Pas­sive at­tack

SARS to tar­get pri­vately held com­pa­nies earn­ing pas­sive in­come

Finweek English Edition - - Creating Wealth - BARRY GER

A RE­CENTLY PRO­POSED CHANGE in South Africa’s tax laws may cause ma­jor headaches for in­di­vid­ual tax­pay­ers who own cor­po­rate en­ti­ties that earn mainly pas­sive in­come – for ex­am­ple, div­i­dends and in­ter­est. Es­sen­tially, it’s been pro­posed such cor­po­rate en­ti­ties be made sub­ject to a higher rate of tax than or­di­nary com­pa­nies and have nor­mally tax-free div­i­dends earned by such en­ti­ties taxed at a rate of 10%.

Al­though the change is set to take ef­fect only when the new div­i­dend tax is brought in (on a date yet to be an­nounced by the Fi­nance Min­is­ter, but most likely late this year or even 2010) many in­di­vid­u­als may won­der whether it’s now time to re­struc­ture their in­vest­ment hold­ings they had un­til re­cently con­sid­ered tax ef­fi­cient.

The new leg­is­la­tion, as set out in the Rev­enue Laws Amend­ment Act 2008, is meant to ad­dress two ar­eas of sup­posed tax avoid­ance that con­cern the SA Rev­enue Ser­vice.

The first re­lates to a fu­ture con­cern, namely the de­fer­ral of div­i­dend taxes. Cur­rently, div­i­dends from SA com­pa­nies are sub­ject to a tax known as secondary tax on com­pa­nies (STC), levied at a rate of 10% when com­pa­nies de­clare div­i­dends. How­ever, STC will be scrapped very soon and re­placed with a div­i­dend with­hold­ing tax that will shift the tax li­a­bil­ity from the com­pa­nies to the in­di­vid­ual share­hold­ers who re­ceive div­i­dends. Cor­po­rate share­hold­ers will gen­er­ally be ex­empt from the new tax.

Rev­enue is con­cerned as­tute in­di­vid­ual share­hold­ers could de­fer the new tax in­def­i­nitely sim­ply by hav­ing only cor­po­rate en­ti­ties they con­trol re­ceive div­i­dends and then de­lay declar­ing those div­i­dends. Hence the pro­posal that th­ese “trapped div­i­dends” be made sub­ject to the 10% tax when re­ceived by cor­po­rate en­ti­ties.

The sec­ond area re­lates to a long­stand­ing prac­tice of tak­ing ad­van­tage of ar­bi­trage op­por­tu­ni­ties be­tween the cor­po­rate and in­di­vid­ual tax rates in SA. Cur­rently, cor­po­rates are sub­ject to a tax li­a­bil­ity of 28% of their an­nual in­come. How­ever, high net worth in­di­vid­u­als face a max­i­mum mar­ginal tax rate of 40%.

In light of this dif­fer­ence in rates it has been, un­til now, stan­dard ad­vice by tax plan­ners that if some­one is go­ing to earn pas­sive in­come you don’t im­me­di­ately need, rather have such in­come earned and taxed in a com­pany’s hands. The new leg­is­la­tion aims to sub­ject that pas­sive in­come earned by the com­pany to a rate akin to that of an in­di­vid­ual.

That tax li­a­bil­ity is not the prob­lem of only the com­pany. The new leg­is­la­tion con­tains a pro­vi­sion that ren­ders in­di­vid­ual direc­tors of share­hold­ers in­volved in the man­age­ment of the com­pany’s over­all fi­nan­cial af­fairs per­son­ally li­able for the com­pany’s tax debts.

Be­fore tax­pay­ers start run­ning off to liq­ui­date their in­vest­ment hold­ing com­pa­nies, it would be pru­dent for them to check whether their in­vest­ment-hold­ing com­pa­nies are ac­tu­ally “pas­sive hold­ing com­pa­nies” as de­fined in the pro­posed leg­is­la­tion. The laws are rather spe­cific in that re­gard. In or­der to qual­ify as a ”pas­sive hold­ing com­pany” an in­vest­ment hold­ing com­pany must meet three re­quire­ments:

First, at any time in the tax year more than 50% of its “par­tic­i­pa­tion rights” (ie, gen­er­ally its shares) must be held di­rectly or in­di­rectly by five or fewer in­di­vid­u­als who are South African res­i­dent tax­pay­ers. (That would seem to ex­clude com­pa­nies wholly held by fam­ily trusts – an over­sight in the leg­is­la­tion that’s sure to be cor­rected in later amend­ments.)

Sec­ond, more than 80% of the com­pany’s an­nual in­come in a given year must con­sti­tute “pas­sive in­come”. Pas­sive in­come is a de­fined term and refers to cer­tain in­come de­rived from fi­nan­cial in­stru­ments. Royalty in­come, cap­i­tal gains, div­i­dends de­rived from in­vest­ments in which the com­pany holds an in­ter­est of 20% or more and, notably, rental in­come, are ex­pressly ex­cluded. So peo­ple who hold their prop­er­ties in com­pa­nies may breathe a col­lec­tive sigh of re­lief.

Third, cer­tain com­pa­nies are ex­empt from the pas­sive hold­ing com­pany regime. Those in­clude en­ti­ties such as over­seas com­pa­nies, banks, listed com­pa­nies and pub­lic ben­e­fit or­gan­i­sa­tions.

Ad­di­tion­ally, there are some mea­sures to pre­vent dou­ble tax. For ex­am­ple, when the pas­sive hold­ing com­pany pays out div­i­dends the new div­i­dend with­hold­ing tax will only be levied on that por­tion of the div­i­dend dec­la­ra­tion that hasn’t al­ready been taxed un­der the new tax laws.

De­spite the afore­men­tioned re­lief pro­vi­sions, the new tax will cer­tainly cause some wealthy South African tax­pay­ers to re­con­sider their in­vest­ment struc­tures.

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