South African tax resident beneficiaries, offshore private companies and offshore trusts – Section 25B (2B)

As most tax advisors, lawyers, accountants and financial services professionals will be aware, Section 10B of the Income Tax contains a provision, known as the ‘participation exemption’ that applies when a SA tax resident holds ten percent or more of the voting rights or membership of an offshore company. More on the participation exemption further below.

The excitement that this provision might generate is tempered somewhat by virtue of the provisions of Section 9D, which, under certain circumstances would cause the net income of the offshore company to be taxed in the hands of the SA tax resident.

Fortunately, the rules regarding the imputation of the net income of the offshore company is subject to exemptions.

Also, if the offshore company is not a ‘controlled foreign company’ (cfc) the provisions of Section 9D don’t apply.

The effect of this is, where a SA tax resident owns 10% or more of an offshore company that is not a cfc, the dividends received from such offshore company are not subject to tax in the hands of the resident.

The rules that are applicable to dividend withholding tax will be thoroughly examined in a follow up article.

Exemptions that apply to the provisions which would otherwise result in the SA resident being liable for tax upon the net income of the cfc include the business establishment exemption and an exemption that applies if the tax rate applicable to the offshore company is a minimum of 67,5% of the SA tax rate. These exemptions are further subject to a slew of provisos, which require further examination at a later date. Suffice it to state that the subject of offshore dividends or income and the taxation thereof in a SA tax resident’s hands is a complex one.

Now, if we assume that the exemptions do apply and that the SA resident who holds members interests or voting rights in a cfc directly, will not have the net income imputed to them, then the dividends would be free in SA from South African income tax.

Compliance with the Income Tax Act at Section 72A, which relates to the reporting of the offshore company income and dividends for SA tax purposes is another matter entirely.?For present purposes, the reader should be aware that such reporting requirements do exist and must be taken note of most carefully.

Many offshore operators tend to own their offshore private company shares in trusts, set up offshore, to protect their interests.

Some jurisdictions have very tough and onerous tax rules. The offshore companies, especially smaller private companies thus are subject to risk from that quarter. For this reason and also for estate planning and insolvency protection purposes, it is often sound advice to hold the offshore company interests in trust.

Section 25B applies to trusts and the distributions from trusts to the beneficiaries. In a previous article, the fact that Section 25B is made subject to the provisions of Section 7 of the Income Tax Act was covered in some detail. (Please contact the writer if a copy thereof is desired).

Section 25B (2A) applies to offshore trusts. ?Distributions from the offshore trust to beneficiaries who are SA residents are only subject to SA tax upon the accrual of the distribution in the hands of the SA beneficiary. This is patent, because the offshore trust itself falls outside of the SA tax net. For sake of clarity, the offshore company, if not managed and controlled in SA is also outside of the tax net. The net income of such an offshore company is imputed to a SA resident, if imputation is applicable, due to deeming provisions in the Act. Thus the double tax avoidance provisions don’t really assist holders of cfc interests in SA.

Back to the offshore trust distribution. If the capital that is distributed has not been subject to tax in South Africa, it is then subject to tax in the SA resident beneficiary’s hands to the extent that this person had a contingent right to the distribution during the years that the trust accumulated that capital.

Normal tax rates apply to the distribution. This is the effect of Section 25B (2A).

Now, if we speak of dividends and assuming again that such dividends would have been tax free by virtue of the participation exemption, there is another hurdle that must be faced. This hurdle is found at Section 25B (2B) which restricts the effect of the participation exemption.

Here we must appreciate the wording of the aforementioned Section 25B (2A). If the dividend were received by a local trust, the participation exemption would have applied if the trust were the holder of 10% or more of the interest in that offshore private company.

The reader will appreciate that Section 25B (2A) provides that the private company dividend would be free of tax had it not been subject to tax in SA, as in a local trust setup. Due to the participation exemption of course.

The effect of holding interests in public companies must, for the sake of brevity, feature in a further article.

The provisions of Section 25B (2B) now come to the fore. These are such that the ‘provisions of section 10B(2)(a) ?- the participation exemption - must be disregarded in respect of an amount received or accrued consisting of or derived, directly or indirectly, from a foreign dividend paid or payable by a company if more than 50 per cent of the total participation rights, as defined in section 9D(1), or of the voting rights in that company are directly or indirectly held or are exercisable, as the case may be, by that trust whether alone or together with any one or more persons that are connected persons in relation to that trust; and?that resident or any person that is a connected person in relation to that resident is a connected person in relation to that trust’.

In a nutshell, if the trust, along or together with a connected person holds 50% or more of the interests in that offshore company, then and in that event, the dividend income is not covered by the participation exemption and is thus subject to tax in SA.

In the unlikely event that the offshore trust does not, together with a connected person, hold 50% or more of the offshore company, the participation exemption WILL apply. Nice.

Fortunately, the amount of tax payable in SA will, under certain circumstances be lower than the full amount that otherwise might apply. The provisions that apply to such a concessionary rate are complex and thus must form the basis of a further analyses at a later date.?