for tax purposes. The reason for this is that section 4 of the Amnesty Act continues to deem the trust’s assets to be that of the applicant, and those assets would not have been disposed of because they comprise only the shares in and claim against the BVI company. Thus the CFC rules will continue to tax all income and capital gains of the BVI company in the applicant’s hands. It is only if the trust disposes of the shares in the BVI company that section 4 will cease to apply.
Foreign exchange gains and losses
If the rules above are not complicated enough, their complexity increases when one overlays the rules governing foreign exchange gains and losses.
Two general principles need to be noted in this regard. With the exception of certain circumstances which are unlikely to be found in an offshore structure of the type discussed in this article:
- foreign exchange gains earned by a company are willy nilly subject only to income tax, in terms of section 24I of the Income Tax Act, while
- foreign exchange gains earned by a trust or a natural person are willy nilly subject only to CGT in terms of Part XIII of the Eighth Schedule to that Act.
In this regard, however, it must be noted that the foreign exchange gains which are taxable, whether as income or capital gains, are essentially only those gains relating to debts owing by or to the entity, ie there are no specific rules for taxing foreign exchange gains on other instruments such as shares or immovable property (though such an exchange gain or loss will be incorporated into the determination of the overall gain or loss). Moreover, it must be remembered that debts include bank balances (after all a bank account is nothing more or less than a debt due by the bank to the account-holder). And, while for CGT purposes it is only realised gains that are subject to tax, for income tax purposes both realised and unrealised gains are brought to account.
Gains by a trust would typically arise where a trust held, say, a dollar bank account and the funds were spent; or invested in a non-dollar denominated debt instrument, for example a Euro bond (where one debt instrument is disposed of for another debt instrument in the same currency, no gain arises). A gain (or loss) would also arise where, say, funds from a dollar bank account are spent on a non-debt acquisition, for example, shares; or where dollars are sold to acquire, say, Euro.
The effect of the aforegoing is that:
- Realised and unrealised gains on debt instruments derived by a company are willy nilly subject to income tax, while
- Only realised gains by an individual or a trust are subject to tax, and then it is CGT.
With these general rules in mind, the following are the various scenarios that one can face.
- Where the trust owns all the assets and the applicant deemed the assets to be his or hers, realised foreign exchange gains will be subject to CGT in the applicant's hands.
- Once the trust has sold the asset which was deemed to be the applicant's, the exchange gain arising in future on any further asset acquired would no longer be that of the applicant but would nevertheless be taxed in his or her hands as a capital gain under paragraph 72 of the Eighth Schedule to the Income Tax Act.
- Where the assets are all held in a BVI company owned by the trust, and the BVI company is deemed to be held by the applicant, the foreign exchange gains, because they are earned by the company, will effectively be subject to income tax in the applicant's hands under the CFC rules, and not to CGT.
- Should the trust for some reason dispose of the shares in the BVI company, or sufficient of them, such that the company is no longer a CFC (for example, more than 50% are sold or awarded to another trust), once again, conservative opinion is that, though section 4 of the Amnesty Act will cease to apply, section 7(8) and paragraph 72 of the Eighth Schedule will again begin to apply. In such case, any currency gain derived by the BVI company will be deemed to be earned by the donor applicant in South Africa. Now, however, because the currency gain is deemed to be that of the donor, who is a natural person, it is once again subject to CGT and not to income tax. This might then be a reason for ensuring that section 4 of the Amnesty Act ceases to apply, ie that the BVI company should no longer be a CFC, because whereas it makes no difference generally if the income and capital gains are taxed in the donor’s hands under the CFC rules or under section 7(8) and paragraph 72, in the case of currency gains it makes a big difference, because under the CFC rules the gains are taxed as income, whereas under paragraph 72 they are subject to CGT.
All in all, it can be seen that there are a number of different issues that will have to be considered in deciding how to restructure post-amnesty.
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.