Double tax danger for foreign companies held by foreign trusts or foundations

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The much-anticipated Draft Taxation Laws Amendment Bill came out on 19 July 2017. 

From an international tax perspective, issues of interest include the proposed changes and additions to the Controlled Foreign Company (CFC) rules. Of concern is the possibility that double tax might be payable in certain cases.

Rules as they stand

South African residents are subject to tax on their worldwide income.

Consequently, to curb tax avoidance, the Income Tax Act contains CFC rules generally aimed at preventing South African residents from shifting “tainted” forms of taxable income offshore by investing in CFCs.

A CFC is a foreign company where one or more South African residents directly or indirectly hold or exercise more than 50% of the participation or voting rights.  Tainted forms of income include passive income such as interest and certain royalties.  It also includes income not attributable to a foreign business establishment of the CFC (meaning a fixed place of business outside South Africa that is properly staffed and equipped).

Thus, the CFC rules make provision for the net income of a CFC to be attributed and included in the income of its South African resident shareholders on a pro rata basis.

New proposal

In his Budget speech on 22 February 2017, the Minister of Finance announced countermeasures for the treatment of foreign companies held by interposed trusts or foundations.

As anticipated, the draft proposals provide for these foreign companies to be potentially included as CFCs for tax purposes.

Another extension to the definition of CFC is any foreign company whose financial results are included for accounting purposes in the consolidated financial statements of a South African company.

Startling new proposal

The startling proposal is the insertion of a new section 25BC to the Act.

This will target for income tax any distribution received by a resident (other than a company) from certain foreign trusts or foundations.  This insertion, aimed at individuals and trusts, would apply where the foreign trust or foundation holds a “participation right” in a foreign company. In other words, if the trust or foundation had been South African tax resident, the foreign company would have been a CFC.

In a sense, then, this proposal treats the foreign company held by the foreign trust or foundation as a quasi CFC.

However, the proposal does not take into account whether or not the relevant foreign company already is an “actual” CFC in terms of the extended scope of the CFC rules.

If it is, South African tax may already have been paid on the relevant amounts.  Also, if one had been dealing with an “actual” CFC, the foreign company might have been exempt from South African tax.

For example, it could be exempt because of the so-called “highly taxed” exclusion, or “foreign business establishment” exclusion in the CFC rules.  This proposal therefore treats the quasi CFC more unfavourably than an “actual” CFC.

Excessive taxes

Another problem with the proposed section 25BC is that it does not address whether or not the income from the foreign trust or foundation actually arose from the underlying quasi CFC.

If the trust has various investments, this could result in excessive taxes, in that any and all distributions from the foreign trust or foundation would be subject to South African income tax.

Surprising insertion

The proposal providing for foreign companies held through interposed trusts or foundations to be potentially included as “controlled foreign companies” was anticipated, and perhaps is even fair from a fiscal point of view.

The surprising insertion of section 25BC still requires more consideration, however.  This insertion was not anticipated following Budget 2017, and poses numerous, clearly apparent possibilities for double taxation or taxation that is inconsistent with the South African tax framework as a whole.


Noxolo Ntombela | Senior Associate in Tax Team | Bowmans | noxolo.ntombela@bowmanslaw.com | www.bowmanslaw.com |


 

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