South Africa has comprehensive controlled foreign company ("CFC") rules in its law. An important exemption is the business establishment exemption, whereby provided there is a real and substantial qualifying business establishment, suitably equipped and staffed by appropriate management and employees, essentially deriving active business profits, the profits will not be taxable in the South African resident shareholders' hands.

Coupled with this is the participation exemption. Whereas normally foreign dividends are taxable in full, with credit given only for foreign withholding taxes paid (subject to a special dispensation set out below), the participation exemption rules provided that if a shareholder held more than 25% of the equity share capital of a foreign company, the dividends receivable were exempt from tax, and the proceeds on disposal of the shares, provided the shares were sold to a non-resident, were exempt from capital gains tax.

Recognising that one could still have a substantial holding below 25%, special elections were made available under the CFC rules. Provided a shareholder held at least 10% but not more than 25%, of the foreign company, the shareholder could elect that the foreign company was a CFC in relation to it, and, what is more, could elect that any relevant exemption, such as the business establishment exemption, was not available to it. In this way, the dividend was exempt but instead the underlying profits were taxed, and credits were claimable in respect of the underlying corporate profits. By so accessing the foreign tax credits, it is possible to minimise, or even eliminate, the tax that would otherwise have been payable in South Africa on the dividend.

In terms of draft legislation published, the minimum percentage for the participation exemption (both for dividends and capital gains tax purposes) has now been reduced from being a holding of more than 25% to a holding of at least 20%. Similarly, the threshold for making the elections referred to in the previous paragraph have been reduced from at least 10% but not more than 25%, to not more than 20%.

Insofar as the capital gains tax exemption is concerned, the draft legislation has also introduced an anti-avoidance provision to prevent shares in a foreign company essentially being sold to another resident, but using various transactions in terms of which the shares are first sold to a non-resident, so as to avail of the exemption.

If passed by Parliament the new changes will apply to any dividend received or accrued on or after 8 November 2005.

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