SOUTH AFRICAN RESIDENCE TAXATION
Submissions to the Parliamentary Portfolio Committee on Finance
Marius van Blerck - Chairman: Scientific Committee
South African Fiscal Association
6 October 2000
This document sets out some submissions regarding the draft legislation on the expansion of the current system of taxing on a source basis (extended by deemed source provisions) to that of taxing residents on a worldwide basis, as reflected in the draft Revenue Laws Amendment Bill, 2000, dated 22 September 2000. These submissions are based on comments made by members of the South African Fiscal Association, a branch of the International Fiscal Association.
This document does not re-visit the overall question as to whether South Africa should be enacting measures of this nature. Suffice it to say that the writer agrees with the views expressed by the Katz Commission in 1997 in its 5th Interim Report, where the negative effects of a move from a source-based tax system are clearly set out. It would have been far better to have extended the deemed source provisions in a focused manner, to combat any perceived shortcomings in the current system, than to have followed the path now before us.
It should be stated at the outset that SARS should be commended on the process used to draft this legislation, as every effort was made to obtain feedback from a wide range of commentators, and the comments received were seriously evaluated in the course of the evolution of the series of drafts which have culminated in the draft before this committee.
Notwithstanding this process, there are some remaining unresolved issues, and we trust that the process of finalising the draft, these will be taken into account. These final submissions appear in Part A below.
Finally, it should be noted that there are some continuing problems associated with the related tax legislation dealing with foreign dividends, as promulgated earlier this year. Since this legislation flows into the draft measures on residence taxation, and will be perpetuated by the latter, it is appropriate to repeat these concerns, which were first brought to this committee’s attention in the writer’s memorandum of 26 May 2000. These concerns are set out in Part B below.
Part A. Residence-based taxation
A.1 Offshore holding companies
It is understood that it is intended that the new legislation should expressly cater for the re-deployment of offshore operating income (that is, income other than passive income) without SA tax consequence, by allowing a SA multinational group to re-invest such income offshore without it falling within the SA tax net. This allows such groups to preserve the value of offshore tax concessions on operating income, at least as long as the funds are invested actively offshore. This is a major advance on the existing foreign dividend legislation. The particular provision dealing with this matter in the draft bill is section 9D (9) (f).
Given the intention of this provision, it is inadequate in that it only deals with dividends flowing from one corporate Controlled Foreign Entity (CFE) to another, and holding companies frequently have major operating investments in companies that will not necessarily be CFE's.
Suggested solution: The exemption in the proposed section 9D (9) (f) (and possibly a corresponding exemption in section 9E) should deal with dividends flowing from any "substantial holding". This term could be defined to correspond with the similar concept in most Double Tax Agreements, where they require a minimum shareholding before a lower rate of dividend withholding tax is granted. This minimum tends to be between 10% and 25%, and in the interests of conservatism, perhaps the higher limit of 25% should be used.
A.2 Offshore costs
The draft provisions contain measures which limit the deductibility of foreign costs to foreign income. This means that, despite net foreign profits being taxable, net foreign losses may not be offset against SA taxable income. This is an anomaly not commonly found in other worldwide tax systems, but given the objective of the Department of Finance that the new system should not reduce the SA tax base, it is both understandable and acceptable. What is more difficult to accept, however, is that this restriction is not imposed in aggregate, but on a company-by-company basis, in that a loss from one foreign entity that is otherwise deductible may not be offset against the taxable profits of another. This may, for example, result in SA tax being payable on offshore "profits" by a group, even though the group's foreign operations are in an aggregate loss position.
Suggested solution: The measures which limit the deductibility of foreign costs to foreign income should apply only to the aggregate position, and should not apply on a company-by-company basis.
A.3 Sales companies
For the exemption in section 9D (9) (b), proviso (ii) (bb) (C) to apply, sales (to independent third parties) must involve delivery of the product within the country in which the selling company is resident. This ignores the reality of foreign sales corporations, which are set up to market products to the international market, and who, of necessity, deal with buyers in a multitude of countries. What the exemption implies is that if a foreign sales corporation were to be located in every single country in which there was a market, the transactions would be exempt, but that centralisation of the sales resources would result in the forfeiture of this exemption.
Suggested solution: The requirement that delivery of the product take place within the country in which the selling company is resident should be scrapped.
A.4 Temporary absences
An exemption from SA tax is provided for individuals temporarily absent from SA, in section 10 (1) (o). However, for the exemption to apply, the individual must be absent from South Africa for a continuous period of at least 183 days during the year of assessment. The need for a yardstick to avoid this concession being abused is appreciated. However, the requirement that the absence period be continuous is problematic. There are numerous reasons why staff on offshore projects may need to return to SA for short periods. For example, senior staff may have to report back on progress, to obtain technical support and to arrange procurements in SA. The lack of good medical care in much of the rest of Africa dictates that hospitalisation often needs to take place in SA. Compassionate leave, when a family bereavement occurs, is another obvious factor.
Suggested solution: The requirement that the individual be absent from South Africa for a continuous period of at least 183 days during the year of assessment should be amended to refer instead to an aggregate period. If this is not acceptable, then there should be a proviso allowing for intervening presences in SA of, say, 14 days in aggregate.
A.5 Designated countries
Since the Foreign Dividend provisions became effective on 23 February this year, there was a delay until 1 September in announcing a list of such countries, and that initial list only contains 32 countries. In addition, there is the anomaly that, since 23 February, the related exemption has been far more stringent than in the new bill, by requiring a Double Tax Agreement to exist, in addition to classification as a designated country.
Suggested solution: The exemption for income from designated countries, as contained in the new bill, should be made retroactive to 23 February 2000, as have many of the other related amendments.
A.6 Tax credits and Secondary Tax on Companies (STC)
In contrast with the present position, the draft bill proposes denying the foreign tax credit in section 6 quat against STC. The reason for this is appreciated, namely, the added complexity of the task of tracking the use of these credits. However, it is clear that numerous anomalies can arise as a result of this change. First and foremost, it must be understood that SA has for years been insisting to foreign tax authorities that our STC is a corporate tax, and should be creditable against foreign tax payable by multinationals who invest into SA. This they have accepted, in some cases with reluctance, and our more recent Double Tax Agreements have put the matter beyond doubt. In contrast, the draft bill denies the offset of their corporate taxes against STC. This substantially undermines SA's previous position.
In addition, practical problems arise. As an illustration, consider a SA holding company with no asset other than investments in a country levying corporate tax at an effective rate of, say, 35%, but which is not on the "designated countries" list. (The relevance of this list is that a dividend from a listed country would not attract STC on onward distribution by the SA recipient). The holding company will pay no income tax (as the foreign tax credit will have exceeded the local tax rate). However, it will pay STC of 12,5% when this income is distributed, and will indefinitely carry forward a tax credit of 5%, which it will never use. The net effect is that South Africa has increased the effective tax rate on the earnings to 42,22%.
Suggested solution: The foreign tax credit should continue to apply against STC, at least until such time as the list of "designated countries" has been sufficiently expanded to substantially eliminate this potential anomaly.
A.7 Foreign pensions
It is noted that the draft legislation proposes a continued exemption of foreign pensions (including locally-paid pensions relating to foreign service) as a temporary measure, for three years, during which period the position will be reviewed. This approach is commendable, and it is trusted that this review will take full cognisance of the potentially disruptive affect of taxing such pensions for those who have already retired, as well as those who may be nearing retirement.
A.8 High net worth immigrants
South Africa, with its many attractions, is often seen as a country in which high net worth individuals from other countries wish to live in, whether through immigration or extended temporary stays. A fiscal attraction in the past was that we would only tax such individuals on a source basis. The move to a worldwide tax basis on residents now creates a substantial fiscal disincentive fur such individuals. Preliminary evidence indicates that the economic benefits created by these individuals is substantial, but the evidence is not yet conclusive.
Suggested solution: This aspect requires further research, but should special measures be introduced to accommodate the situation, these should at the very least (a) continue to fully tax local source income, and (b) impose a minimum flat rate tax on "deemed" foreign income.
Part B. Foreign dividend taxation
B.1 Past reserves
Problem: Most South African-based multinationals have undistributed foreign reserves in their foreign subsidiaries. These reserves have accumulated in terms of dispensations under our exchange control regulations.
In the circumstances, it is inequitable to subject such reserves to taxation on repatriation to South Africa, as they would not have been taxed if repatriated to the South African holding company on an annual basis (which would have occurred more commonly had there been no exchange control restrictions in South Africa).
Suggested solution: Reserves that accumulated in the period to February 23, 2000 should be able to be repatriated to South Africa at any time without a tax charge. This should be subject to an external audit certificate verifying the quantum of reserves at that date. This requires modification of the relevant exemption and timing provisions.
B.2 Capital gains
Problem: Where a foreign subsidiary of a South African multinational group sells a major foreign asset, and pays minimal foreign tax (international capital gains are often relatively lightly taxed, and are sometimes not taxed at all). The subsidiary is now unable to repatriate the past reserves to South Africa without first subjecting the international capital gain to tax in South Africa! Furthermore, the international capital gain will in fact be taxed under the company income tax system, and will suffer tax at an effective 37,78%, far higher than the planned rate on domestic capital gains!
Suggested solution: Where foreign dividends flow from reserves comprising capital gains, the tax rate on the relevant proportion of the foreign dividend should be restricted to the corresponding South African rate on domestic capital gains.
B.3 Tax incentives
Problem: The new system will negate the granting of tax incentives by foreign jurisdictions for operational investments, because operational income taxed at a "favourable" tax rate (of below 27%) will automatically be taxed at 30% when dividended to South Africa, and will also be subject to STC (bringing the total tax charge to 37,78%) when distributed onwards. Most other worldwide jurisdictions allow their multinationals to keep the benefit of such incentives through a variety of means, on the basis that there is no cost to their fisc, while they will ultimately benefit from this growth. The most common method is to allow foreign operational activities to reinvest operational earnings into further operational expansion without coming within their worldwide tax system, and this has been partially provided for in the new residence tax draft legislation (see A.1 above). Another method is to allow certain approved foreign tax incentives to qualify for unilateral (as distinct from tax treaty) "tax sparing", of which the best example is probably found in Germany.
Suggested solution: It is suggested that unilateral tax sparing provisions be introduced, particularly insofar as incentives offered by other developing countries are concerned. SADC countries should, of course, be the first priority. The advantage of unilateral tax sparing provisions is that the scope of relief will be defined in each case by the South African Revenue Services (SARS), on application by a taxpayer, or by a foreign government. Should SARS believe the incentive to be inappropriate or overly generous, it will simply not be approved. It is stressed that a unilateral tax sparing system of this nature is absolutely imperative to encourage investment in developing economies.
B.4. International Holding Companies and Headquarter Companies
Problem: The Katz Commission Report already referred to stated that:
The current source system facilitates the development of South Africa as a major location for domestic or foreign businesses to base holding companies, headquarters companies and finance companies for investment and trade into Africa, and in particular Southern Africa. Preserving and even extending that state of affairs will benefit the South African economy directly and help the country to acquit itself of its regional developmental responsibilities.
Later, the Report recommended that:
The current favourable regime for corporate headquarter and holding companies (which will be retained by the Commission's recommendations as to source), should be further enhanced:
- through appropriate exemptions regarding fee income to such companies, and
- through a statutory commitment that headquarter and holding companies established at the time of any change in legislation that affects the favourable status, will be protected by delayed implementation, or would be given a phase-in period in which to adjust.
These recommendations were accepted. However, not only were they not implemented, but a mere three years later the source system is to be abolished. This is a major blow to a small but growing sector of our economy.
Suggested solution: A special status for such companies should be introduced, provided that all of their substantive operations are conducted outside South Africa, and that the substantial majority (perhaps 80%) of their shareholders are non-residents. (The reason for not making this 100% is to enable them to make use of South African expertise through corporate joint ventures.) This tax status should include retaining the source basis, exempting them from tax on foreign dividend income and fees flowing from other countries, as well as from capital gains tax on foreign assets.