Sophisticated tax loopholes to be closed

Ernst & Young

17 February 2010

Also: possible thin- Capitalisation loopholes being closed

Corporate Reorganisations

Default elections involving intra-group rollovers
Taxpayers generally prefer rollover relief when engaged in various reorganisations including intra-group transactions. Hence corporate relief rules contained in section 41 - 47 of the Income Tax Act No. 58 of 1962 (Income Tax Act) apply automatically provided certain conditions are met and parties involved in the relevant transaction do not elect otherwise. However, taxpayers engaged in the intra-group transfers where items are regularly disposed of such as trading stock prefer to fall outside the corporate relief rules due to tracing problems. It is therefore proposed that a different methodology be provided for this class of intra-group transfers to simplify compliance.

Share-for share reorganisations of listed companies
Unlisted and listed share-for -share transactions qualify for tax relief under section 42 of the Income Tax Act provided certain conditions are met. For instance, the acquiring company is required to determine whether the target shareholder holds the target shares as trading stock or as a capital asset. As it is impractical to establish this from a listed share context, it is proposed that conditions of this nature be waived in the case of listed share-for-share transactions; to the extent the waiver does not create opportunities for tax avoidance.

Reorganisations of bad debts
Corporate relief rules are designed so that the acquiring company generally "steps into the shoes" of the party transferring qualifying assets or in other words, the assets are acquired on a tax neutral basis. As a result, creditors cannot claim a bad debt deduction for debts if the creditor claim is acquired in a reorganisation with the default occurring subsequently. It is proposed that corporate relief rules be modified so that bad debt deductions can be claimed in these circumstances, provided this does not give rise to double losses.

Possible Thin- Capitalisation loopholes being closed
South Africa has thin capitalisation rules for income tax purposes which apply to certain related parties. South Africa's thin capitalisation legislation currently applies to non resident entities for South African tax purposes which have granted financial assistance directly or indirectly to a "connected person" which is South African tax resident. Where the Commissioner is satisfied that the financial assistance granted by investor to the resident is excessive in relation to the fixed capital of the resident, any interest relating to the excessive portion of the financial assistance will be disallowed as a deduction in the hands of the resident and deemed to be a dividend subject to secondary tax on companies at 10%. Currently, a debt : equity ratio of 3:1 is permitted.

The Budget Review for 2010 indicates that South Africa's thin capitalisation legislation is to be extended and will apply to foreign owned South African branches as the current rules appear not to apply to non resident entities with unincorporated South African branch operations. This allows foreign investors to form a foreign company with excessive amounts of debt whilst remaining free from the thin capitalisation rules, even though the main operations of the foreign company are contained within a South African branch. It is considered that interest on this excessive debt may adversely affect the tax base to the same extent as excessive debt in a foreign-owned resident company. This apparent loophole will now be closed.

Closure of sophisticated tax loopholes
In line with the Government's goal of achieving lower rates by broadening the tax base, the Minister of Finance has announced from the Budget Review that the one area of concern is the use of sophisticated tax avoidance schemes. He mentions that the scale of these schemes often presents substantial loss to the fiscus even when considered in isolation. As a result the following are some of the schemes have been identified for closure:

· Cross-border mismatches

There is a proposal to amend the Income Tax Act in order to clarify the tax treatment of unacceptable schemes associated with tax treaties and inappropriate use of foreign tax credits. No specific detail was provided on which schemes will be regarded as unacceptable.

· "Protected cell" companies

A controlled foreign company ("CFC") is a foreign company where a more than 50% interest (participation or voting rights) is held directly or indirectly by South African residents. However, some taxpayers bypass this CFC regime through the use of "protected cell" companies. A statutory cell company effectively operates as a multiple limited liability entity, with each cell protected against the other. Investors most often will have full control over the cell, but fail to satisfy the CFC ownership requirements in the foreign entity overall. It is proposed to treat each cell as a deemed separate company with the CFC ownership requirements measured separately.

· Participation preference and guaranteed shares

Certain taxpayers remit funds from South Africa through deductible payments (e.g. interest) and bring back same funds to South Africa tax free through foreign dividends eligible for the participation exemption. It is proposed to deny the participation exemption for preference share dividends, guaranteed dividends and any dividends derived directly or indirectly from South Africa.

· Restricting the cross- border interest exemption

An exemption exists for local interest payments to any foreign legal person, unless the payment is made to a local branch of a foreign legal person. Bar South Africa's thin capitalisation and transfer pricing provisions, a foreign investor may invest in South Africa via debt with little restriction. There is a proposal to restrict the exemption to contain the leakage. Presumably, an interest withholding tax is contemplated. However, the proposed changes will not affect investment in South African bonds, unit trusts, bank deposits or other financial instruments of a similar nature.

· Transfer pricing

The Minister has proposed to provide a uniform set of transfer pricing rules to deal with artificial pricing or the misallocation of prices within the various components of a single transaction. These rules will align the treatment on both onshore and offshore transaction. The proposed changes will ensure that an arm's length principle is achieved.