South Africa
Anne Bennett
Webber Wentzel
South Africa
South Africa has launched a number of initiatives in recent years aimed at making its tax system more attractive to foreign investors. Additional moves in this direction are envisaged in terms of proposed tax amendments, which were released for comment in June 2011. While this is good news, it is unfortunately not the whole picture, reports Anne Bennett of Webber Wentzel.
The policy of encouraging foreign investors to South Africa through certain tax reforms has been somewhat undermined by the simultaneous proposed enactment of a number of other tax measures likely to have the opposite effect.
Headquarter companies
On the positive side, this year's tax proposals include a number of suggested changes designed to enhance the attractiveness of the headquarter regime which came into force on January 1 2011.
Aimed at encouraging foreign investors to use South African intermediary holding companies as gateways into Africa, the headquarter company regime "switches off" South Africa's controlled foreign company (CFC), transfer pricing and thin capitalisation rules for qualifying companies, as well as allowing cross-border dividends and interest paid by these companies to be free of any withholding taxes. Headquarter companies are, however, liable to full South African corporate tax, at a rate of 28%, on income such as interest and management fees. Because they are South African tax resident, they have access to South Africa's already good and rapidly growing network of tax treaties.
A number of proposed measures in the 2011 draft Taxation Laws Amendment Bill are aimed at assisting South African companies that hold and manage foreign subsidiaries. These benefits will apply to all South African companies, and not just to headquarter companies.
Foreign dividends received by, or accrued to, any South African company are tax exempt if the shareholder holds at least 20% of the equity shares and voting rights in the company paying the dividend. The 2011 proposals envisage a drop in this qualifying percentage from 20% to 10%. Where foreign dividends do not qualify for tax exemption, it is proposed that the rate of tax applicable to them will be reduced to 10% for both companies and individuals.
Similarly, the 20% holding requirement, which applies in the context of tax exemption for disposals of foreign shares held as capital assets, is also to be dropped to 10%. However, it has also been proposed that the participation exemption will no longer apply where foreign companies are sold to companies that qualify as CFCs under South African tax law.
This year's proposed amendments also include changes designed to codify principles relating to the source of income that previously had to be gleaned from case law. For example, interest will be considered to be sourced in South Africa if it is attributable to any amount incurred by a person that is South African tax resident or if it is received or accrued in respect of the domestic use of any funds or credit obtained under an interest-bearing arrangement. These source rules will be relevant for the determination of when South Africa will grant tax credits for foreign taxes suffered on the income concerned. As a general rule, no foreign tax credits are available for South African source income, though, under certain circumstances, a tax deduction may be granted.
A notable exception to the general rule mentioned above is proposed in relation to management fees and other service fees derived by a South African tax resident from services rendered in South Africa. Should such fees suffer foreign withholding tax, this tax will be creditable against the South African tax due on the income concerned. The credit will be allowed even if, under the provisions of a relevant tax treaty, the foreign country is arguably not entitled to levy the withholding tax. This is an extremely welcome development for South African companies providing services to entities located in, for example, other African countries that impose high withholding taxes on cross border technical, management or other fees.
It is to be hoped that these new measures will increase the level of interest in South African headquarter companies. Though it is still early days, to date there has been not been a significant level of interest in the new regime. In part, this has been attributed to the relative inflexibility of the regime and, in particular, the tests relating to shareholders, assets and income that need to be satisfied every year. Each shareholder in a headquarter company must hold (on its own or together with connected persons) at least 20% of the equity shares and voting rights in the company. Therefore a listed company cannot be a headquarter company. In addition, at least 80% of the headquarter company's assets and income must meet specified criteria.
A pre-approvals process was mooted as part of the 2011 tax proposals, but it is not clear if this will in fact go ahead. Such a process may deter interested parties unless the pre-approval process is coupled with some guarantee of fiscal stability, for example an undertaking that the regime applicable to the headquarter company will remain unchanged for a specified period and will not, under any circumstances, be altered with retrospective effect. This is an issue of concern because, though the regime is new, fundamental changes are already being made to it and it has been proposed that some of these will be enacted with retrospective effect to January 1 2011.
Regional investment funds
Measures were introduced last year designed to attract foreign investors, and in particular foreign private equity funds, to South Africa. Foreign limited partners in a partnership that has a South African general partner were placed in the same position in regard to South African tax as if they had invested directly, rather than through a partnership. They are not pulled into the South African tax net simply because of the activities of the South African general partner, provided that such activities are focused on investing in shares or otherwise relate to financial instruments. Additional changes have been proposed this year to further reinforce this protection.
Unfortunately, this welcoming approach was undermined by a proposal that can almost certainly be classified as the most controversial in this year's package – namely the indication of Government's intention to suspend the rules allowing for assets to be transferred on a tax-neutral basis within a South African group of companies. Treasury's reason for the proposed suspension was to buy time to investigate certain abusive transactions identified by Treasury and by the South African Revenue Service (SARS) which purportedly have made use of the restructuring provisions concerned. Following a storm of protest and intensive lobbying, Treasury has relaxed its stance on this slightly. At the time of writing, it is proposed that any intra-group reorganisation that wishes to benefit from tax neutrality, and which results in the creation of debt, will have to be pre-approved before the interest on the debt can qualify for deduction.
The reason that this development is particularly unwelcome to foreign private equity investors is that South African tax law does not provide for any general system of tax group relief or fiscal consolidation. It also does not permit a tax deduction for funds borrowed to buy shares. Consequently, in the context of share acquisitions, investors borrowing to purchase shares have sometimes resorted to intra-group sales of assets or businesses to introduce additional gearing (and related tax deductible interest expense). Because SARS and Treasury have known about this practice for years, and seemingly have been happy with it, the steps they are now taking to curtail it with immediate effect have taken the market by surprise.
This is not the only area of uncertainty in regard to the tax deductibility of interest expense. South Africa is tightening up its thin capitalisation rules from October 2011. A practice note giving guidance on exactly how the new rules will work has been promised since the beginning of the year, but has not yet been released. In addition, this year's tax proposals contain further changes to the proposed new rules, designed to take effect in tax years beginning on or after April 1 2012.
Mixed messages
The measures proposed to strengthen the tax benefits offered by South Africa as a holding company location are indicative of the Government's eagerness to attract foreign investment. It is understandable that any government would want to take steps to address instances of tax arbitrage and abuse. That said, the challenge faced by the South African Treasury is to avoid sending a mixed message by one the one hand encouraging foreign investors through regimes such as the headquarter company regime, while at the same time deterring them by creating ripples of fiscal uncertainty in areas of direct relevance to foreign investment such as the deductibility of interest expense on foreign debt, coupled with practices such as the sudden introduction of fundamental and restrictive tax changes with no advance warning or consultation.
Anne Bennett (anne.bennett@webberwentzel.com)
Partner at Webber Wentzel