SARS to target privately held companies earning passive income
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.