The ‘startling’ new tax rule that could affect your overseas earnings
Treasury is trying to close a loophole involving foreign trusts, but critics say its solution is a blunt instrument with unintended consequences including double taxation
Some of the changes proposed to the anti-avoidance rules relating to a controlled foreign company have been expected.
But one of the proposals has been described as surprising, startling and even grossly unfair.
National Treasury has been concerned that current anti-avoidance rules relating to these foreign companies are inadequate to capture new structures that have been emerging since 2008.
However, a newly proposed section may have unintended and harsh tax consequences for South African individuals who are beneficiaries of foreign trusts.
Treasury says in the latest draft Taxation Laws Amendment Bill that the controlled foreign company (CFC) rules do not "capture foreign companies held by interposed foreign trusts or foundations".
CFC rules are aimed at preventing South Africans from shifting passive income offshore, such as interest or certain royalties, by investing in a CFC.
A company is considered a CFC when one or more South African residents hold more than 50% of the participation or voting rights in the foreign company.
Noxolo Ntombela, senior associate at Bowmans, explains that the net profits of a CFC have to be accounted for in the South African shareholder’s income tax.
The reason is that South African residents have been taxed on their worldwide income since 2001.
However, foreign entities such as foreign trusts and foreign foundations do not fall within the ambit of South African CFC rules.
Ntombela says new structures were created where the CFC is being held through the foreign trust or foundation — effectively breaking the link between the CFC and the South African resident.
This structure was not clearly stipulated in South African legislation, which means the profits made by the CFC fall outside the South African tax net.
"A new proposal now deals with this mischief of interposing a foreign trust or a foreign foundation between the South African resident and the foreign company."
It is proposed that if the foreign trust’s financial statements form part of the parent company’s consolidated financial statements, the company is still a controlled foreign company and the tax implications are applicable to the foreign trust.
There are certain exemptions and exclusions where the foreign net profits do not have to be brought into the South African shareholder’s income.
One is called the "foreign business establishment", which means the foreign company has employees, and it has offices with the necessary equipment and facilities to do its business. In such an instance it is not required to include the net profits into the South African shareholder’s income for tax purposes.
With this in mind, Ntombela says the introduction of a new section into the Income Tax Act comes as a huge surprise.
Section 25BC is aimed at individuals and trusts. "It looks at the same structure where there is a CFC that is being held by a foreign trust, but now states that any distribution from that trust received by a South African resident (individual and trust) would be subject to income tax."
She says this proposal does not take account that some CFCs fall outside the South African tax net because they meet the foreign establishment or high tax criteria.
It also does not take into account that the trust can have other investments which have nothing to do with the underlying CFC. It simply paints every distribution with the same brush.
"This proposal has not carved out these issues thoughtfully," she says.
Ernest Mazansky, director at Werksmans Tax, says the section is grossly unfair for a number of reasons.
He says several issues need attention before a rational and reasonable anti-avoidance provision can be enacted.
The amendment should strike at the mischief targeted, without having a whole raft of unintended consequences for innocent transactions.
He says if one assumes a foreign company falls under the rules of a CFC, but it does not have to pay tax in SA because of the relevant exemptions, why then should the dividend from the trust be taxable when ordinarily a dividend from a CFC would not be taxable?
He also wants to know what would happen if the holding of the CFC represented only a small percentage of the trust’s assets. "Why should all of the trust’s distributions be taxable, as opposed just to a distribution out of the dividend from that CFC?"
Elandre Brandt, member of the international tax committee of the South African Institute of Tax Professionals, agrees and says the changes are unfair as any distribution from the trust will be taxable.
"Even though the aim of the proposed amendments seems to be at foreign companies held by foreign trusts, the provisions of the section go further than that."
Brandt says even if the nature of the amount distributed is a foreign dividend that would be exempt from South African taxation, it will be reclassified as a taxable income amount.
The section may also introduce double taxation. If foreign taxes were paid by the entities in the underlying structure, they would not be creditable against the South African tax that is paid as a result of the new section.