(OVER)TAXING LOOP STRUCTURES IN SOUTH AFRICA
In his February 2020 budget speech, the Minister of Finance announced structural reforms to the existing exchange control regime in an effort to relax it. One of the items to be addressed was the rules relating to ‘loop structures’.
A loop structure arises where a South African exchange control resident (individual or company) has an interest in a foreign structure and that foreign structure directly or indirectly owns assets in the Common Monetary Area (CMA), consisting of South Africa, Eswatini, Lesotho and Namibia.
The law currently prescribes that these structures are only permitted in very limited circumstances, typically where South African exchange control residents in aggregate do not own more than 40% of the shares in the foreign company, regardless of the extent of ownership held by the foreign company in the South African assets, including resident companies.
The intention is to abolish the exchange control prohibition on loop structures. However, this will only be possible once National Treasury and the South African Revenue Service (SARS) are both satisfied that adequate measures have been introduced into the South African Income Tax Act (Act) to address any concerns about potential tax leakage arising from the removal of this prohibition.
The draft Taxation Laws Amendment Bill (Draft TLAB) released for comment on 1 August contains these proposed tax measures.
It is very concerning that some of the proposed changes do not only address perceived tax leakage, but add a substantial additional tax burden, thus penalising loop structures especially in the controlled foreign company (CFC) context.
It appears that this would apply even to current permissible loop structures in those rare instances were approval was granted for residents to own more than 50% of the shares in an offshore entity which owns South African assets.
Accordingly, while loop structures will become permissible from an exchange control perspective, some of the tax proposals are so punitive that one can only speculate as to whether South Africans will in fact benefit from the proposed loop structure relaxation.
Important proposed changes are outlined below.
- CFC legislation (section 9D)
Where the CFC rules apply, a notional calculation is performed to determine an amount equal to a pro rata share of the CFC’s net income, which is broadly speaking, the taxable income of the CFC as calculated under the Act.
This amount must be included in the income of resident shareholders of the CFC. Currently, when preparing a CFC calculation for a foreign company that owns South African shares, the standard income tax exemption applicable to South African dividends applies. Accordingly, the dividend would be exempt from income tax for purpose of the CFC calculation.
The dividend declared by the South African company to the CFC would already have been subject to dividend withholding tax at a rate of 20%, unless the rate was reduced in terms of an applicable double tax agreement (DTA) to, for example, 5%.
South African corporate shareholders who have invested via CFCs are thus not in as favourable a position as they would have been had they held the shares in the South African company directly, as there is tax leakage in the form of dividend withholding tax.
However, in terms of the Draft TLAB the income tax exemption for dividends would not apply to CFCs. Instead, approximately 71% of these dividends would be included in the net income calculation and be taxed at the rate applicable to the shareholder of the CFC.
For a resident corporate shareholder being taxed at 28%, this results in a 20% effective tax rate on South African dividends received by a CFC. In addition, the inclusion rate is not adjusted where the resident shareholder is an individual, which means that South African dividends could be taxed at a rate of up to 32.14% where the resident shareholder of the CFC is an individual.
It is important to highlight that this calculation will only affect the notional amount calculated for CFC purposes. The tax cost will therefore not be reduced under any applicable DTA. The dividends are likely to have already been subject to dividends tax at a rate of at least 5% when distributed by the South African company to the CFC.
The Draft TLAB does not contain any proposal to provide an exemption from dividends tax where dividends are declared by a South African company to a CFC. Also, while the CFC rules permit a section 6quat credit for foreign withholding taxes, no credit is available in respect of South African withholding taxes. This means that South African dividends received by a CFC will effectively be taxed at a rate of between 25% and 40% for corporate shareholders in a CFC and a rate of up to 54.14% for individual shareholders.
The CFC rules also currently provide that where the CFC has a taxable capital gain, the inclusion rate will be 40% where the resident shareholder is a natural person. The Draft TLAB proposes for this provision to be deleted, with the effect that natural persons who are shareholders in a CFC will pay capital gains tax at a rate of up to 36% on any capital gains included in the CFC net income calculation.
According to the Explanatory Memorandum on the Draft TLAB, the proposed amendment is intended to ensure that CFC structures are not used as tax planning opportunities for South African individuals.
However, the application of the proposed amendment is much wider. It is important for the scope of the proposed amendment to be narrowed to ensure that it does not unduly penalise resident shareholders in the CFC.
- Shareholders in companies ceasing to be South African tax resident
It is proposed that section 9H be amended to deal with shareholders of companies that cease to be South African tax resident. The provision suggests that where a company ceases to be a South African resident, the holder of the company’s shares must be treated as having disposed of those shares at market value.
However, a company which ceases to be South African resident is already - in terms of section 9H - deemed to have disposed of its assets, and also to have declared a dividend to its shareholders.
The proposed amendment of section 9H is very concerning as it does not seem to take the deemed disposal of assets by the company itself into account, nor the deemed distribution of a dividend.
It is not clear why it is considered necessary for the South African resident shareholder, who will remain subject to South African tax, to trigger a tax liability at this time, other than to penalise and discourage tax migrations.
Moreover, the proposed exchange control relaxations have made it very clear that companies will not be permitted to move their tax residence under the relaxation rules unless there are very exceptional circumstances, so the argument that these rules are needed to address the proposed exchange control changes is flawed.
- Movement of shares from the South African register to a foreign register (proposed introduction of section 9K)
The Draft TLAB also proposes the introduction of a section that deems shareholders to dispose of their listed shares at market value, where such shares are transferred from a South African exchange to a foreign exchange.
The Explanatory Memorandum to the Draft TLAB explains that currently, exchange control approval is required before a resident is permitted to migrate a listed share to a foreign exchange. It is now proposed that the ‘export’ of a share to a foreign exchange will trigger a deemed disposal and thus potentially, a tax liability.
This proposed amendment seems overly burdensome and it is not clear why a tax trigger on the export of the share is deemed necessary. It is likely to impact on the majority of South Africa tax residents who continue to own these shares, but through a different exchange.
The fact that the share is exported does not mean that it will leave the South African tax net. The only potential tax loss is in respect of dividends tax and securities transfer tax in those instances where a foreign company’s shares are moved from a South African exchange to a foreign exchange.
There is thus no reason to provide for a deemed disposal similar to those instances where a taxpayer ceases to be resident, other than to penalise and thus discourage the export of shares.
- Participation exemption (paragraph 64B of the Eighth Schedule to the Act)
It is proposed that the exemptions contained in paragraph 64B of the Eighth Schedule to the Act should not apply to the sale of a share in a CFC, to the extent that the value of the assets of that CFC is derived from assets directly or indirectly located, issued or registered in South Africa.
From a practical perspective, it would be preferable to include a de minimis rule, for example, that this provision would apply only where the South African assets constitute 10% or more of the market value of the CFC’s assets, and then, as is proposed, to apply only to the extent of the South African assets.