China’s investment in SA could add to the country’s tax revenue woes
The tax to be paid on the Chinese loans of R200bn has not been made public, which is a problem
SA’s tax collections may decrease significantly as a consequence of the recent news that China has committed to invest approximately R200bn in the country. Approximately R33bn of this will constitute a loan to Eskom. A loan will also be advanced to Transnet in the amount of R4bn.
The loans will be advanced by the China Development Bank and the Industrial & Commercial Bank. The interest charged on these loans has not been made public, but we know that the Eskom loan has a term of 15 years and the Transnet loan a term of five-and-a-half years.
From a South African tax perspective, given the magnitude of the investment, it could result in a significant reduction in tax collections over the period of the loans on the basis that these loans will be made to South African taxpayers. Taxpayers will be able to deduct the interest payments for tax purposes, provided that the taxpayer is carrying on a trade and the interest is incurred in the production of its income.
Therefore, interest on loans to, for example, fund working capital or acquire capital assets, should be tax-deductible for the borrower. Of course, for taxpayers such as Eskom, the deduction would simply increase their assessed loss for tax purposes, thereby postponing the time until they return to tax-paying status.
SA does not have any rules protecting its tax base in respect of transactions such as the envisaged loans by the two Chinese banks
The issue of interest deductibility in a cross-border context is very topical in international tax circles. In this regard, base erosion and profit shifting (Beps) is referred to by the Organisation for Economic Co-operation and Development (OECD) as tax-planning strategies that exploit gaps and mismatches in tax rules to shift profits to low- or no-tax locations.
The OECD states that, working together in the OECD/G20 Beps project, more than 60 countries jointly developed 15 action plans to tackle tax avoidance, improve the coherence of international tax rules, and ensure a more transparent tax environment.
The Beps Action 4 Report deals with ways to limit interest deductibility in respect of cross-border loans. The OECD’S final report on this action plan recommended a three-tiered approach to limiting interest deductions in a cross-border context. In respect of these rules, entities should, for example, only be allowed to deduct interest up to a fixed percentage of earnings before interest, tax, depreciation and amortisation.
In this regard, SA, like most countries, has rules limiting interest deductions where such interest is paid to a non-resident. The main rules in this regard are transfer pricing/thin capitalisation and certain statutory provisions contained in the Income Tax Act, 1962. However, these rules only apply in respect of loans between related parties.
Therefore, SA does not have any rules protecting its tax base in respect of transactions such as the envisaged loans by the two Chinese banks. While the Beps Action 4 Report suggests that a formula limiting the tax deduction of interest in all circumstances should apply, SA has not implemented this proposal.
SA does impose withholding tax on interest paid to non-resident lenders. This is set at 20%. However various double-tax agreements reduce the withholding tax to a lower percentage. The double-tax agreement with China reduces the rate to 10%. However, the China Development Bank operates from multiple jurisdictions; it may therefore choose to advance the loan funding or a portion thereof from a jurisdiction that has a zero withholding tax on interest for SA.
It is therefore possible that the interest on the loan will be fully tax deductible in SA for the borrower. No restriction will be placed on the ratio of debt:equity in respect of the relevant investments. In addition, there is no formula limiting the tax deduction in respect of the interest, given that the parties will not be related to each other. Finally, it is possible that, depending on the jurisdiction from which the loan is advanced, no South African interest withholding tax would be charged thereon.
If the loan is denominated in a foreign currency, the interest rate is likely to be lower than the prime rate, but any exchange difference ... will be tax deductible for the South African borrower
Equity or dividends?
Contrast this with the position where the investment is made in the form of equity. In simple terms, while interest payments are generally tax deductible, dividends are not. In addition, dividends tax at a rate of 20% will be levied on dividends paid to non-resident entities. This rate is reduced in terms of the China-SA double-tax agreement to 5%.
If, and to the extent, the funding comes in the form of equity investments in South African entities, the tax equation looks very different. There is no tax deduction for the issuing company in SA and dividends tax at a rate of 20% (reduced to 5% in terms of the double-tax agreement with China). In addition, unlike interest, virtually all SA’s double-tax agreements allow SA taxing rights in respect of dividends paid to non-residents. It would therefore not be possible for an equity investment into South African entities to be routed through a jurisdiction that does not allow SA taxing rights in respect of dividends paid.
Furthermore, if the equity subscribed is in respect of shares in "land rich" companies, SA would also be entitled to impose capital gains tax on any gain made on the shares at the time of their eventual disposal by the Chinese investor.
A simplified example with certain assumptions can be used to illustrate the principles set out above. Assume the entire R200bn is invested by way of loan-funding to South African entities and interest is charged at the prime rate over a period of 10 years. The value of the interest deduction is R200bn x 10% x 28% = R5.6bn a year for 10 years. In terms of this example, on a non-present value basis, R56bn would be lost to the South African fiscus.
If the loan is denominated in a foreign currency, the interest rate is likely to be lower than the prime rate, but any exchange difference (which economic theory predicts will be a loss as the rand depreciates against the foreign currency) will be tax deductible for the South African borrower.
To illustrate the principles, we could assume the entire R200bn comes in the form of an equity investment, which pays an annual dividend of 5%. No tax deduction will be granted to any South African entity. Instead, dividends tax will be levied on the dividend at a rate of 5%, that is, R500m in tax collected by SA annually. On a non-present value basis, this results in a R5bn tax collection over, for example, 10 years. In addition, there may be some capital gains tax on the ultimate disposal of the equity investments.
In conclusion, interest on the loan-funding from the two Chinese banks will be fully tax deductible for the South African borrowers, assuming the general requirements for a tax deduction are met. Furthermore, given that, unlike dividends tax, many of SA’s double-tax agreements have not been renegotiated to provide SA with taxing rights in respect of interest, it is possible that no interest withholding tax will be imposed on the interest paid to the two banks. The Chinese investments could therefore be very costly for the South African fisc.
• Dachs is head of ENSafrica’s tax department. He writes in his own capacity.