The difference between the present “source” regime in South Africa from the “residence” basis elsewhere is not all that substantial. CFC rules were not needed when exchange control was very strict. Now South Africa is following Australia, France, the United States, the United Kingdom and other countries. The Katz Commission dealt specifically with the issue. The legislation was passed in 1997 introducing new sections 9C and 9D to the Income Tax Act. “Passive Income” is defined to include annuities, interest, rentals and royalties. It is deemed to have a South African source, though there is an exception for business-related income, and pre-immigration sources may be grandfathered for three years.
A CFE is a person which is not a natural person, effectively managed outside South Africa, in which South African residents have a 50% or greater participation. Its income is deemed to be that of the participators. A gift to a foreign entity causes its income to be attributed to the donor.
There are exceptions in favour of cases where the foreign tax burden is 85% or more of the equivalent S.A. tax, in favour of permanent establishments, and in favour of immigrants (for a three year period). Credit is given for foreign tax.
A number of future developments may be expected Revenue interpretations, further legislation, adjustments for holding companies and headquarter companies. The concepts of “control”, and “substantive business enterprise” will need to be refined. Legislation is expected confirming the favoured status of the international holding company or headquarter company.
The legislation appears on the whole essential to the ultimate abolition of exchange control, but a number of issues remain to be addressed.
After-tax return is the basis for evaluating a return. It is important to encourage foreign investment, notably in tourism. Exchange control is a most important consideration.
In the field of indirect investment, South Africa is an interesting emerging market. Bonds show significant returns. There is no capital gains tax, but disposals within five years are regarded as trading. Unit trusts are commonly used and are effectively tax transparent. There is a small (0.25%) securities transfer tax.
There is no restriction on foreigners buying land. Not more than half the purchase price may be borrowed. The property is subject to estate duty.
Foreign investment is facilitated by the development of Industrial Development Zones, and a permitted debt/equity ratio of 3:1. There are exchange control restrictions on local borrowing.
The general rate of corporation tax is 35%. There is a 12.5% tax (“STC”) on distribution. There is no group tax system. There are the usual provisions for carry-forward losses, expenses, depreciation and so on. STC is a tax on the company and not on the shareholders, but new tax treaties are allowing credit for it (and in practice the Netherlands and UK authorities give credit for it).
South African residents may have credit for foreign taxes paid on taxable income. A VAT regime is in force. Royalties paid to non-residents require government approval; they suffer a withholding tax of 12%. There is a donation tax applicable to individuals.
Some incentives are available to foreign investments. There is a tax holiday scheme of limited duration and subject to stringent conditions. There is a system of government grants to cover costs of shipping machinery and equipment. There are schemes for export marketing and export credit. There is, however, a very significant tax cost on seconding foreign specialist staff to a South African enterprise.
Outward investment is strictly limited by exchange control and when permitted strictly controlled.
There is a general anti-avoidance provision in the tax legislation, as well as a number of specific ones.
Many of the Katz Commissions recommendations are controversial notably those on incentives.
The criteria for taxability in South Africa are source and residence, and the SA Courts appear to consider that an individual can only be “ordinarily” resident in one jurisdiction at a time. Measures against tax avoidance tend to follow some 10 or 15 years after the comparable provisions in UK or Australian legislation. The legislation is archaic and confusing. There have been extensive changes in the tax department and the judiciary, in line with recent political changes; “schemes” are unpopular with the courts; rulings are hard to obtain.
Business profits and service fees are taxed only if they have a South African source ”source” being where a business is carried on or sales made. Dividends suffer STC but are not taxed in the hands of the shareholder. Non-residents suffer no tax on interest. There is no tax on capital gains. But investment income (apart from local dividends) is taxable on a world-wide basis in the hands of SA residents only and rates are of the order of 40%.
The themes of tax planning are
foreign business profits if possible, protected by a tax treaty
investment in non-CFE
investment in SA equity and
split service contracts.
Companies can re-domicile in South Africa; an offshore company can “clone” itself in South Africa; a business can be operated in South Africa as a branch; intellectual property or equipment can be sold (at a high price) to a SA company. Interest may be deductible in South Africa without being taxable in the hands of the non-resident lender (if the interest is not connected to a business in South Africa). If the lender is resident in a country that also operates a source-based tax system, as in Hong Kong, the interest will go tax-free. The 3:1 debt/equity ratio is negotiable. Management fees or royalties charged to a South African business will be taxable in South Africa unless provided from offshore.
The Controlled Foreign Entity mechanism treats the investment income of the CFE as that of the South African residents who control it. This rule may be circumvented by placing investments in a personal insurance policy, by using a company and trust structure or by investing through a 50-50 joint venture. For the moment at least the 85% rule makes Malta useable as the base for investment into South Africa.
The Commission has been concerned with tax reform a concern experienced in most countries, both developed and developing, from the 1970s. Of particular concern has been the need to democratise the tax system, to make tax a legitimate instrument of government and of the constitution. The Commission foresaw that political change would bring many millions into the economic community.
Time was pressing. The first report was prepared in 4 months, and appeared in November 1994. The need to be immediate and relevant prevented a more leisurely and holistic approach, but guidelines could be given. The fundamental precept was to provide broadly-based low-rate high-yield taxes, both direct and indirect.
The tax system is required to be beneficial to the economy but nevertheless clear, fair and balanced, simple and certain, and internationally competitive.
The Commission has issued seven interim reports. The first report dealt with general principles, the second with transfer pricing and so on. Three more interim and a final report are awaited. Reduced rates of direct taxes are fundamental to the reforms, to be recouped by economic growth, the broadening of the tax base, better administration and indirect taxes. The Commission also evaluated incentives; it recommended incentives on the expenditure side. Almost 40% of the first report dealt with tax administration: restructuring was required, emphasising autonomy and efficiency.
The Commission recommended a tax amnesty against much advice, especially from abroad. It took evidence from foreign firms and considered the 1992 report of the World Bank; it concluded that non-tax factors were predominant in evaluating an investment project and incentives were of little importance. At the request of the Reserve Bank, the Commission considered debt/equity ratios in the context of exchange control liberalisation. In the same context, the Commission recommended a modification of the territorial basis but not its total abolition: active income remains on the source basis, passive income is on a residence basis.
The Handbook contains the following articles:
International Joint Ventures
A Base for Investment Elsewhere in Africa
Exchange of Information within the EU
Judging the Judges: the Impact of the Constitutional Court on Business in South Africa
South Africa: The Netherlands of Africa
International Royalty Planning
Tax Aspects of Cross-border Hedging Transactions
Recent Amendments to the Exchange Control Regulations in South Africa and their Implications for Income Tax and Cross-Border Trade and Investment
Tax Aspects of Cross-Border Asset Financing
In some limited, but interesting, circumstances the United Kingdom functions as an offshore jurisdiction – as a “stepping stone” for royalties, as a location of a holding company, as a base for trusts (providing a “remittance basis” for income and freedom from capital gains tax) and as a jurisdiction for “cosmetic” vehicles notably the agency company and the limited partnership.
Transfer pricing was in the past widely used by multi-nationals to reduce taxable profits, overcome exchange control restrictions or avoid customs duties. The anti-avoidance provisions were difficult to apply.
In 1995, the Katz Commission recommended the adoption of the UK rules and adherence to the OECD guidelines. Section 31 applies the arms length principle. Strangely, the rule for determining residence is expressed to be management or control evidently intended to include application to branches.
The effect of applying the transfer pricing rules may be to decrease deductions or increase profits; it may also involve STC or penalties. There are quite onerous disclosure requirements. The burden of proof is on the taxpayer to displace any adjustment made by the Commissioner. Rulings are available.
The taxpayer needs to make a contemporary study of his pricing practice in relation to other comparable transactions. It is wise to retain documentation of such study.
The 3:1 debt/equity ratio is simply a guideline. Higher ratios may be argued for, but this is becoming more difficult.
Tax planning in this area may include transfer of risks and functions offshore. A re-organisation must have a purpose other than a merely fiscal one.
The purpose of a treaty is to encourage international trade. It clarifies which state has the taxing right on particular kinds of income; it has provisions to avoid double taxation and to prevent fiscal evasion. Definitions are broadly similar, though not identical; an undefined term takes its meaning in the tax system in question. Each Article in the OECD model has an extensive commentary. Provision is made for transfer pricing and exchange of information.
Tax havens and countries with a source basis (Hong Kong) have no treaties. But “treaty havens” do Cyprus, Malta, Mauritius. And most treaties are between high-tax countries. They do not cover indirect taxes.
“Residents” can benefit from a treaty: the expression is defined, and not always in the same way (see e.g. the Australia/UK treaty and the Kingrup case). Mere liability to tax in one country does not exclude tax in another: the concept of “residence” serves to avoid double taxation.
A “permanent establishment” is defined. It does not extend to a buying office or to a general agent acting in the ordinary course of his business. In the absence of a permanent establishment, business profits are generally taxed only in the country of residence.
It has to be remembered that treaties do not create tax liabilities: in many instances, the treaty rate is greater than the domestic rate (if any).
Sometimes the dividend, interest and royalties require the recipient to have a “beneficial interest” in the income. “Royalties” are defined; sometimes with surprising results.
In the Lamesa case, the Australian court held that the capital gains tax did not apply though a company with several layers of subsidiaries, the last of which held real property in Australia.
Article 17 applies to artistes and sportsmen. They cannot shelter behind a loan-out company. The Article applies only to their income as such.
Article 24 is the non-discriminatory Article. It applies to nationals, as opposed to residents. It is little understood, and needs to be invoked more often.
The 1962 Swiss Federal Decree was intended to prevent treaty shopping through Switzerland. Many treaty provisions and domestic legislation have similar effect.
Companies in Mauritius are presently investing abroad. When the offshore regime began in 1992, there were only 4 treaties. The original regime with tax exempt companies and companies paying a “voluntary” tax has been abandoned and more treaties entered into.
The Mauritius/India treaty was of great importance, but India extended similar privileges to other jurisdictions and ended the favoured treatment of dividends. But it is still useful for capital gains and interest.
There are now 19 treaties, and 12 more in the pipeline. Some are specially attractive. And Mauritius has suspended its exchange control. It offers the company, the trust and the société. They can be incorporated fairly quickly. The sociétés deserve to be more used. Mauritius offshore entities pay tax at 15% but tax credits are so generous that the tax rate does not in practice exceed 1.5%: the 1996 Regulations provide for credit for actual tax suffered, a further credit for underlying tax (through any number of subsidiaries), a unilateral tax sparing credit, and a fallback 90% credit for notional tax paid.
Tax treaties follow the OECD model. Any “person” liable to tax as a resident may take advantage of them including companies, sociétés, trusts, unit trusts. A société is taxable only if it gives notice of its wish to do so. All the treaties have a capital gains tax clause, and Mauritius does not have a tax on capital gains. They also have an “other income” clause: it has been applied in India to a distribution from a unit trust.
The Mauritius treaty with South Africa is the only South African treaty with a tax-sparing clause. There is also a tax sparing clause in the Mauritius treaty with Singapore.
The treaties with Europe have various advantages. Among those with Asian countries, the provisions for interest in the Singapore treaty and those for dividends in the Indonesia treaty deserve special mention. The treaties with countries in Southern Africa are specially attractive.