Foreign tax credits

Magda Snyckers

27 May 2009

What you can and can’t claim.

The South African Revenue Service (Sars) has recently issued Interpretation Note No. 18 which deals with the rebate or the deduction of foreign taxes as provided for in section 6quat of the Income Tax Act, Act 58 of 1962, as amended. This is a comprehensive Interpretation Note which sets out Sars's view of the scope, interpretation and application of section 6quat. Of particular interest are Sars's views regarding the interaction between section 6quat and double taxation agreements (DTAs). We summarise some of the points of interest below.

Generally speaking, section 6quat deals with the claiming of foreign taxes paid or proved to be payable by a taxpayer as a deduction from a taxpayer's South African tax liability (ie, the so-called tax rebate). It also provides for a deduction from taxable income so much of the foreign taxes which does not qualify for the rebate. The latter deduction is provided in section 6quat(1C) which was introduced into the Act in 2007. Foreign taxes which qualify for the rebate do not qualify for a deduction. Only the foreign taxes which do not qualify for the rebate may be eligible for a deduction in terms of section 6quat(1C).

In addition, a resident does not have a choice between the rebate and the deduction as relief from South African tax. The rebate would provide greater relief as the foreign tax is directly deducted from the actual South African tax as opposed to a deduction from income which merely reduces taxable income.

Section 6quat(1)(a) provides that the rebate may only be claimed in respect of income from a source derived outside the Republic which is not deemed to be from a source within the Republic. The concept "source" is not defined in the Act, but it is a well established concept based on case law. In addition, the Act contains provisions which provides for income to be deemed to be from a South African source (see section 9 of the Act).

The Interpretation Note deals with the term "source" in the context of section 6quat. It states that although there is no universal definition or understanding of the meaning of "source", in many instances the actual source of an amount is located in South Africa despite the fact that the money flows from a foreign country to South Africa for the ultimate benefit of a South African resident. Sars's view is that in these instances the foreign country will not have any taxing rights in respect of the amount. It does not provide any basis for this statement apart from stating that the source of income is not to be confused with the source from which the income is paid.

It goes on to state that this does not apply when a DTA between South Africa and a foreign country has a "deemed source" provision, allowing the foreign country to tax an amount derived from a true source outside that country. According to the Interpretation Note, the "deeming source" rule in a DTA overrides the South African tax rules for determining the source for certain income items and capital gains.

The "deeming source" rule in a DTA to which the Interpretation Note alludes is typically found in the Interest Article in a DTA. For instance, Article 11(5) of the DTA between South Africa and Australia provides that interest shall be deemed to arise in a Contracting State when the payer is resident of that State for purposes of its tax. Thus, if the payer is resident in Australia but makes a payment to a recipient in South Africa, based on the Interpretation Note even though the normal source and deemed source may be located in South Africa, in such an instance, the source would be deemed to be the State where the payer is resident, that is, Australia and a section 6quat credit may be claimed.

It further states that a South African resident will not qualify for a tax credit when -

tax has been levied by the tax authorities of a foreign country on a payment to a South African resident;
the source of the payment is South Africa; and
although there is a DTA with the foreign country, it does not contain a deemed source rule.

The Interpretation Note states that in these circumstances the resident must seek a refund of the withholding tax from the foreign country under the DTA. This is not necessarily a practical option nor is the taxpayer guaranteed success.

Although section 6quat would not apply to the above scenario, the provisions in the DTA which deal with the elimination of double taxation could apply. A credit should then be provided in accordance with the provision of the DTA.

Where the income is sourced in South Africa or deemed to be sourced in South Africa and no DTA has been entered into between South Africa and the country where the foreign tax liability was incurred, the resident may qualify for a section 6quat(1C) deduction in respect of the foreign taxes which do not qualify for the tax credit.

The Interpretation Note proceeds with, inter alia, an analysis of the elimination of the double tax provisions under a DTA and sets out Sars' views in this regard.

Section 6quat and the specific provisions in DTAs dealing with the elimination of double taxation are technically complex provisions and their application is critical in calculating a taxpayer's liability.

Although the Interpretation Note provides a welcome clarification of Sars' views on certain issues, it is by no means a definitive guide as Sars is not bound by its own interpretation notes, nor do they have the force of legislation. As stated in the recent tax case, ITC 1830, 70 SATC 123, a practice note is not binding in that the Commissioner cannot change the law by making concessions to address unintended results.

Therefore, taxpayers claiming foreign tax credits should take note of the Interpretation Note but should remember that it only provides guidance as to Sars' current views on the issues it addresses.

*Magda Snyckers is a tax director at ENS