South Africa: Outward Investment from South Africa - The Offshore Perspective

In 2001, the winds of change began to blow through the South African taxation system, sweeping away the source-based taxation which had made South Africa a popular location, and replacing it with a tax on world-wide income; in addition, the government introduced a capital gains tax in 2002. Since then there have been further complex changes, particularly to the corporate taxation regime.

Although many of the changes apply to both groups, we will deal with the issue of South African based individuals and companies separately, but please remember that the information given below is not investment advice, and that it is important to seek professional advice before setting up any kind of offshore or international entity.

Companies - The Offshore Perspective

Although Finance Minister Mr Manuel increased the permitted amount that a SA resident company could invest offshore in his 2001 budget, (from R50 million, which is approximately USD6.3 million, to R500 million, which equates to approximately USD63 million) under the new tax rules, a resident company is liable for tax on world-wide income. In his 2003 budget, the limit was further increased to R1bn.

In a further blow to South African based companies, the finance minister also saw fit to do away with the institutional asset swap mechanism which allowed institutional investors to swap a portfolio of South African assets for an offshore asset package.

International companies wanting to establish a presence in South Africa used to be able to receive tax privileged foreign income by establishing as an International Headquarters Company, which was viewed as essentially non-resident for tax purposes; but the IHC regime was suspended in 2004 because such companies were excluded from making use of South Africa's tax treaty network.

Therefore, the best course of action for those with any kind of business presence in South Africa is to limit, as far as possible, the extent of that presence. Many corporations make use of offshore holding companies in jurisdictions which have strong ties with South Africa (for example Mauritius, the Channel Islands, the Cayman Islands, and the Isle of Man) to hold investment portfolios and other assets. This means that the South African branch of the operation will be taxed at normal SA corporate rates, but returns on other assets held in the offshore company can benefit from a low-tax regime. This works as long as not more than 50% of the offshore company is ultimately owned in South Africa - otherwise the offshore company is a Controlled Foreign Entity (CFE) and its South African owners (those with an interest over 10%) will be taxed on a proportionate part of its income (there are complicated exceptions for genuine operating income, ie for an operation with 'commercial substance').

The use of offshore subsidiaries in tax-planning took a blow in 2002 when South Africa began to tighten up on transfer-pricing rules, including the treatment of loans made to offshore subsidiaries. SARS is now assessing the companies on the interest they should have accrued on such loans.

Until 2004, foreign entities owned from South Africa were exempt from local income tax only if the countries in which they generate income were on the designated country lists issued by SARS. Countries such as Australia and Spain enjoyed such tax concessions. SARS uses three criteria in determining whether a country should fall on the designated list: the country must have a tax system similar to SA, it must operate on a residence-based system of taxation and it must have implemented CGT.

The Isle of Man has become a particular favourite for outward investment, with at least 35 of the largest South African companies operating on the island at the time of writing. Although the reforms of South Africa's taxation system have made it less advantageous for particular types of South African companies to invest in subsidiaries abroad, the fact that many South Africans had already heard of the Island has ensured that the IOM remains a leading contender for personal investment and wealth management despite considerable competition from other offshore business centres.

In 2004, recognising that existing rules tended to discourage corporate investment in South Africa, the government decided to scrap the 30% tax imposed on non-exempt overseas corporate earnings. South African economists applauded the move, suggesting that it could pave the way for the return of millions of rand invested overseas during the immediate post-apartheid period.

Such foreign entities as do fall outside the income tax net are still subject to capital gains tax (CGT) in SA on gains and losses. However, there are exemptions which are available to controlled foreign entities. Such a foreign entity would qualify for an exemption if a gain was subject to tax in a designated country at a rate of 13.5% (at the time of writing) or more. It would also qualify if the gain was attributable to a business establishment unless the assets sold generated dividends, interest rentals, annuities or income of a similar nature. An entity would also be exempt if a gain is attributable to a sale of shares.

Capital Gains Tax doesn't exist in the offshore jurisdictions likely to be used by South African companies for asset-holding structures, but a resident South African may have a problem with capital gains tax on the offshore disposal of assets - as with income, it is important to make sure that assets held offshore have commercial 'substance' or are held within entities which themselves have substance and are not likely to be classified as CFEs.

'Substance enhancement' is obtained by the utilisation of domestic experience, the availability of unique services in the offshore jurisdiction, the application of commercially justifiable profit margins, and the management of the company (within limits) in the chosen jurisdiction.

The 2002 (Second) Revenue Laws Amendment Act introduced significant changes to the tax treatment of international shareholdings and share transactions.

Under what is known as a participating share exemption, the sale of ordinary or participating preference shares in an active foreign company is exempt if sold by a controlled foreign entity that owns more than 25% of the active company's shares sold. A comparable exemption will also apply to dividends from active foreign companies' shareholdings. However, portfolio income including the sale of foreign shares and income from diversionary transactions is taxed.

National treasury director Keith Engel said that it had been decided not to follow the UK in exempting all share transactions as this would encourage share portfolios to be lodged in controlled foreign entities in order to sell them free of capital gains tax.

The sale of foreign non-currency assets excludes currency gains and losses, but these are accounted for if they arose from foreign equity instruments such as listed foreign shares, listed unit portfolio interests and commodities listed on an index. This applies to all taxpayers. The amendments also stipulate that all companies, trusts with a trade and any individual who trades in currency assets - actual foreign currency, foreign currency loans and forwards - is subject to income tax under section 24I of the Income Tax Act on an annual mark-to-market basis (that is deemed annual sales to determine income gains or losses) with respect to all their foreign currency assets.

All other individual taxpayers are subject to the capital gains tax regime with respect to all their foreign currency assets when they convert into and out of a foreign currency. The 24I regime was also amended to prevent tax avoidance through hedging mechanisms.

Amendments to the foreign currency laws announced in Trevor Manuel's 2003 budget meant that unrealised foreign currency gains were no longer subject to tax. When the rand depreciated in 2001, SA residents with foreign assets found that their assets were more valuable. However, SA-resident holding companies which had made loans to offshore companies found themselves with an unpleasant side effect - the unrealised gains of such loans were subject to taxation.

Under the amendment, which was retrospective to October 1, 2001, a gain or a loss is only brought to account when the loan is repaid by an SA group to its controlled foreign company.

Peter Dachs, international tax partner at the Sonnenberg Hoffman Galombik law firm welcomed the news, observing that the taxation of currency gains has in the past been the "biggest tax issue for SA groups operating offshore due to the rand's volatility and the ever changing nature of the law governing this issue."

The 2002 legislation also narrowed the exemption for financial institutions to prevent disguised passive treasury operations and more subtle forms of round-tripping, by, for example, shifts of interest offshore followed by the repatriation of dividends. Technical amendments were also made to the foreign dividend tax legislation, mostly in favour of the taxpayer; these latter amendments were also backdated to the introduction of the residence based and foreign dividend tax system in 2001.

In September, 2005, it was proposed to change the rules governing the taxation of offshore corporate income. In future, the tax liability of profit generated offshore by a South African company would be assessed according to the level of South African ownership under new plans proposed by the South African Revenue Service (SARS).

Under the draft Revenue Laws Amendment Bill a firm's income will be taxed in South Africa where more than 50% of South African shareholders exercise voting control in the foreign arm of the domestic company or the parent company.

The tax law situation at the time the proposals were introduced dicated that any income earned by an offshore company controlled from South Africa, otherwise known as a controlled foreign entity, is liable to be taxed if South African tax residents hold rights to the offshore unit's capital and profit.

According to tax experts, multinational groups that have offshore operations will be required to take a tax test in order to qualify for exemptions to the new rules. If they do not qualify, they will be taxed at the normal rate of corporate tax (28% in 2008).

Intellectual property disposed of by foreign branches will be exempt from tax in South Africa under the proviso that the company has held such property for at least 18 months. The proposed changes also reduce the burden of paperwork needed by companies to gain tax breaks on overseas activities.

In addition, the new rules remove the requirement for insurance, banking and financial services companies to apply for licences from the banking authorities to carry out activities overseas.

Individuals - The Offshore Perspective

The introduction of residence-based taxation and Capital Gains tax also affected individuals resident or based in South Africa. For taxation purposes, residence is assumed if an individual has some continuity of residence in the country, or clearly intends to return there. Therefore it is imperative that expatriates based there for professional purposes, or high-net-worth individuals spending any length of time there are aware of their residency status at all times, and do not stay longer in the country than is permitted for a temporary resident.

Individuals can also make use of offshore holding companies in friendly offshore jurisdictions in order to avoid unnecessary taxation on outside income (but the remarks above about 'commercial substance' and Controlled Foreign Entities also apply in the case of individual resident shareholders).

Many individuals engaged in the provision of professional services in areas such as finance, construction, engineering and IT have traditionally chosen to establish a Personal Service Company offshore when supplying services in South Africa. The offshore company can contract to supply the services of the individual outside the country, and the fees earned can accumulate in a low tax environment. Payments can then be structured in such a way as to minimise their exposure to South African income tax.

As an alternative to Personal Service Companies, there are organisations established offshore for the purposes of providing financial services to international companies and individuals. In the case of an expatriate sent to South Africa from another country, this might mean being employed out of the offshore jurisdiction rather than South Africa, which could have significant taxation benefits for the company and the employee.

Personal Service Companies however don't work for South African residents - the interposition of a corporate entity (personal service company) to escape income tax achieves less than nothing: such companies are taxed at a rate of 33% (at the time of writing) and may not claim any deductions except, broadly, salaries and any fringe benefits to the extent that they are taxable in the hands of the recipients.

As with corporate use of offshore jurisdictions, SARS has targeted what it regards as illegitimate use of offshore. But in 2003, Trevor Manuel introduced an amnesty on the repatriation of illegal offshore investments which the government hoped would see billions of Rand flowing back into South Africa. The government took a 5% cut of all money coming in under the amnesty scheme. There was also a levy of 10% for those who wished to keep their funds offshore. Under the amnesty, those making a full disclosure of any offshore assets and liabilities that breached previous rules on foreign exchange controls and tax regulations prior to February 28, 2002, were exempted from criminal or civil sanctions.

The original Taxation Laws Amendment Bill provided for a six month window between May 1 and October 31 for people to declare funds targeted by the amnesty, and applied to income taxation only; but it was later extended to February 28, 2004, and was broadened to cover other taxes such as PAYE (Pay As You Earn) and Value Added Tax (VAT).

"Where people had committed offences in terms of taxes that are not covered by the amnesty, these offences often acted as a bar to making an application for amnesty," the Revenue Service explained in a statement. As a consequence, the legislation was amended in December 2003 to accommodate those who were reluctant to come forward fearing punishment for outstanding bills in other taxes.

"People who have evaded taxes that are not covered by the amnesty and have taken these amounts offshore may now apply for amnesty," SARS announced, adding that taxpayers must approach the department within sixty days of making an application for amnesty to declare outstanding tax and arrange payment.

"To encourage these people to come forward, SARS will not raise additional tax or penalties on the evaded taxes that they now disclose or prosecute them for the evasion," the statement added.

According to press reports emanating from Johannesburg, within two days of the original announcement, enquiries concerning R3 billion had already been submitted to South African Revenue Service commissioner Pravin Gordhan by various tax consultants. It is thought that this could be just the tip of the iceberg: some have estimated money parked illegally in offshore accounts at anything up to R90 billion.

Rhodes University Professor Matthew Lester at the time doubted the success of the scheme, citing many people's fear of prosecution. "South Africans are terrified of bringing their money back, tripping up the SARS computer and being prosecuted" he said.

However, the Finance Minister reported in October 2005 that up to R4 billion (USD613m) was expected to be repatriated to South Africa from offshore as a result of the tax and foreign exchange amnesty, which concluded in 2004.

In total, some 43,000 applications were filed under the amnesty. Manuel stated that the government had collected some R2.3 billion in tax from the amnesty applications that have already been processed.