An analysis of the South African income tax treatment of interests in loop structures

Abstract

The overall purpose of the South Africa's exchange control regulations is to regulate the outflow of capital from the country and to protect the domestic economy from capital movement. Historically exchange controls have been applied as part of the policy armoury to counter various base erosion and profit shifting (BEPS) arrangements including loop structures. Loop structures pose a risk to the South African tax base as they present an opportunity for abusive tax planning as they can be used as a vehicle to facilitate the avoidance or deferral of taxation by accumulating income abroad. Over the last two decades trends towards globalisation and economic liberalisation, have necessitated the phasing out of exchange controls. The recent shift to a capital flow management framework, coupled with National Treasury's aims of attracting foreign direct investment (FDI), and promoting international competition have culminated in lifting of exchange control restrictions on loop structures. The lifting of these restrictions were accompanied by amendments to the ITA aimed at protecting the tax base by refining the tax treatment of capital flows and to restrict the artificial reduction of dividends and capital gains tax where a foreign company is used in a loop structure to avoid or defer tax. The aim of this study was to analyse the principles that underpin the controlled foreign company (CFC) regime both globally and in South Africa to determine the appropriateness of the recent changes to CFC rules as contemplated in section 9D and paragraph 64B of the Income Tax Act as it relates to loop structures to ensure they are accommodating to investors investing back into South Africa on the one hand and still protect the South African tax base efficiently on the other hand. This study revealed that National Treasury did not target all loop structures, but only those where South African shareholders interpose a CFC between themselves and their interests in South Africa. Based on the analysis performed it was determined that the amendments appear to be effective as an anti-tax avoidance measure where a CFC forms part of a loop structure, which is its main purpose. However, the amendments do have wider implications for South African shareholders of a CFC that holds South African interests and would in particular instances go beyond its purpose as an anti-tax avoidance measure. It was revealed that the amendments were introduced to ensure that, where South African residents implement loop structures, the tax treatment of the South African interest held via the loop structure would be the same as the tax treatment that would have applied, if the South African resident directly held those interests. This study indicates that when the impact of the amendments is considered, the principle of equity and neutrality is not achieved with all loop structures. International competitiveness is vital to attract FDI, and the amendments should not inadvertently hinder otherwise legitimate commercially driven transactions, nor should it cause problems for the meaningful protection of the fiscus.