The ramping-up of country-by-country (CbC) reporting to regulate transfer pricing and combat cross-border tax evasion, in terms of the Organization for Economic Co-Operation and Development’s (OECD) base erosion and profit shifting (BEPS) policies heralds a new tax landscape. It makes different demands of tax authorities worldwide and considers information at a finer level of detail. It also creates greater visibility amongst tax authorities and exposes companies with international structures especially those that have not been implemented correctly.
The risk associated with international structures thus rises significantly and companies need relevant strategic advice to ensure that these structures withstand the scrutiny of tax authorities across the world.
It is important to note that ‘tax’ should always follow business and never the other way around. There should always be a valid business purpose and commercial rationale for setting up an offshore structure. The following international tax principles should always be considered:
Substance over form, whereby true effect will only be given to the legal form of a transaction if the substance is the same. It would be important to demonstrate that there are capital infrastructure and people in the offshore entity sufficient to support the revenue that is being recognized in that country. You cannot have a post box in a tax favourable jurisdiction without people functions, risks and assets that are commensurate with the revenue being recognized there. How would a revenue authority know, you may ask? They could request the financial statements of the offshore entity and soon deduce that there is no substance by virtue of income being accounted for but no corresponding rental expense, payroll and other expenses that would need to be incurred in the production of that income, in other words, no substance.
Residence, place of effective management (‘POEM’) or management and control are basic tests of residency in most countries. In other words, you cannot have an offshore entity in country B that is effectively managed in another country, country A. In that case, the offshore entity in country B could be considered to be a tax resident of country A. The basic principle around POEM is it is the place where the key decisions are taken by directors and senior managers i.e. the place where the ‘shots are called’.
Controlled Foreign Company Rules (‘CFC’) which are implemented in tax legislation in most countries. In South Africa, these rules apply if an SA tax resident or residents, either individually or jointly, hold more than 50% of the participation rights or are able to exercise more than 50% of the voting rights either directly or indirectly in a foreign entity. In that case that foreign entity is considered to be a CFC and subject to tax in SA subject, to certain exclusions one of which is the Foreign Business Establishment exclusion which in broad strokes means that it must have an office that it intends to occupy for at least a year with people, capital infrastructure and resources.
Transfer pricing generally relates to all intercompany transactions. In South Africa, the legislation applies to all cross-border intercompany transactions between connected parties which generally means where there is at least a 20% shareholding. It would need to be supported to Revenue Authorities across the globe that pricing is market-related. The recent implementation of Country by Country reporting creates greater visibility to tax authorities’ across the world on the activities, size, financial and tax position of companies within the Multinational Entity Group.
South Africa Sourced Income – South Africa has a worldwide basis of taxation whereby non-residents are taxed on South African sourced income. As such if your offshore entity conducts activities in South Africa and these activities are considered the originating cause of income, such income would be subject to tax in South Africa subject of course to any double taxation relief that may exist by virtue of a Double Taxation Agreement.
General Anti Avoidance Provisions would be the overarching wrapper to ‘catch all other’ not caught by one or more of the above principles.
South African beneficiaries of Offshore Trusts – South African resident beneficiaries as a general rule are taxed where a donation is made to an offshore trust but also where interest-free loans are advanced. In such case, the attribution rules apply to attribute income and capital gains of the offshore trust which are taxed in the hands of the SA beneficiary.
Where a distribution is made by the offshore trust to an SA beneficiary the latter will be taxed on that distribution based on the nature of the income out of which it was distributed e.g. if it was a foreign dividend the beneficiary will be taxed at an effective rate of either 0% or 20% depending upon the shareholding in the foreign company declaring the dividends and if it is interest, a marginal tax rate of 45% may be applied or a tax rate of 18% on a capital profit.
In terms of the Act, there is an exemption from tax on foreign dividends where the person holds at least 10% of the equity shares and voting rights in the foreign company; referred to as the participation exemption. This exemption also applies to the disposal of share where the disposal is exempt from CGT.
As such, if the current year’s income of the trust comprised a dividend, that dividend is not taxable in the hands of the donor or the lender under the interest-free loan and neither is it taxable as a capital gain if the trust had disposed of the shares.
Similarly where such dividend or gain has been capitalized and in a future year that capital was awarded to a beneficiary in SA that award would be exempt from tax on the dividends or the CGT. However if the trust had earned the dividend and distributed in the current year, the beneficiary would have been taxable at the rate of 20% while a capital profit made in the same year is not taxable.
Draft legislation has now been put out for public comment incorporating the following changes to the attribution and distribution rules.
In determining an amount that should be included as taxable income in the hands of a resident who made a donation, settlement or other dispositions to a foreign trust and that foreign trust holds shares in a foreign company, it is proposed that the participation exemption in respect of foreign dividends should be disregarded, provided that those foreign dividends are paid by a foreign company where more than 50 per cent of the total participation rights or voting rights in that foreign company, are directly or indirectly exercisable by that resident who made a donation settlement or other dispositions to a foreign trust or connected person in relation to the resident.
If these attribution rules do not apply and a trust receives a dividend where it holds a greater than 50% interest, and the dividend is capitalized, an award out of capital in the future year to a beneficiary in SA will be taxable at an effective rate of 20%. The participation exemption will not apply.
The new rules if included in the legislation will also apply to CGT so that where CGT would not have applied under the attribution rules, or out of an award of capital in the current or future year, will in future be subject to CGT. The participation exemption will not apply.
The new rules are intended to apply to any dividend received or disposal of shares on or after 1 March 2019.
If these changes are successfully implemented, it should mean that any dividend on a qualifying interest or any profit on disposal of a qualifying interest derived by an offshore trust on or before the 29 February 2019 and capitalised should still be able to be awarded out of capital, tax-free in the following year
Contact us at Tuffias Sandberg if you in need of assistance in local or international tax-related issues.