South Africa: An Investment Gateway into Africa

In The Economist recently, Barclays CEO Bob Diamond argued that Africa’s success will hold lessons for reviving finance and the economy elsewhere (17 November 2011, ‘The Next Frontier for Finance’).

Promising as this seems, the reality is that doing business in Africa is different from doing business in most other places in the world. Local knowledge partners are key to the success of the venture and often financing takes the form of equity rather than debt.

South Africa is often referred to as the ‘gateway’ into Africa. It certainly provides investors with access to the commercial, financial and technical expertise necessary for setting up and implementing their investments in Africa and elsewhere

However, from a taxation perspective, in the past South Africa has not been able to compete with a number of other jurisdictions, in particular the Netherlands and Mauritius, as the country of choice through which investments might be structured. Prior to 2011, tax impediments included controlled foreign company (CFC) rules, taxation of dividend payments to shareholders and thin capitalisation and transfer pricing rules.

However, in order to remove these tax impediments and in a bid to boost the country’s credentials as the powerhouse of Africa, last year the South African government introduced a tax and exchange control regime that would make the country more attractive as a location for setting up holding companies (the ‘HQ regime’).

The regime applies to holding companies set up with the principal objective of holding investments outside of South Africa. In essence the regime exempts headquarter companies from CFC rules, tax on paying or receiving dividends, and thin capitalisation and transfer pricing rules in relation to financing.

For tax purposes, there are basically four qualifying requirements for companies:

1. Tax residence: The company must be tax resident in South Africa. The company will be tax resident in South Africa if it is incorporated or has its place of effective management in the country
2. Investor requirement: For each tax year since inception, each shareholder (alone or together with other companies within the same group of companies) must hold at least 20 per cent of the equity shares in the company.
3. Investment requirements: At the end of each tax year, 80 per cent of the base cost of the company’s assets must be represented by equity or debt investments in non-South African entities in which the company holds an equity interest of at least 20 per cent.
4. Income requirement: At the end of each tax year, 80 per cent of all the company’s income (including dividends, interest, royalties, management fees and service fees) must be derived from non-South African entities in which the company holds an equity interest of at least 20 per cent.

A headquarter company will be eligible for the following elements of tax relief.

CFC Rules: The fact that a headquarter company holds shares in a foreign company, directly or indirectly, will not be relevant to whether that company is a controlled foreign company. In effect, the presence of the headquarter company will be ignored and the CFC status of its foreign subsidiaries will be determined based on the indirect participations in those foreign companies held by the headquarter company’s shareholders.

Dividend payments to shareholders: As a headquarter company is a resident company it would, in the normal course, be subject to secondary tax on companies (STC) in respect of dividends declared to its shareholders. Similarly, the proposed dividends tax would apply once it replaced STC. Under the proposals, the headquarter company would be excluded from these rules. It should also qualify for the participation exemption in respect of foreign dividend income and a dividend received by the headquarter company’s resident shareholders should also be exempt.

Dividends should therefore flow through to the headquarter company without any tax cost.

Dividends received: As a South African tax resident, the headquarter company is entitled to all deductions and exemptions under the Income Tax Act, such as the participation exemption. In terms of the participation exemption, the headquarter company may receive foreign dividends tax free, if it holds more than 20 per cent of the equity share capital and voting rights in the paying subsidiary, provided the paying subsidiary is not a foreign financial instrument holding company. (It is proposed that the 20 per cent qualifying threshold be reduced to 10 per cent in terms of the 2011 Taxation Laws Amendment Bill.)

Thin capitalisation rules: A headquarter company will not be subject to the thin capitalisation rules in relation to foreign loans that are used to finance foreign companies in which the headquarter company has an equity interest of at least 20 per cent.

Transfer pricing rules: The transfer pricing rules do not apply to interest paid to shareholders of a headquarter company, ie, deductions of the interest expense on such loans will be limited to the interest earned on the corresponding advances to the foreign companies.

The transfer pricing rules will also not apply to loans made by the headquarter company to its subsidiaries, ie, interest will not be imputed to the headquarter company where low or no interest is charged on loans to its subsidiaries. 

Other than in relation to the thin capitalisation rules, the headquarter company would be subject to the normal rules relating to transfer pricing. This would, for example, require the company to earn a margin on any back-to-back arrangements (intellectual property licences and service supplies).

Interest, royalties and service fees would be subject to tax at the normal rate of tax, currently 28 per cent.

CGT on disposal of subsidiaries: A headquarter company is also entitled to the participation exemption on realised foreign gains, in terms of which it may realise capital gains tax free, if it held more than 20 per cent of the equity share capital and voting rights in the disposed of subsidiary for longer than 18 months, provided the paying subsidiary is not a foreign financial instrument holding company. (It is proposed that the 20 per cent qualifying threshold be reduced to 10 per cent in terms of the 2011 Taxation Laws Amendment Bill.)

Withholding tax on interest: With effect from 1 January 2013, but subject to relief under a relevant double tax treaty, certain interest payments from South Africa will be liable to an interest withholding tax of 10 per cent. 

A headquarter company will not be liable to this interest withholding tax, ie, interest payments to its shareholders will not be subject to the withholding tax. 

CGT on exit: In terms of the 2011 Taxation Laws Amendment Bill it is proposed that the structure of the participation exemption relating to headquarter companies be amended in that the term ‘headquarter company’ will no longer be included in the definition of foreign company. Instead a specific subsection will be added to the act to make the participation exemption relevant to headquarter companies.  

Exchange Control

With effect from 27 October 2010, the South African exchange control authorities relaxed regulations regarding exchange controls, resulting in them being treated as a non-resident for exchange control purposes. However, for statistical purposes, a headquarter company needs to report on the extent of its offshore investments, including the source of funds, new or existing funds, destination, loan funds from local sources, etc. 

As a non-resident, a headquarter company may therefore raise and deploy capital offshore without restriction. It can freely borrow from abroad and such funds may be deployed locally or offshore. Transactions by South African entities with headquarter companies will be viewed as transactions with non-residents. These transactions will be regarded as occurring outside South Africa.

In addition to the tax qualifying criteria above (but not the income requirement), a headquarter company must meet the following additional requirements in order to register for the exchange control regime:

• The shares and/or debt of the headquarter company may not be listed on the JSE Limited nor may the shares in the headquarter company be directly or indirectly held by a shareholder with shares or debt listed on the JSE Limited.
• No more than 20 per cent of the headquarter company shares may be directly or indirectly held by residents.

Proposed Amendments in  the2011 Taxation Laws Amendment Bill

• The 80 per cent cost of assets test will be relaxed. The 80 per cent asset requirement will no longer be determined with reference to cash and cash equivalents, such as money market deposits (ie, assets with a market value equal to base cost). This proposed amendment aligns the tax requirements with the exchange control requirements in relation to cash and cash equivalents. 
• The new headquarter company regime will require pre-approval.  In the case of companies formed or established on or after 1 January 2011, this pre-approval may come from either the South African Reserve Bank or from the National Treasury.
• Companies formed before 1 January 2011 seeking to enter the headquarter company regime may do so only upon approval from the National Treasury. Approval will be granted if Treasury is satisfied that the headquarter company treatment will enhance South Africa as a regional headquarter destination; lead to the creation of additional skills or related intellectual infrastructure; and will not lead to the erosion of the South African tax base. The headquarter company, once approved, would be required to submit annual reports to the Minister. 

Accordingly, subject to meeting the tax and exchange control requirements, a headquarter company which invests into Africa can be used to great effect to provide an African hub and could reduce taxes on dividends and capital gains from its subsidiaries.