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Foreign tax will have good, bad outcomes

Thursday, 04 June 2015   (0 Comments)
Posted by: Author: Pierre Heistein
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Author: Pierre Heistein (Iol)

As of January 1, 2016, South Africa is expected to introduce a 15 percent withholding tax on service payments to non-resident entities.

This means that every time a business or person operating out of South Africa wants to pay for a service offered by a foreigner or foreign company, an additional 15 percent will be paid on the costs.

It is unclear at this stage whether the motive of the tax is to provide an extra source of revenue for government, or whether it is to discourage the purchase of foreign services and outflow of foreign exchange. A number of factors in the economy will be affected by such a tax imposition – some for better and others for worse.

The primary consequence of the tax will be an increase in the cost of doing business in South Africa. The increased tax burden must either be absorbed by the company – decreasing its profitability – or passed on to the consumer.

In the case that the costs are passed on to the consumer and the final consumers reside within South Africa, the tax imposition will lead to increasing pressure on inflation. For exporters this increase in costs will be passed on to foreign clients and the effect on inflation will be minimal however the price competitiveness of exporters will drop.

Illicit financial flows

The increasing cost of paying for foreign services will incentivise companies to find illicit methods of sending money out of South Africa to avoid paying the new taxes. A total of 65 percent of the world’s illicit financial flows (IFFs) come from commercial activity.

Companies have many tools at hand – such as abusive transfer pricing, false invoicing of services, and unequal contracts – if they wish to engage in illegal transfers of value or tax avoidance. With the imposition of the foreign payments tax, South African Revenue Service will need to tighten its regulation and vigilance to ensure that the policy is not undermined by IFFs.

Impact on local business

The policy is not all bad news though. While there will be some drop in business activity due to decreasing competitiveness and a slight outflow of foreign investment, there will also be a redirection of spending and extra stimulus to the local economy.

A foreign payments tax generally has the effect of raising tax revenues in countries where foreign involvement in exports is high but the quality and capacity of local service providers is low. In these cases the purchase of foreign services is unavoidable and the tax rate becomes tax revenue. This is especially typical in oil producing nations such as Nigeria and Angola.

But in South Africa the economic structure is different and the tax is likely to have a stronger impact on driving local economic growth than raising tax revenue.

The increased spending and investment in the local economy will help to drive growth, advance skills development, and increase employment. While redirecting attention to local resources can help build capacity, South Africa runs a risk of closing itself off from foreign skills and technological advancements.

Before implementing the new foreign payments tax the South African Treasury will want to carefully consider which foreign services help to drive South Africa forward. Where foreign services have a positive externality to the local economy they should be considered for a tax exemption.

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