In advising on international corporate transactions we often advise taxpayers that directly, or indirectly through a foreign subsidiary, dispose of their equity shares in foreign subsidiaries or equity investments resulting in a taxable capital gain. What looks like a simple transaction, capable of being executed in a tax neutral manner, could very easily result in adverse tax implications for the disposing shareholder.
To illustrate the risks and pitfalls, we will use an example of a disposal of equity shares in a foreign holding company A, that has two wholly-owned foreign subsidiaries B and C.
The disposal of equity shares in A is subject to capital gains tax (CGT) in the hands of the disposing person, unless the so-called participation exemption applies to exempt any gain arising from the transaction from CGT.
Broadly speaking the participation exemption applies where the equity shares in A are disposed of for an amount equal to or exceeding market value, and the person disposing of these shares (whether alone or together with another group company):
- held an interest of at least 10% of the equity shares and voting rights in that foreign company;
- held the interest for at least 18 months prior to the disposal; and
- the shares are disposed of to a person that is not a resident or a CFC for South African purposes.
In assessing tax risk, taxpayers often stop at this point of the enquiry, assuming that if they comply with this exemption, the transaction will be tax neutral.
There is, however, a second level of resultant disposals that need to be considered for CGT purposes and which could result in effective double taxation of any gain arising on the transaction.
A company is a CFC for South African tax purposes if South African residents hold more than 50% of the participation rights, and can exercise more than 50% of the voting rights in the foreign company.
Where A, B or C cease to be CFCs for South African tax purposes, each company is deemed to have disposed of all of its assets at market value on the day before the day it ceases to be a CFC. In our example, this situation arises where, as a result of the disposal of shares in A to a non-resident A, B and C cease to be CFCs as they are no longer controlled by South African residents. The resultant taxable capital gain of A, B and C must then be attributed to the controlling South African shareholders of A in accordance with the provisions of section 9D.
The Income Tax Act, however, provides some relief. The deemed disposal rules described above do not apply if, in our example, a person disposes of an equity share in A (a CFC), the capital gain is exempt under the participation exemption and as a direct result (A) or indirect result (B and C) of this disposal these foreign companies cease to be CFCs.
The result of the deemed disposal rules is an effective double taxation. In our example, should the disposal of the shares in A not qualify for the participation exemption, the South African resident shareholders in A that hold at least 10% of the participation and voting rights in A will be subject to tax on both the gain arising from the disposal of the A shares, and the attribution of net income from A, B and C on the gain resulting from the deemed disposal of these assets. Although these taxable amounts are derived from the same underlying economic value they are included in the taxable income of the shareholders of A by way of different legal mechanisms. No credit mechanism exists to prevent this economic double taxation.
In planning the disposal of foreign equity shares it is therefore essential to ensure that the disposal of the shares in A is exempt under the participation exemption, and that any foreign companies that cease to be CFC do so directly or indirectly as a result of this tax exempt transaction.
A high risk area is where piecemeal disposals in foreign companies are made. Assume that A, B and C are CFCs on account of A’s 6 South African residents shareholders collectively holding 51% of the participation rights and voting rights in A. 5 shareholders each holds 10% each and one shareholder holds 1%. If the shareholder that holds 1% disposes of its shares in A, A will cease to be a CFC. The disposing shareholder will not qualify for the participation exemption as he did not hold at least 10% of the equity shares in A. However, the disposal will result in an attribution of net income in the hands of the 5 shareholders, but not in the hands of the 1% disposing shareholder as this shareholder does not hold at least 10% of the participation and voting rights in A. This scenario could, for example, also arise where the 1% shareholder distributes its shares in A to its non-resident shareholder by way of a dividend in specie.
The disposal of shares in foreign companies therefore need to be dealt with, with great caution and requires detailed planning to prevent potentially nasty surprises.