For some time the government has been concerned by the use of interposed foreign trusts to avoid the taxation on controlled foreign companies (CFC’s). New rules were proposed in 2017, but were subsequently withdrawn due to their wide nature and complexity. The Taxation Laws Amendment Act, 2018 (Act No. 23 of 2018), brings into law new anti-avoidance rules that will apply with effect from 1 March 2019.
The nature of governments concern has been that South African residents are able to circumvent the application of the CFC rules by interposing a foreign trust that maintains the shareholding of a foreign company. This has enabled residents to re-characterise income from foreign companies in order to avoid tax.
In terms of Section 7(8)(a) of the Income Tax Act, to the extent that any amount is received by or accrues to a foreign trust as a result of a donation, settlement or other disposition made by a South African resident, which would have constituted income had that trust been a resident, then that amount is included in the income of that person for local tax purposes.
However, income as defined is determined after excluding from gross income any items that are exempt. The participation exemption in Section 10B(2)(a) exempts from income any foreign dividend where that person holds at least 10% of the equity shares and voting rights in the company declaring the foreign dividend.
As a result of the participation exemption, the foreign dividend would not constitute income as defined, and there would be no amount to be attributed to the person that made the donation, settlement or other disposition.
New anti-avoidance provisions
In order to counter the loophole as envisaged above, Section 7(8)(aA) has been introduced. In terms of the new provisions, when determining the amount of income to be included as taxable income in the hands of a person under Section 7(8)(a), it will disregard the participation exemption in respect of foreign dividends under Section 10B(2)(a). That participation exemption will be disregarded where more than 50% of the total participation rights in that company are directly or indirectly held by that person, whether alone or together with any connected person.
In practical terms, we shall consider the following scenario: a South African resident effectively holds shares in a foreign company via a foreign trust where that resident was the settlor. The trust holds more than 10% of the shares in the company. In respect of foreign dividends received by or accrued to the foreign trust, Section 10B(2)(a) would exclude them from the definition of income. On the application of Section 7(8)(a), there would therefore be no amount to include in the taxable income of the South African resident. However, as a result of the new Section 7(8)(aA), the participation exemption in respect of the foreign dividends will be disregarded, and the amount must be included in the income of the resident if the following is met:
- More than 50% of the total participation rights in the company are held by the foreign trust, whether alone or together with connected persons; and
- The foreign trust has a connected person relationship with the South African resident that made the donation settlement or other disposition, or any person connected to that resident.
This will result in the foreign dividends being an amount that could be included in the taxable income of the resident.
What is important to note is that these new provisions do not affect Section 10B(3) of the Act whereby a portion of the taxable foreign dividends are subject to an exemption. This results in the foreign dividends being effectively taxed at the same rate as local dividends.
Further anti-avoidance provisions in the Income Tax Act
Further to the insertion of Section 7(8)(aA), similar anti-avoidance provisions have been included in Section 25B. This applies where a resident beneficiary acquires a vested right in an amount received by or accrued to a foreign trust. There will be a similar disregarding of the participation exemption when the amount represents a foreign dividend, resulting in an amount of income that would be included in the taxable income of the South African resident beneficiary.
In addition, the participation exemption is now also disregarded in respect of the sale of foreign shares for the purposes of the attribution of capital gains, set out in paragraph 72 and 80 of the Eighth Schedule to the Income Tax Act.
These additional provisions are also effective as from 1 March 2019.
Any South African residents planning a foreign investment structure that may fall foul of these new provisions, or with foreign structures already in place, should seek advice to understand whether these new laws may have any negative impacts, or to understand the financial impact of any exposure.
Director: Tax and Trusts, Johannesburg