SARS Overreacts After SCA Decision On Exit Taxes
12 November 2012
Posted by: Author: Barry Ger
SARS Overreacts After SCA Decision On Exit Taxes
In a tax court case in 2010,a taxpayer successfully challenged the levy by the South African Revenue Service (SARS) of the so called ‘exit taxes’, taxes that are imposed when someone changes their place of residence for tax purposes.
The decision was taken to the Supreme Court of Appeal (SCA) and, on 8 May 2012, judgment in the case of Commissioner for the South African Revenue Service v Tradehold Ltd (case no 132/2011) was handed down. The taxpayer was successful once again. What was surprising,however, was SARS’s somewhat belligerent response to its defeat: a media statement was issued immediately that decried the judgement as contrary to the legislature’s intention and shortly thereafter (on 5 July 2012) legislative amendments were proposed that overhauled and extended the laws relating to exit taxes.
This, it is submitted, was an overreaction. This article will attempt to show that the decision of the SCA rested on very specific and unique facts that are unlikely to be encountered again.Taxpayers who believe that a loop hole has been opened by this case, allowing a departure from South Africa without tax are sadly mistaken.To put this into perspective, it would be useful, as a starting point to explain a little about how exit taxes work.
What are exit taxes ?
Essentially, exit taxes refer to the tax consequences that arise upon ceasing to be a resident of South Africa.The case, under discussion, concerned itself specifically with the capital gains tax (CGT) consequences.
Upon ceasing to be a tax resident, a person is deemed to have disposed of certain of its assets for proceeds equal to their market value. If the proceeds from this deemed disposal exceed the base cost of the affected assets, the taxpayer will be liable for tax on the capital gain that arises.Moreover, this deemed capital gain is treated as having arisen on the day before the taxpayer ceases to be a tax resident so that SARS will still have the power to tax these gains.
SARS justifies the imposition of these taxes on the basis that once an entity of person has terminated their South African tax residence, South Africa loses its right to tax certain assets. But for these taxes, SARS argues, the latent capital gain that was built up in these assets while the person was in the country will be forever lost to South Africa’s tax base.
Furthermore, these taxes provide a useful anti-avoidance mechanism designed to prevent taxpayers from leaving the country purely so that they may realise their capital assets in jurisdictions which have lower, or no, CGT.You may ask, of course, just how does one cease to be a tax resident? In the case of an individual, this may be accomplished by emigrating. In the case of a company, however, it is generally performed by changing the company’s place of effective management to another country in a manner that will result in a shift in tax residence.While a discussion of the concept of a place of effective management goes some what beyond the scope of this article, let it be understood, as the place where the managerial decisions affecting the company are taken.
A brief description of the facts
The facts in the Tradehold case were that the taxpayer, Tradehold Ltd, a South African investment holding company that had been listed on the Johannesburg Stock Exchange, resolved on 2 July 2002 that, since an investment company requires limited management, all future board meetings were to beheld in Luxembourg. This meant that, from 2 July 2002, all future managerial decisions would be made outside of South Africa. In other words, from that date, the company had its place of effective management in Luxembourg and not in South Africa.The taxpayer had thus become a resident of Luxembourg. Notwithstanding this, the taxpayer was viewed as remaining a resident of South Africa for domestic purposes only because it was incorporated here.
However, this state of dual residency would not last long.On 26 February 2003, the definition of ‘resident’ in the South African Income Tax Act changed to make it clear that it excludes taxpayers who were deemed to be exclusively residents of other countries for the purposes of double taxation agreements (i.e. treaties that determine taxing rights between countries so that countries may not subject a taxpayer to tax on the same amount). As the South Africa-Luxembourg treaty deems taxpayers effectively managed in Luxembourg to be Luxembourg tax residents,the taxpayer ceased to be a South African resident for domestic tax purposes as of 26 February 2003.
The loss of domestic residence was, SARS alleged, the trigger for the aforementioned exit taxes.SARS argued that in its tax year ending on 28 February 2003, the company would be deemed to have disposed of its shares and would thus have to pay CGT on the gain that was treated as having a risen in its hands.
The taxpayer disagreed. It pointed out to SARS that the South Africa-Luxembourg treaty had a clause in it which stated that gains from the alienation of property, aside from certain exceptions, would be taxable only in the country in which the taxpayer was resident. As the taxpayer was a resident of Luxembourg from the date when it moved its effective management there for treaty purposes, the taxpayer argued that even if a gain was deemed to have a risen upon it ceasing to be a South African resident, South Africa could not tax it.
SARS rejected this argument. According to SARS, the clause in the treaty only referred to actual transfers of ownership in property, not deemed alienations of property, as was the case here. Hence the treaty could not be used to exempt the taxpayer from tax. It contended that if the treaty did apply to deemed alienations, then it would mean that taxpayers who migrated to countries with similar treaties to the one South Africa had concluded with Luxembourg would never face exit taxes. (This was some what misguided since the law required the exit taxes to arise on the day immediately before the day the person ceased to be a resident of South Africa, in any event.)
Rulings of the courts
SARS’s argument did not find sympathy in the Tax Court or in the SCA.Both courts upheld the taxpayer’s objection to its assessment.
In their view, a deemed disposal of property should not be treated any differently from an actual disposal of property for tax treaty purposes.The term ‘alienation’ in the treaty was neutral and could refer to both actual and deemed disposals that gave rise to capital gains.
The mere fact that taxpayers who migrated to countries which had treaties with these clauses and thus would not be taxed on their deemed disposals was no reason for concluding that the treaty did not apply. After all,the same could be said of taxpayers who actually disposed of their property in South Africa but were shielded from South African CGT because of this clause in the treaty.
From 2 July 2002 then, the South Africa-Luxembourg treaty became applicable to the taxpayer and Luxembourg had exclusive taxing rights over all the taxpayer’s capital gains.The reaction to the judgement Our revenue authorities reacted almost immediately to the decision. On the day following the judgment, a media statement was released which claimed that the ruling "that a double taxation agreement applied to a deemed disposal and thus did not allow for an exit charge”had "disturbed the balance that has been achieved”. It warned that, after the judgement was studied by the National Treasury and SARS, amendments with an effective date running from the day the judgement was delivered may apply to clarify that a tax treaty did not apply to deemed or actual disposal while a taxpayer is resident in South Africa. This threat was carried out.
In the Draft Taxation Laws Amendment Bill, 2012 which was released in July 2012, new measures were proposed to bolster and extend exit taxes.It has been proposed that from 8 May 2012, any persons that change tax residence will be deemed to end their tax year on the day before they become resident of the foreign country. This is to ensure that they cannot rely on tax treaties to escape exit taxes.
In addition to the CGT charge, companies that leave South Africa will be hit with dividends tax as well. Upon departure,they will be deemed to have distributed their assets to shareholders and thus will be levied with an extra 15% tax on the value of those assets. (This is similar to the Secondary Tax on Companies of 10% that used to be imposed when companies changed their South African residence prior to 1 April 2012).
It may be submitted that although the reasoning of the courts is not beyond reproach, SARS’s response is unwarranted.As a consequence of the 2003 change to the definition of resident and the fact that the disposal is deemed to take place on the day before residence ceases, the circumstances of this case can never be replicated, and any change to the laws relating to exit taxes is unnecessary. Tax treaties can be applied only when two countries have a right to tax the same income.
Sometimes this is because a taxpayer may be resident of one country but derives income from source in another. At other times, this arises because the same income is sourced in two different countries; or, as in the circumstances under discussion,a taxpayer is resident of both countries.At the date when the taxpayer in this case changed its place of effective management (i.e. 2 July 2002) to Luxembourg, it was still possible for a South African tax resident to remain a resident of South Africa and become a resident of another country as well. It was for this reason that the South Africa-Luxembourg treaty could be of application on the day before the taxpayer ceased to be a South African resident (1 July 2002), i.e. the date on which the deemed capital gain arose.
Since 26 February 2003 though, when the definition of resident changed, dual residence when a treaty exists is all but impossible.This means that, on the day before a taxpayer ceases to be South African resident, the taxpayer can only be South African resident and a treaty cannot be of application in the same way the South Africa-Luxembourg treaty was in this case.
If a treaty is not of application, it would not be able to interfere with the South African laws concerning exit taxes.South Africa would therefore be free to tax gains arising from the deemed alienation of a taxpayer’s property without worrying about clauses in international treaties assigning taxing rights to foreign climes.
While it is heartening to see a taxpayer finally victorious in the SCA after so many recent dubious decisions that went the other way, it must be acknowledged that the principles of this particular judgement are confined to very limited circumstances.It is unfortunate that SARS did not realise this and has now burdened our already turgid Income Tax Act with even more redundant and restrictive amendments. If the proposals are adopted, companies leaving South Africa will now be worse off than they were prior to the case. Notwithstanding the judgement in the Tradehold case, exit taxes are still with us and will be for some time to come.
Source: By Barry Ger (TaxTalk)