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By David Warneke*
A bombshell hidden in the detail of the 2017 Budget review relates to the taxation of offshore trusts. It refers to the 2015 Budget review in which it was announced that measures would be introduced to the tax treatment of foreign companies held by interposed trusts. No specific countermeasures were however introduced and the 2017 Budget review proposes that such countermeasures be introduced to curb abuses.
What appears to be targeted is the fairly common situation in which an offshore discretionary trust is established and holds the shares in an offshore company. Most often, funds are advanced to the offshore trust which subscribes for shares in the offshore company, or funds are advanced direct to the offshore company. The offshore company then invests in foreign shares or other assets. Profits accruing to the offshore company are effectively converted into foreign dividends in the hands of the foreign trust, which escape South African income tax.
The 2015 Budget Review stated that consideration would be given to taxing such foreign companies as ‘controlled foreign companies’ (‘CFCs’). However, as mentioned above, no countermeasures were enacted.
The implication of treating such a foreign company as a CFC would be that a South African resident or residents would potentially be taxed on the underlying net income of the foreign company (determined as if the foreign company were a SA tax resident) in proportion to their participation rights in the foreign company. If the foreign company had invested in minor holdings of less than 10% in other foreign companies, for example foreign listed securities, then the South African resident would potentially be subject to income tax on dividends received from such foreign listed securities at a maximum effective rate of 20% and capital gains tax on the disposal of such foreign listed securities.
The proposal does not specify the circumstances in which South African residents would be deemed to hold participation rights in the offshore company so that the CFC rules might apply. For example, most foreign trust structures are set up such that the trustees, the majority of whom are foreign resident, have full discretion with regard to the vesting and distribution of income and capital. In such a case the deeming of a South African resident or residents to control the foreign company represents a legal fiction.
It is unclear whether the proposal is likely to seek to tax the beneficiaries of such a discretionary trust on a notional proportion of the net income of the foreign company or to tax the founder of the trust.
However it should be borne in mind that in the majority of cases, funds are introduced into the foreign trust or company by way of a loan. Such loan if made between a South African tax resident and the foreign trust or foreign company on non-arm’s length terms and conditions would generally give rise to the transfer pricing rules in terms of which the loan is deemed, for fiscal purposes, to be on arm’s length terms and conditions. An arms’ length rate of interest is therefore deemed to apply to the loan which interest is subject to income tax in South Africa in the hands of the lender.
If an arm’s length rate of interest on the loan is subject to income tax in South Africa then hopefully the proposal would not either not apply or compensation would be made for the inclusion of the interest in the hands of South African tax residents.
Clarity will be provided when the first draft of the Taxation Laws Amendment Bill of 2017 is released, most likely to be in June 2017.
- David Warneke, Head of Technical Tax, BDO South Africa