Taxation Laws Amendment Bills, 2008: Company restructuring measures
21 February 2008
This media statement is being released along with the general media release that provides a brief overview of the Taxation Laws Amendment Bills, 2008. The purpose of this release is to highlight certain matters relating to company restructurings that require attention. The first portion of this media release describes the legislative remedy for certain uncertainties in respect of intra-group rollover relief arising from the Revenue Laws Amendment Act, 2007. These changes further close loopholes in respect of this relief. The second portion of this media release describes the closure of loopholes relating to cross-border exemptions.
Misuse of intra-group rollover relief
In 2007, the section 41 definition of a group of companies qualifying for rollover relief (and group debt cancellation relief) was narrowed. All companies within a group not only had to be a single economic entity (akin to divisions of a single company), but these companies further had to operate under the same tax playing-field from both a policy and administrative tax perspective. As a consequence, only companies subject to comprehensive tax on worldwide income would remain within the group definition.
The net effect of these changes, amongst others, was to remove all foreign incorporated companies from the section 41 group definitions. This change was set to become effective as of 1 January 2009.
2. Foreign companies
a. Rationale for the 2007 exclusion restated
Some commentators contended that no rationale existed for the exclusion of foreign incorporated companies as long as intra-group relief was limited to transfers between fully taxable companies. The exclusion was also said to improperly limit foreign investment to a single entry point. It was argued that South African brother-sister companies should remain part of the same group even though these companies were linked solely through a common foreign parent company.
Both underlying company assets and shareholdings must be completely within the South African tax net in order to protect the tax base. Evidence already exists that the previous failure to have group shareholdings fully within the tax net created tax avoidance opportunities. In one set of schemes, taxpayers used these foreign controlled brother-sister groups to convert fully taxable profits under the secondary tax on companies into capital gains free from tax by virtue of the foreign shareholding. These dangers can best be illustrated through the following example. In addition, underlying capital gains could also be wrongfully compromised.
Foreign Parent owns all the shares of Operating Subsidiary (a South African company) with a R800 000 base cost. Operating Subsidiary owns business assets with a value of R1 million and a base cost of R200 000 and Operating Subsidiary has R200 000 of share capital and R800 000 of profits. The group enters into the following transaction to shift all Operating Subsidiary assets under direct Foreign Parent control.
Step 1: Foreign Parent forms Newco Subsidiary (another South African company) with nominal consideration.
Step 2: Operating Subsidiary transfers all of its assets to Newco Subsidiary in exchange for a Newco Subsidiary note of R1 million (guaranteed by Foreign Parent).
Step 3: Newco Sub distributes all the recently received business assets to Foreign Parent.
Prior to the Revenue Laws Amendment Act, 2007, Foreign Parent, Operating Subsidiary and Newco Subsidiary were all part of the same group. As a result,
In Step 2: If an election was made, the transfer from Operating Subsidiary to Newco Subsidiary was a tax-free section 45 rollover with the R200 000 base cost of the business assets rolling over to Newco Subsidiary.
In Step 3: Because Newco Subsidiary has no profits, the subsequent distribution is viewed as a capital distribution (which is free from the Secondary tax on Companies). Moreover, because Foreign Parent is a non-resident, any capital gains resulting from the capital distribution in respect of the Newco Subsidiary shares similarly went untaxed. The only tax remaining was the underlying gain on the business assets.
The net effect, barring the application of the general anti-avoidance rule, is to eliminate one level of tax. With a little more planning, it may even be possible to transfer the Operating Subsidiary shares to Newco Subsidiary (i.e. assets with a high base cost and low market value) to trigger an artificial loss for Newco Subsidiary as a means to offset the gain on the business assets transferred. However, upon implementation of the change to the group definition, the benefits of this scheme are effectively terminated.
Operating Subsidiary and Newco Subsidiary will no longer be part of the same group, thereby eliminating the tax-free rollovers used to initiate this transaction.
b. Foreign companies treated as South African tax residents
One related issue is the exclusion, from a group of companies, of foreign incorporated companies that are effectively managed within South Africa. While these companies were fully subject to the South African tax, concerns existed about administrative enforcement (and the ease with which these companies could re-shift their tax residence abroad).
After further consideration, this exclusion will be removed. These entities do not give rise to the tax avoidance difficulties as outlined above because they are fully within the tax net. Moreover, failure to include these entities may be problematic in terms of tax treaty anti-discrimination provisions, and these entities may even offer non-tax practical advantages when foreign investors seek to invest in South Africa. Foreign companies with South African tax residence are fully within enforcement reach as long as these companies have registered as external companies under the Companies Act (1973). Re-inclusion of these foreign companies will be effective when the new section 41 group definition goes into effect.
3. Immediate closure of ongoing tax avoidance schemes
The main problem with the section 45 rollover regime is the asymmetry this section causes between the assets transferred and the consideration received in exchange. Group assets transferred retain a rollover tax cost, but consideration received in exchange obtains a market value tax cost. This asymmetry has been used by certain taxpayers to artificially cash-out subsidiary operations wholly free from tax. Section 45 rollover reliefs was never intended to apply in respect of this cashing-out; it was merely intended to allow for the deferral of gain/loss when assets are moved within a single group. This cashing-out can best be illustrated through the following example.
Parent owns all of Operating Subsidiary. Operating Subsidiary has assets with a value of R1 million and a base cost of R200 000. Parent plans to sell Operating Sub to Independent Purchaser. In order to effect these goals, the parties enter into the following transactions:
Step 1: Parent forms Newco Subsidiary for nominal consideration.
Step 2: Operating Sub transfers all of its assets to Newco Subsidiary in exchange for a R1 million notes issued by Newco Subsidiary (and guaranteed by Parent).
Step 3: Operating Subsidiary distributes the R1 million notes to Parent as a dividend, leaving Operating Subsidiary as an empty shell.
Step 4: Parent transfers all the shares of Operating Subsidiary to Newco Subsidiary in exchange for the issue of additional Newco Subsidiary shares.
Step 5: Independent Purchaser pays R1 million for the note and nominal consideration for all the shares of Newco Subsidiary (which in turn owns all of Operating Sub).
Parent, Operating Subsidiary and Newco Subsidiary are all part of the same group. As a result:
In step 2: The transfer from Operating Subsidiary to Newco Subsidiary is currently a tax-free section 45 rollover with the R200 000 base cost of the business assets rolling over to Newco Subsidiary.
In step 3: The dividend distribution by Operating Sub of the Note to Parent is free from the Secondary Tax on Companies under section 64B(5)(f) by virtue of the group relief election (no capital gains tax arises because the note has a base cost equal to its R1 million market value).
In step 4: The transfer of the Operating Sub shares by Parent to Newco Sub will not generate any gain (and may even trigger a clogged loss) because Operating Subsidiary is now an empty shell.
In step 5: The sale of the R1 million note and the Newco Subsidiary shares generates little or no tax. The R1 million note has a R1 million base cost, which is equal to the note's market value. Due to its indebtedness by virtue of the note, the Operating Sub shares have little or no net value that can be taxed.