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Anti-corporate migration laws, equity and South Africa as a headquarter location

Monday, 13 April 2015   (0 Comments)
Posted by: Authors: Justin Liebenberg and Charles Makola,
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Authors: Justin Liebenberg and Charles Makola (EY)

A discussion on South Africa’s anti-corporate migration laws and the ways in which they inhibit local equity raising efforts and the use of the country as a headquarter location

The anti-corporate migration amendment to paragraph 11 and 35 of the eighth schedule to the Income Tax Act discourages the use of South Africa as a hub for headquarter companies and makes it impossible to fund foreign acquisitions through the issue of local shares. An international company that restructures its business by moving offshore subsidiaries into a company headquartered in a different region may do so on a cash-free basis or a combination of cash and equity or scrip. A cash-free transaction would generally be undertaken where no value exits the group. In the case of a foreign acquisition, a combination of cash and debt would normally be used. 

For example, a foreign parent company ("ParentCo”) that owns shares in foreign subsidiaries ("ForeignSubs”) could decide to locate the shareholding of the ForeignSubs in an intermediary holding company based in South Africa ("SACo”).  The commercial reasons for choosing South Africa as a base can vary – the location, size of economy, financial market access, relative political stability, and so forth.  

Before 2014, this transaction could be undertaken wholly or partially on a cash-free basis, through a cross-issue of shares.  That is, (i) ParentCo would establish a SACo and (ii) contribute its shares in ForeignSubs to the SACo in exchange for the issue of the SACo’s shares.  The transaction would not attract any South African income tax implications because no South African economic value would have actually changed hands.  The issue of shares by a company has long been tax-free (in other words, is not a disposal for capital gains tax purposes).   Paragraph 11(2)(b) of the eighth schedule to the Income Tax Act specifically excluded the issue of shares from the definition of disposal.

However, in 2013, an amendment was brought into paragraph 11(2)(b) that had the effect of triggering a disposal in the case where the shares are issued in exchange for foreign shares. The amendment came into effect on 1 January 2014.  In terms of the revised paragraph, the issue of a share by a company that is a resident to any person in exchange directly or indirectly for shares in a foreign company constitutes a disposal for capital gains tax purposes.  Given that there is no cost base on the issue of shares, the base cost of the shares will be nil.  However, the proceeds of sale are deemed to be the fair market value of the shares in the foreign company.  

Applied to the facts under consideration, the effect of the amendment is that the SACo will be liable for capital gains tax at an effective rate of 18.65 per cent on the fair market value of the ForeignSubs shares.  This is the case even though the ForeignSubs were never under the direct or indirect South African corporate tax base. 

The Draft SARS CGT guide (issue 5) provides that the amendment will also apply where a company issues shares in exchange for cash and then uses the cash to acquire shares in a foreign company.  This is on the basis that the amendment targets both ‘direct and indirect’ foreign share acquisition.  Thus in the example, SACo will potentially suffer the same tax treatment if it was to fund the acquisition of the ForeignSubs by raising local equity capital. 

The aforementioned result arises because there seems to be a disparity between the wording of paragraph 11(2)(b) and the intention of the legislature.  The purpose of the revised paragraph, as noted in the Explanatory Memorandum to the 2013 Taxation Laws Amendment Bill, was arguably to prevent the indirect shifting of economic value that is already attached to the South African tax base outside the direct South African tax reach.  Through this shift, taxpayers were supposedly able to exit the investment tax-free.  The argument is that:

  • Had the resident shareholder disposed of the shares in a South African company, the disposal would be liable for capital gains tax.
  • The issuing of shares to a foreign shareholder instead of a direct disposal of the existing shares represents the shifting of value from the direct to an indirect South African capital gains tax framework.  Considering that non-residents are generally not subject to tax on disposal of domestic shares (subject to exceptions), the shares issued to a non-resident may never be subject to capital gains tax in South Africa.  Furthermore, to the extent that a substantial equity stake (more than 10%) of the foreign entity is acquired by the resident, the ultimate disposal of those foreign shares would be exempt from South African tax if exited to an uncontrolled foreign third party. 

It appears that the targeted scenario is different from the ParentCo scenario described above.  In the scenario described, SACo clearly has no intrinsic pre-transaction value to shift offshore.  Taxing SACo under the circumstances also appears to be contrary to the general thread of the Income Tax Act on taxing incoming value.  For example, had ParentCo or the ForeignSubs simply assumed tax residency of SA no tax implications would accrue.  The companies under the circumstances would rebase their assets; in recognition that the incoming value was accrued outside the SA tax net.  

There is also a question of what is the asset being disposed of? The deeming provision in paragraph 35(1A) assumes that it is a share. The CGT guide appears to be of the view that the asset would be a personal right created pursuant to an agreement to issue shares.  That is, a personal right to have the shares taken up is created and the actual issue of shares constitutes the disposal of such right.  If this is so, there appears to be a conflict in the wording between para 11(2)(b) and paragraph 35. If the asset is something other than a share, then arguably paragraph 35 does not provide deemed proceeds. In the absence of the deemed proceeds the proceeds in the current circumstance may arguably be nil.

A further question relates to the base cost of the asset. Arguably, the base cost of the ‘personal right’ is the cost of creation of such right.  The SARS CGT guide assumes that a company would have paid nothing for the personal right, resulting in an almost zero base cost (except for legal fees and other ancillary costs). A distinction is made between the base cost of the foreign shares acquired (which is deemed to be the market value in terms of section 40CA) and the base cost of the personal right created. 

This amendment creates significant uncertainty and has the effect of greatly hindering the creation of South African regional holding companies.  Foreign companies (including continental African companies) cannot readily be placed under South African company control without a significant tax charge.  The line between a legitimate local equity raising transaction to fund a foreign acquisition and the targeted avoidance is also blurred.

It was encouraging that the item was put at the top of the National Treasury/SARS workshop agenda for possible inclusion in the 2015/16 budget cycle.  During this workshop (held in December 2014), National Treasury raised various concerns, including the economic implications of the tax-free inversion of national champion companies (mainly listed companies).  Whilst arguably understandable, it still remains unclear what options National Treasury would likely consider if the item is adopted for legislative consideration.  The inclination seems to be to refine the anti-avoidance provision to make it more focused on the targeted tax ills.

This article first appeared on the March/April 2015 edition on Tax Talk. 

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