In accordance with indications in the Budget, this year's tax amendments focus strongly on international tax matters. The amendments are contained in the Taxation Laws Amendment Bill, B28 – 2010, which was published on Tuesday, 24 August 2010.
The discussion below explains the main amendments impacting cross-border transactions.
Another withholding tax
It is always big news when a new withholding tax is introduced, and this year's amendments paved the way for the introduction of a withholding tax on interest paid to non-residents.
The withholding tax accompanies a radical shift in the policy underlying the taxation of South African interest earned by non-residents. Currently, the tax laws provide for a near-blanket exemption for South African interest earned by non-residents, subject to exception in limited instances. This situation will turn around upon the amendments taking effect on 1 January 2013 so that South African interest paid to non-residents will, as a rule, attract tax, subject to certain exemptions.
The withholding tax will be levied at a rate of 10% and will be payable within 14 days after the end of the month during which the interest is paid. It is not clear whether the withholding tax will be a final tax. If this is the case, interesting questions about the application of the transfer pricing rules in this context could be raised.
The existing near-blanket exemption has not been amended, nor has it been repealed. An amendment in this regard is to be expected.
The 10% withholding tax will not apply to non-residents who are currently not eligible for the exemption, namely individuals spending in excess of 183 days per year in South Africa and non-residents carrying on business through a South African permanent establishment. Indications are that these non-residents will continue to be taxed at the normal tax rate applicable to them and not at the reduced 10% rate at which the withholding tax is levied.
The proposed exemptions from the interest withholding tax for non-residents earning South African interest will be limited to interest earned:
- on qualifying debt instruments (e.g. government and listed bonds);
- from qualifying borrowers (the SARB, banks in the absence of back-to-back loans, headquarter companies in respect of arm's length interest payments and non-residents spending fewer than 183 days per year, and not having a permanent establishment, in South Africa);
- in respect of qualifying transactions (international trade and transactions involving dealer and brokerage accounts);
- in terms of a portfolio of a collective investment scheme, other than a collective investment scheme in property; and
- non-residents currently not qualifying for the interest exemption (although they will probably continue to be taxed at the higher normal tax rate on South African interest).
The intention is for South African tax treaties with low tax jurisdictions to be renegotiated where those treaties provide for a nil withholding rate. Treaties with high tax jurisdictions providing for a nil withholding rate seem to be acceptable.
Foreign dividend definition
With effect from 1 January 2011 the definition of a foreign dividend will change drastically. Essentially, in future, amounts paid by foreign companies will constitute foreign dividends for South African tax purposes if they are treated as a dividend, or similar to a dividend, by the foreign company in terms of the income tax laws, or failing which the company laws, applicable to the foreign company.
The amendment is partly necessitated by the fundamental changes to the South African Companies Act.
The amended definition, on the face of it, appears simple and straightforward. It is, however, foreseen that attempts to apply foreign laws for purposes of determining South African tax liabilities could give rise to numerous complications.
The participation exemption provides, generally speaking, for an exemption from tax of foreign dividends on an equity holding of 20% or more.
With effect from tax years commencing on or after 1 January 2011, foreign dividends linked to round-tripping transactions in terms of which one person makes a tax-deductible payment to a recipient who is not taxed on the receipt, will no longer be eligible for the participation exemption.
The exclusion to the CGT participation exemption relating to foreign financial instrument holding companies ("FFIHCs") will in future also apply to the participation exemption for foreign dividends, so that foreign dividends from FFIHCs will not be eligible for exemption. Consequently, the participation exemption will essentially be limited to dividends arising from active foreign business operations. It is foreseen that it could become an onerous, and in some instances even impossible, exercise for taxpayers earning foreign dividends to determine whether the foreign company concerned is a FFIHC.
Tax status of certain foreign entities
In practice it often happens that a foreign entity or arrangement could, for South African taxation purposes, be categorised under more than one type of taxpayer. For example, a foreign collective investment scheme in securities constituted as a trust could meet the definition of a company for South African tax purposes, but it remains a trust. The same dilemma arises with certain foreign partnerships, co-operatives and certain hybrids.
A welcome attempt was made to address this uncertainty. The amendment in this regard is limited, though, taking form through the concept of a "foreign partnership", which includes tax transparent partnerships, associations or bodies of persons formed or established under the laws of a foreign country. This does not appear wide enough, though, to include, for example a foreign vesting (and thus also tax transparent) trust.
In terms of the new rule, "foreign partnerships" will, for South African tax purposes, also be treated as tax transparent. The amendment is of immediate effect for foreign partnerships established on or after the date when the new legislation was published (24 August 2010) and for existing entities meeting the definition of a foreign partnership the amendment will become effective in their tax years commencing on or after 1 October 2010.
South African investors in foreign partnerships may find it difficult to collect the information relating to the underlying income and gains generated by the foreign vehicle in order to comply with their South African tax obligations. It often proves near impossible to obtain the information from abroad – an important reason why South African taxpayers in the past simply treated these investment vechicles as companies, and thus opaque for tax purposes.
Going forward, only foreign collective investment schemes in securities and participation bonds are included in the definition of a company for South African tax purposes and in respect of these the confusion referred to above could still arise if they are constituted as trusts. Foreign collective investment schemes in property will, however, be taxed in accordance with their legal status.
Limited boost for South African investment funds
South African tax laws could result in foreign, passive investors in certain funds with a South African presence unexpectedly being regarded as having permanent establishments in South Africa.
Recognising that this situation is unacceptable, an amendment provides that qualifying (essentially passive foreign) investors in equity funds constituted as partnerships or trusts will not be regarded as having a South African permanent establishment by virtue of such investment.
Although this amendment is a positive step in the right direction it seems unnecessarily limited to:
- equity funds. Why not include funds with underlying investments in resources, renewable energy, agriculture and other popular African investments?
- avoiding a permanent establishment for the investor. Why not extend the provision to avoid the fund's tax residence being in South Africa by virtue of the actions, in South Africa, of its managers?
This amendment comes into operation from the commencement of tax years commencing on or after 1 January 2011.
Transfer pricing and thin cap rules
Effective from tax years commencing on or after 1 October 2011, the transfer pricing and thin cap rules will be contained and dealt with in one composite section.
This will mean that thin cap rules will in future also apply to local branches of foreign companies.
In order for the rules to be invoked, it is now explicitly required that a tax benefit must result from the non-compliant transaction.
In the case of a contravention of the arm's length principle, the remedy will be broader than a simple adjustment of the price. Rather, the contravening transaction can be taxed as if it was entered into between independent persons dealing at arm's length.
The headquarter company regime
The introduction of the headquarter company regime is directed at establishing South Africa as a jurisdiction of choice for investments into Africa.
Essentially, the regime provides for a relaxation for headquarter companies of the controlled foreign company and arm's length rules, and for dividends declared by these companies to benefit from the same exemptions available to foreign dividends. In the context of the headquarter company regime, all dividends declared by the company will escape taxation under the participation exemption, except those connected to round-tripping transactions.
The requirements to qualify as a headquarter company are strict and, apart from the third requirement listed below, must be complied with without interruption during its existence. The requirements can be summarised as follows:
- Its shareholders must hold 20% or more equity and voting rights.
- 80% or more of the cost of its assets must be attributable to an interest of 20% or more in foreign companies. The interest is to be in the form of equity in, loans to or IP licensed to the foreign companies.
- 80% or more of the total earnings of the company must consist of income from the above 20% interests, or gains on the disposal of these interests or IP.
It will be interesting to track the popularity of this regime in practice. The biggest challenge appears to be its introduction in isolation and in particular without a simultaneous offer of tax treaty benefits to investors in the rest of Africa. Much of its future success may depend on treaty re-negotiations by South Africa with other African countries to support the "Gateway into Africa" initiative.
As promised in the Budget, it is clear that the Revenue Authorities are having a thorough look at the South African tax treatment of international transactions. Taxpayers in this space should watch developments as it is clear that many of the amendments will require further refinement.
Taxpayers will need to re-assess their existing structures, especially those giving rise to South African interest being paid to non-residents and passive foreign structures relying on the participation exemption for the tax-free repatriation of dividends to South Africa.
On a more positive note, the amendments clearly signify an intention to support and facilitate international transactions and to clarify some of the many complications arising in analysing the tax treatment of these transactions.
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.