ANTI-AVOIDANCE TAX RULES AND FOREIGN TRUSTS
FOR SOME time, the government has been concerned by the use of interposed foreign trusts to avoid the taxation on controlled foreign companies (CFCs).
New rules were proposed in 2017, but were withdrawn because of their wide nature and complexity. The Taxation Laws Amendment Act of 2018 brought into law new antiavoidance rules that applied with effect from March 1, 2019.
The nature of the government’s concern has been that South African residents are able to circumvent the application of the CFC rules by interposing a foreign trust that maintains the shareholding of a foreign company. This has enabled residents to re-characterise income from foreign companies to avoid tax.
To counter the loophole as envisaged above, section 7(8)(aA) has been introduced into the Income Tax Act. In terms of the new provisions, when determining the amount of income to be included as taxable income in the hands of a person under section 7(8)(a), it will disregard the participation exemption in respect of foreign dividends under section 10B(2)(a). That participation exemption will be disregarded where more than 50 percent of the total participation rights in that company are directly or indirectly held by that person, whether alone or together with any connected person.
In practical terms, we shall consider the following scenario: a South African resident effectively holds shares in a foreign company via a foreign trust where that resident was the settlor. The trust holds more than 10 percent of the shares in the company. In respect of foreign dividends received by or accrued to the foreign trust, section 10B(2)(a) would exclude them from the definition of income. On the application of section 7(8)(a), there would therefore be no amount to include in the taxable income of the South African resident. However, as a result of the new section 7(8) (aA), the participation exemption in respect of the foreign dividends will be disregarded, and the amount must be included in the income of the resident if the following is met:
◆ More than 50 percent of the total participation rights in the company are held by the foreign trust, whether alone or with connected persons.
◆ The foreign trust has a connected person relationship with the South African resident that made the donation settlement or other disposition, or any person connected to that resident.
This will result in the foreign dividends being an amount that could be included in the taxable income of the resident.
What is important to note is that these new provisions do not affect section 10B(3) of the Act whereby a portion of the taxable foreign dividends are subject to an exemption. This results in the foreign dividends being effectively taxed at the same rate as local dividends.
Further to the insertion of section 7(8)(aA), similar anti-avoidance provisions have been included in section 25B. This applies where a resident beneficiary acquires a vested right in an amount received by or accrued to a foreign trust. There will be a similar disregarding of the participation exemption when the amount represents a foreign dividend, resulting in an amount of income that would be included in the taxable income of the South African resident beneficiary.