Is the current international tax focus on base erosion and profit shifting (“BEPS”) relevant for tax-exempt pension funds?
In particular, should the trustees and/or administrators of pension funds take note of the finalisation by the Organisation for Economic Co-operation and Development (“OECD”) of the 15 point action plan to address BEPS?
Both of these questions should be answered “yes” by South African pension funds that invest outside of the country. More specifically, the OECD’s Report on Action 6 entitled “Preventing the Granting of Treaty Benefits in Inappropriate Circumstances” (“Action 6”) and the public discussion draft entitled “Treaty Residence of Pension Funds” which was released in February 2016 (“Discussion Draft”) are relevant for pension funds.
Although Action 6 identifies treaty abuse as one of the most important BEPS concerns and it recommends certain treaty anti-abuse provisions in order to, inter alia, address instances which result in double non-taxation, Action 6 and the Discussion Draft contain good news for tax-exempt pension funds.
To contextualise the recommendations in Action 6 and the Discussion Draft for South African pension funds, a brief summary of the taxation of pension funds in terms of South African law is necessary. In this regard, a “pension fund”, as defined in section 1 of the Income Tax Act, is exempt from income tax and capital gains tax. The definition of a “pension fund” refers, inter alia, to any fund (other than certain specified funds) that is approved by the Commissioner for the South African Revenue Service (“Commissioner”) in respect of the year of assessment in question and, in the case of any such fund established on or after 1 July 1986, is registered under the provisions of the Pension Funds Act. Therefore, a pension fund that is approved by the Commissioner is exempt from South African income and capital gains tax.
However, such a pension fund could be exposed to foreign taxes in respect of foreign investments. These include foreign taxes levied on income sourced in the foreign country, capital gains tax upon the disposal of investments and withholding tax levied on remittances from the foreign country. South Africa has entered into a number of treaties with foreign countries to reduce withholding taxes and limit or reduce double taxation. Seeing that the pension fund is exempt from South African tax, it would not be able to offset foreign taxes paid against the South African tax payable. It is therefore very important for a pension fund to be able to rely on the relief available to South African residents in the treaties to which South Africa is a party.
In order to rely on the treaties to which South Africa is a party, the pension fund has to qualify as a “resident” under the treaty. Each treaty has its own definition of a “resident” but typically, this definition requires a person to be liable to tax in South Africa. This raises the question whether a pension fund that is exempt from tax will be liable to tax in South Africa.
Currently, the OECD commentary on the Model Tax Convention notes that a person is considered liable to comprehensive taxation even if the contracting state does not in fact impose tax. It notes that a pension fund may be exempt from tax, but is exempt only if such fund meets all the specific requirements for exemption in the contracting state’s tax laws. The OECD commentary notes that if it does not meet the standard specified, then it is required to pay tax. Although this is generally the case in the South African context, i.e. the pension fund needs to comply with the definition of “pension fund” in the Income Tax Act in order to qualify for the tax exemption and the definition requires, inter alia, that the Commissioner approves the fund (and contain conditions which must be satisfied for such approval), this is not always the case since the pension fund definition also includes funds that are established in terms of specific statutes which do not require approval by the Commissioner.
Furthermore, difficulties may arise in instances where the other country to the treaty does not regard such pension funds as residents, which are entitled to the relevant relief.
It is in this context that Action 6 provides good news to pension funds, in that it stated that:
“Additional work will also ensure that a pension fund should be considered to be a resident of the State in which it is constituted regardless of whether that pension fund benefits from a limited or complete exemption from taxation in that State. This will be done through changes to the OECD Model Tax Convention, to be also finalised in the first part of 2016, that will ensure that outcome for funds that will meet a definition of “recognised pension fund”… (our emphasis).
As part of the further work, the Discussion Draft contains proposed draft changes to Articles 3 and 4 of the OECD Model Tax Convention and allowed for comments to be provided.
Once the recommendations in the Discussion Draft are finalised and implemented, treaties entered into by South Africa that are based on the OECD Model Tax Convention would need to include a specific reference to a “recognised pension fund” in the residence definition, which would entitle such pension fund to the benefits that the specific treaty provides. This would provide certainty to a South African pension fund that qualifies as “recognised pension fund” that it is entitled to the relief provided in such treaty.