In terms of the current law, interest earned by non-resident lenders from South African (“SA”) resident borrowers is generally exempt from SA income tax. The interest may be sourced or deemed to be sourced in SA, but the exemption applies provided that the non-resident lender did not carry on business in SA through a permanent establishment (“PE’) during the relevant year of assessment, in the case of legal persons. In the case of individuals, the interest will be exempt from SA income tax provided that the nonresident was not physically present in SA during the relevant year of assessment for more than 183 days.
In February this year, changes to this exemption were announced as part of a number of amendments intended to close “sophisticated tax loopholes”. In this regard, the Budget Review states that “The purpose of this exemption is to attract foreign investment, but the overly broad nature of the exemption means that investors in tax havens can invest in South African debt with little restriction. The exemption will be restricted to contain the leakage. However, none of the changes anticipated will affect foreign investment in South African bonds, unit trusts, bank deposits or the like.”
The proposed amendments to the interest exemption, if promulgated in the current format, do much more than close tax avoidance schemes. They may end up discouraging foreign investment in SA.
Generally, interest earned by a non-resident from a SA resident borrower will be sourced or deemed to be sourced in SA under section 9(6) of the Income Tax Act, 58 of 1962 (“the Act”) and will, therefore, be subject to SA income tax unless an exemption applies or an applicable double tax agreement (“DTA”) provides relief.
In terms of the proposed amendments, such interest will only be exempt from SA income tax if it is earned in respect of Government debt, instruments listed on the JSE, debt owed by a bank, debt owed by the South African Reserve Bank (“SARB”), debt owned by another non-resident (for example debt owned by a SA branch of a foreign company), the purchase or financing of goods imported to or exported from SA, dealer and brokerage accounts or certain interest distributed by certain collective investment schemes.
This means that interest earned by a non-resident on shareholder’s loans or through fiscally transparent investments funds such as private equity and hedge funds will, with effect from 1 March 2011, attract SA income tax.
A number of issues are not adequately dealt with in the proposed legislation and it is expected that some of these issues will be addressed in the next draft.
Furthermore, the limited exemption will not apply if the non-resident carries on business in SA through a PE situated in SA. This PE exclusion should only apply if the interest is attributable to the PE exclusion. If the local PE has no link to the interest earned by the non-resident, it is submitted that the interest should still qualify for the exemption.
The proposed legislation makes no exception for interest earned by a non-resident from a headquarter company. If the proposed headquarter company regime is to have any chance of success, it is submitted that the exemption must be expanded to include interest earned by a non-resident from a headquarter company.
The proposed legislation makes no provision for the collection of the income tax from the non-resident. There is no provision for a withholding mechanism. It appears that the non-resident will simply be required to register as a taxpayer in SA and be liable for income tax at a rate of 33% on the interest earned. In terms of general principles, the non-resident should be entitled to income tax deductions for the expenditure actually incurred in the production of the interest income. This can of course all be done by e-filing. However, unless the proposed legislation is amended to include clear rules on how the final tax liability will be calculated and collected, the South African Revenue Service (“SARS”) may have a difficult time enforcing the tax.
Interest earned by a non-resident from a SA branch of a foreign company, will continue to qualify for the exemption. Therefore, if a SA branch of a non-resident is funded by another foreign entity in the group, the non-resident investor has a better SA tax result than if the non-resident established a subsidiary in SA. Although, SA branches of foreign companies will in future be subject to the thin capitalisation rules, the favouring of SA branches over SA subsidiaries of foreign companies could not have been intended.
The proposed legislation applies in respect of any interest that accrues, is received, becomes payable or is deemed to have accrued on or after 1 March 2011. This means that it applies to existing debt instruments. Depending on the gross up provisions of existing instruments, SA borrowers may find that their cost of funding has increased significantly. This increased cost of funding may in turn result in the interest payable on the debt exceeding the exchange control limits and the interest payments approved by SARB at the time that the debt was introduced to SA, which may, in turn, result in the payment of the increased costs being illegal.
Finally, a number of the DTAs concluded by SA will provide relief from the proposed income tax on interest earned by non-residents provided that the interest is not attributable to a PE which the non-resident has in SA and that the non-resident is the beneficial owner of the interest. This includes some DTAs with so-called ‘tax havens’. Unless SARS embarks on another round of renegotiating DTAs to limit the relief for interest earned by non-residents, non-residents will be able to circumvent the tax by providing the funding through an entity tax which is resident in an appropriate DTA jurisdiction.
The real downside of the proposed legislation is that if routing the funding through an appropriate DTA jurisdiction is too costly or administratively burdensome, non-residents will simply increase the cost of funding to the SA resident borrowers or take their funding elsewhere.