CGT trap for foreign fixed property
By now we all know that when a South African resident (whether a company, a trust or an individual) ceases to be tax resident in South Africa there is, in principle, a capital gains tax (CGT) exit charge triggered.
The exit charge is triggered by way of a deeming provision in the CGT legislation, which deems the cessation of residence to be a disposal for CGT purposes.
Upon cessation of residence, a person is deemed to dispose, at market value, of all assets, the actual disposal of which will escape the South African CGT net as a result of the cessation of residence. The charge is not limited in any way with reference to the CGT which South Africa would have been entitled to collect upon an actual disposal of the assets.
And that, in my view, is unfair, given the policy and reasoning underlying the exit charge.
The exit charge is explained, from a policy point of view, as an opportunity to give South Africa the last bite of a cherry, so that the growth in value of the asset, up until the time of cessation of residence, will be taxed (even though normally the tax trigger is an actual disposal).
For example, if a resident acquired listed shares during 2003 at a cost of R1m and those shares are worth R1.3m in 2007 when the resident ceases South African tax residence, the resident will be subject to an exit charge calculated on the growth of R300 000. The principle appears fair, as (a) South Africa would have taxed the gain upon an actual disposal of the shares at a time when the person was resident in South Africa, but (b) as a result of the cessation of residence, South Africa will no longer be able to tax the gain upon an actual disposal.
The exit charge is, therefore, aimed at giving South Africa taxing rights to that portion of the gain that is derived during a time when the person was still resident in South Africa. This principle is well-recognised internationally and does not leave a sense of injustice, other than the obvious cash-flow problems it creates. It is submitted that a better rule would be to trigger the tax, but to allow a deferral until the asset is actually sold.
The unfairness generally presents itself in respect of fixed property, held on capital account by a resident and which is situated in a country which is party to a double tax treaty with South Africa.
South Africa does not levy CGT on gains arising from the disposal by non-residents of fixed property situated outside South Africa. But, in principle, it levies CGT on gains arising from the disposal of the world-wide assets of its residents. The cessation of residence, therefore, deprives South Africa of its CGT rights on the disposal of fixed property situated outside South Africa, and the exit charge is devised as a mechanism to give South Africa the right to tax the growth (unrealised gain) in the foreign fixed property up to cessation of residence.
What the exit charge does not take into account, though, is the fact that South Africa's taxing rights, in respect of actual disposals, are subject to, and in fact limited by, the terms of its double tax treaties. And often, the result of a treaty will be to deny, or substantially limit, South Africa's taxing rights in respect of the disposal by its residents of fixed property situated in a foreign country. The technicalities of how the South African taxing rights are limited (for example through tax credits or exclusive taxing rights) are not relevant to the principle that South Africa, generally, and at least to a substantial extent, surrenders taxing rights to gains resulting from the actual disposal by its residents from fixed property situated in treaty countries.
When residence ceases, and a deemed disposal of fixed property situated in a treaty country results, South Africa taxes the full amount of the unrealised gain up to date of cessation of residence. The impact of tax treaties, which would generally reduce or deny South Africa's taxing rights were the resident, whilst resident, actually to have disposed of the asset, is simply ignored.
The result is that South Africa's last bite of the cherry, which becomes available rather artificially (through a deemed disposal), is often a lot bigger than the bite would have been under the normal rules applicable to actual disposals.
Double taxation on the portion of the growth of the foreign fixed property, upon its ultimate actual disposal, will be a real possibility, as there is generally no mechanism in terms of which the exit charge levied by South Africa could reduce future gains realised and taxed in a foreign country on the actual disposal of the property.
The result is that the disposal of an asset specifically dealt with in a relevant tax treaty (between South Africa and the country of source of the foreign fixed property) for the avoidance of double tax, will not avoid double tax.
It is appreciated that it will be impractical to change all of South Africa's treaties to address the problem. It will equally be rather clumsy to deal with the issue through a system of tax credits.
What is suggested is that the local CGT rules be amended to simply align the position of a deemed disposal resulting from cessation of residence with the position that would have resulted had the resident actually disposed of the foreign fixed property at the time of cessation. This could be done by providing for a cap to the capital gain resulting from the cessation of residence to the amount which would have attracted CGT in South Africa upon an actual disposal of the relevant asset at the time of cessation of residence.
Similar to the deemed disposal rule applicable to cessation of residence, the death of a person also triggers a deemed disposal at market value of all the assets of the deceased. The same problem manifests itself here - fixed property situated in a treaty country, the actual disposal of which would have benefited from treaty relief (generally resulting in a reduction or removal of South Africa's taxing rights), will simply attract full CGT in South Africa on the growth up to death.
The situation on death is complicated even more by the fact that it is not unusual for many of our treaty countries to also impose CGT on death. If a resident owns fixed property situated in those countries, there is an additional dilemma - which country now gets the first bite at the cherry?
The fact that a similar unfair result arises on death (in fact, the death charge could be even more complex and potentially more onerous) seems to indicate that this inequitable result was not intended as a penalty for persons ceasing their South African tax residence.
I doubt whether this result was intended at all. But legislative interference would be required in order to address this situation. Until then, taxpayers will need to keep this in mind as part of their tax planning.
*Doelie Lessing is a director at Werksmans Incorporating Jan S De Villiers
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