Despite challenges faced in recent years with the global pandemic as well as political and economic instability, South Africa has a booming fintech and technology industry. In particular, we are seeing tremendous growth in interest and investment in South African technology businesses. These companies are all intellectual property ("IP") rich, as IP underpins the technology assets that their businesses are based on.
Funding from non-resident investors is often a major stumbling block for start-ups. One of the reasons is, that South Africa has exchange controls and restricts the externalisation of IP owned by South African exchange control residents to related non-resident parties. Non-resident investors are often reluctant to invest into a South African company where the primary asset, the IP, is subject to exchange control restrictions. Further, South African exchange controls previously prohibited so-called "loop structures".
Loop structures typically entailed the formation by a South African resident of an offshore structure, which by a re-investment into South Africa, acquires shares or some other interest in a South African resident company or a South African asset. To overcome this issue, parties often had to resort to complex structures such as mirrored shareholdings. On 1 January 2021, the Financial Surveillance Department of the South African Reserve Bank ("SARB") abolished its policy on loop structures to encourage inward investments into the country. However, loop structures set up before 1 January 2021 are still considered to be "unauthorised" and are required to be reported to the SARB and regularised.
Many South African companies are looking to externalise their South African IP to attract foreign investment and/or to grow their business in the international markets. There are three main areas to consider when dealing with South African-owned IP, namely:
- exchange controls;
- tax; and
- IP law.
Whilst we do not go in-depth into these areas of consideration, we set out below some of the key aspects.
So can you sell your South African IP?
From an exchange control perspective, whilst the SARB has relaxed the exchange control rules applicable to IP, at present, authorised dealers are only permitted to approve the outright sale, transfer and assignment of intellectual property to unrelated non-resident parties if:
- the transaction is at an arm's length and the price represents a fair and market-related price;
- the authorised dealer views the sale, transfer or assignment agreement;
- the authorised dealer is provided with an auditor's letter or IP valuation certificate confirming the basis for calculating the sale price;
- the transaction is subject to appropriate tax treatment; and
- the assigned or transferred IP is not licensed back to a South African resident party.
Where a South African company undertakes IP development work for a non-resident party under a subcontract, any IP developed by the South African company would need to be assigned to the non-resident party for such non-resident party to legally own any IP developed under a sub-contract. Any such assignment requires approval in terms of the South African Exchange Control Regulations.
The sale, assignment, cession and/or waiver of any IP rights in favour of a related non-resident party requires prior approval from the SARB.
What about cross-border licensing arrangements?
What is possible is the licensing of IP by South African residents from non-resident parties, both related and unrelated, provided it is done at a fair market-related price. Similar, to the case of the assignment or transfer of IP, the authorised dealer is required to view:
- a copy of the licence agreement; and
- an auditor's letter confirming the basis of the calculation of the royalty rate or licence fee.
What are some of the tax considerations?
From a tax perspective, it is important to understand that IP is considered to be an asset for capital gains tax ("CGT") purposes and assuming such IP is held on a capital account, the disposal/sale of such IP will trigger CGT.
If South African companies are paying a royalty in respect of the use of the IP of a non-resident party, their tax deductions may be limited in terms of the Income Tax Act. This applies to licences for so-called "tainted IP". In this regard, the Income Tax Act contains anti-avoidance provisions which target IP sale-and-leaseback arrangements where certain parties are located outside of the tax net. IP will be "tainted" in situations where South African developed IP is sold to a non-resident or tax exempt entity and is then licensed back to the South African creator, or other South African end users who pay and claim as a tax deduction, the licence fees to use such IP.
Whilst there are ways in which to set up structures which may allow for the externalisation of South African-owned IP, the next issue that requires close focus is the ongoing management of such non-resident IP holding companies. Some important aspects to keep in mind in this regard include:
- the effective management and control of the foreign company (focussing on where the key management and commercial decisions that are necessary for the business are, in substance, made). If the effective management of the foreign company is deemed to be in South Africa, SARS has the right to tax the worldwide income of any such foreign company.
- whether such a foreign company constitutes a so-called controlled foreign company ("CFC") (a foreign company will constitute a CFC if more than 50% of the participation rights in any such foreign company are held by South African residents). Where the foreign company constitutes a CFC, the profits of the foreign company may, in certain circumstances, be attributed to the resident shareholders and taxed in their hands; and
- transfer pricing.
From a transfer pricing perspective, the legal and economic ownership of the IP must be aligned to ensure that the legal owner is entitled to the benefits flowing from the exploitation of the IP. The alignment of legal and economic ownership is analysed with a focus on the performance of the so-called "DEMPE" functions, which refers to the "Development, Enhancement, Maintenance, Protection and Exploitation" of the IP. A functional analysis is required to be undertaken in this regard.
A functional analysis is factual in nature and takes place against the background of which role player acts as the central entrepreneur in the business, carries the financial and legal risk associated with the IP and is ultimately responsible for the value creation.
There are several complex tax, IP law and exchange control considerations to be kept in mind when considering the structuring of IP assets.
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.