Unbundling and black economic empowerment emerged as major catalysts for Merger and Acquisition (M&A) activity in 1996, the former accounting for 18% and the latter 11% of the total transaction value of M&A transactions recorded for the year, according to the latest Ernst & Young annual Survey of Merger & Acquisition Activity. The total value of M&A transactions recorded during 1996 was R62,2 billion, a 43% increase over 1995. The survey records 276 deals in which values were disclosed, 50% more than in 1995.
The total value of M&A transactions in 1996 was 7,7 times greater than the R8,1 billion recorded in 1993 at the start of the present economic upturn.
A discernible trend in 1996 was the significant increase in the number of mega deals (deals valued at more than R1 billion). There were 18 mega deals in 1996, valued at R40 billion (64,5% of the total), as against just 5 such deals in 1995, valued at R26,3 billion.
The largest transaction during the year was the R6,1 billion restructuring of Anglovaal’s mining interests into two operations: a diversified mining, development and exploration company and a single, consolidated gold mining, development and exploration company. It did this by consolidating all mining interests, with the exception of its 21,9% interest in the Saturn joint venture (which receives royalties from the Venetia mine), into Middle Witwatersrand, renamed Avmin. Black Economic Empowerment
According to David Thayser, corporate finance partner at Ernst & Young, the pace of black empowerment activity picked up in 1996, creating a new and diversified corps of black shareholders who succeeded in acquiring some excellent assets, including Johannesburg Consolidated Investments (JCI) and Johnnic.
There were 45 black empowerment deals in 1996, with a disclosed value of R7 billion, compared with 23 deals with a disclosed value of R12,4 billion in 1995 (the 1995 figure includes the R12 billion unbundling of JCI, and thus an element of double counting exists). These figures do not reflect the full picture, however, as values were not disclosed in a large number of black empowerment deals.
No fewer than three giant black empowerment deals appear in the 1996 list of mega deals:
- African Mining Group’s (AMG) acquisition of 34,9% of JCI for R2,9 billion (since going to press the form of the deal has been altered as a result of difficulties experienced by AMG in raising finance);
- the R1,6 billion restructuring of New Africa Investments Limited (Nail); and
- the epochal acquisition by the National Empowerment Consortium (NEC) of 35% of industrial conglomerate, Johnnic, for R2,6 billion.
Although slightly smaller than the African Mining Group’s acquisition of a controlling stake in JCI, the Johnnic deal established a new frontier in black empowerment by vesting ownership in a broad alliance of black groups from business, labour and community organisations, with grass roots representation of more than a million people. Whereas in previous years black empowerment was dominated by a relatively small group of black-controlled companies, exposing the beneficiaries to charges of “enrichment” rather than “empowerment”, in 1996 there was an earnest attempt to broaden the black ownership base. The National Empowerment Consortium (NEC), comprising close to 40 business, trade union and community groups, established a new model for black empowerment which holds important lessons for future privatisation’s and large-scale empowerment exercises, says Thayser.
1996 saw the emergence of trade union and community-based investment groups such a Mineworkers Investment Company (MIC), affiliated to the 370 000-member National Union of Mineworkers, the SA Clothing and Textiles Workers Union (Sactwu) Investment Group, the SA National Civics Organisation Investment Company, Women’s Investment Portfolio, among others. These groups now exert substantial influence over assets worth several billions of Rands, occupy seats on company boards and have a say in key management decisions such as investment and labour policy.
Another trend in 1996 was the formation of alliances and partnerships between white and black business groupings with a view to transferring skills to emerging black entrepreneurs. For white businesses, the formation of black empowerment partnerships is becoming critical in securing government contracts and licences. The acquisition of Highveld Stereo by the Africa on Air consortium, comprising MIC, South African Clothing & Textile Workers Union Investment Group, Women’s Investment Portfolio Holdings and Primedia, is a case in point.
Unbundling was another major transaction driver in 1996: “The acceleration of unbundling activity suggests a renewed search for business focus as a means of optimising shareholder value, and is indicative of the increasingly competitive environment in which companies are forced to operate,” says Thayser. “This is in stark contrast to the 1960s and 1970s, when companies pursued conglomeration and diversification as a hedge against business risk.”
The largest unbundling, which was also the second largest transaction of the year, was that of Genbel. This took place in two phases and involved the distribution of the underlying shares – inter alia, Dimension Data, Genbel Securities (Gensec), Engen, Gencor, Grintek, Investec, Sappi, Murray & Roberts, Malbak, Servgro, Omni Media, Pick ‘n Pay and others – to Genbel shareholders. The total transaction value was R5,22 billion.
The value of inward investment announced in 1996 was R4,1 billion, marginally higher than the R3,9 billion reported in 1995. While the sharp depreciation of the Rand in 1996 reduced the net cost of SA assets to foreign buyers, international experience suggests that periods of currency volatility – which are symptomatic of a more general economic malaise – tend to curb investor appetites. Given the Rand’s weakness in 1996, it is perhaps surprising that foreign investment remained as strong as it did.
In one of the largest post-election investments by a foreign company, Malaysian energy group Petronas acquired 21,6% in Engen in a deal valued at R1,2 billion. The rationale for the deal was to accelerate both groups’ objectives of expanding into Africa. Engen simultaneously announced a rights issue to raise R605 million, underwritten by Petronas, in which Sanlam and the Rembrandt Group waived their rights to allow Petronas to reach its target of a 30% shareholding in Engen.
The value of outward investment reported in 1996 was R6 billion, up from around R2 billion in 1995. Two deals in which Anglo American was the acquiror accounted for nearly half of the 1996 value.
In one of these, Anglo American acquired an effective 11,8% interest by acquiring 28% of the voting rights in Brazilian pulp producer Aracruz Celulose SA from Souza Cruz, the Brazilian subsidiary of BAT Industries. The deal was valued at R1,12 billion ($250 million). Aracruz is the world’s largest and lowest-cost producer of bleached eucalyptus pulp. The deal strengthens Anglo’s South American paper and pulp interests.
Disinvestment of R760 million was reported. The largest disinvestment recorded was the R730 million disposal by Royal & Sun Alliance Insurance of its 77,8% interest in Protea Assurance Company Ltd.
Some 40,2% of deals in 1996 involved the merger or acquisition of related businesses, 13% were joint ventures, 2,7% were group restructurings and 2,9% strategic alliances. Buyers paid an average price-earnings (PE) ratio of 19 in 1996, as against the JSE Overall Actuaries Index average of 18. This compares with an average transaction PE ratio of 20 (and a JSE Overall Actuaries Index PE of 16) in 1995.
Buyers paid an average 112% premium to net asset value, somewhat lower than the 123% reported in 1995. Thayser says the premiums reflect the high values currently being placed on intangible assets such as brands, trademarks and specialist know-how. The premium to JSE share price paid by buyers averaged 11%, as against 9% in 1995.
In conclusion, Thayser says the pace and scale of M&A activity in 1996 reflects an economy at an advanced stage in the cyclical upswing, augmented by a business sector undergoing sweeping transformation: “This is evident from the number and size of black empowerment and unbundling deals being reported,” he says.
The entrepreneurial spirit of the business men and women in South Africa is strong, alive and vibrant. Every day, innovative and dedicated individuals at all levels of business across the country demonstrate that they have what it takes to survive and prosper in today’s economy. Their relentless pursuit of success and excellence inspired the establishment of the Entrepreneur of the Year awards programme (EOY) to reward such achievement. The EOY programme was founded by the Ernst & Young Milwaukee office in 1986 to find and reward that particular State’s most talented and successful entrepreneurs. EOY is now an international programme honouring the best entrepreneurs in Canada, United States, Mexico, the Caribbean, France, Belgium, and South Africa etc. The programme will be operational in 100 regions around the world by the year 2000, making it a truly international programme.
South African EOY Programme
This year, the South African Entrepreneur of the year programme will be sponsored by Ernst & Young in conjunction with ABSA, Sanlam, SBDC and the Business Times. The search for outstanding entrepreneurs will be conducted across South Africa’s nine provinces. The competition is judged strictly on merit. The criteria for judging are based on both a quantitative and qualitative analysis of the business as a whole. Quantitative criteria includes growth in turnover, profits, owner’s equity and job creation. Qualitative criteria, on the other hand, includes an all-important analysis of entrepreneurial flair, initiative, ability to overcome obstacles, innovation, creative and ingenious marketing techniques, development of local and/or international markets, as well as community involvement.
Award recipients in nine regions will be selected by a judging panel, which will include entrepreneurs, academics and prominent business and community leaders. Regional functions will be held to announce provincial winners. The process will be completed by the end of August and a national awards event will be held in October. All regional winners will compete for the title of Entrepreneur of the Year. The Entrepreneur of the Year and all regional award recipients will be inducted in the Entrepreneur of the Year Institute. The national winners will attend the international Best Entrepreneurs Under The Sun annual awards ceremony and conference in Palm Springs, USA in November. The conference provides an ideal opportunity to network with some of the best entrepreneurs in the world. If you would like to enter, or would like to nominate a colleague or business associate, contact Sarah Finlayson on (011) 498-1696 for an entry form.
Interim and Preliminary Reports
Since the requirement for auditors to review interim reports was changed to make it no longer compulsory for all companies to have their interim reports reviewed, a number of instances have been noted where disclosures given in interim reports do not comply with the Johannesburg Stock Exchange (JSE) regulations. The JSE is now taking action by writing to certain companies along the lines of the letter given below.
|Dear Sir, |
Interim Results / Preliminary Results
Your company’s interim/preliminary results for the period ending ………….. refers.
The JSE’s requirements for the minimum contents of interim reports/provisional annual financial statements, have not been complied with.
We enclose herewith a checklist which details these requirements. Those items which do not comply have been marked with a cross. [Not attached].
We would appreciate your urgent reply explaining your company’s reasons for non-compliance, together with your undertaking that all future announcements of this nature will in fact comply with the Listing Requirements of the JSE.
It should be noted that the JSE requirements are in some cases more prescriptive regarding the format of presentation than the requirements for annual financial statements. For example:
- Income before dividends, interest and depreciation is to be stated, whereas some companies may show income after these amounts in their annual financial statements, with the amount of dividends, interest and depreciation taken into account in determining income being shown by way of a note.
- Current liabilities are to be shown, whereas some companies are instead showing interest free and interest bearing liabilities in their annual financial statements.
- Intangibles are to be shown separately from fixed assets in the balance sheet, whereas some companies may include intangibles in fixed assets in their balance sheet in annual financial statements. In terms of the JSE regulations which were altered in June 1996, the only companies that are required to have their interim reports reviewed are the following:
- companies whose auditors issued a disclaimed or adverse audit report in the previous year, unless the JSE decides otherwise, and
- mining companies’ quarterly reports when required by the JSE.
When companies elect or are required to have their interim reports reviewed, the reviews are to be conducted in terms of guidance issued by the SA Institute of Chartered Accountants. In addition, the interim report is to state that it has been reviewed, with the auditor to be named and is to state that the auditor’s report is available for inspection at the registered office of the company, if the auditor’s report is not published in the interim report. Whilst a company may elect to have its results reviewed, it does not have the same option for preliminary reports. Preliminary reports, which are required to be issued when there has been a delay in the issue of annual financial statements, must be reviewed by auditors.
The checklist attached to the letter from the JSE only details those disclosures which are in addition to those required by the Fourth Schedule of the Companies Act. A checklist which includes both the Companies Act and JSE requirements is available upon request. Although there is no requirement for interim reports to be reviewed, this does not mean that such reviews are not of value.
Given below are some factors that should be considered before a decision is taken that a review is not required.
- A review will enhance the credibility of the interim report.
- A review will help to ensure that all the required disclosures are given.
- A review will include a consideration of whether items are treated in a consistent manner in the interim report and annual financial statements.
- A review will include an overview of those judgmental areas which could significantly affect the earnings of the company.
- Whilst management may consider that the cost of the review may outweigh its benefits, it needs to be considered whether the general body of shareholders share this view.
- Directors/the Audit Committee will have more confidence in the interim reports they issue if a review has been carried out.
- A review could detect distortions that can be caused by smoothing of income or problem areas which have not been reported to shareholders timeously.
- A review could detect problems earlier than if no review had been carried out.
- A review may show that companies are treating certain items in their interim reports in a manner which differs from other companies, and which may make their results less comparable with those of other companies.
The amendments to the regulations which will permit South African individuals who invest abroad or to hold foreign currency bank accounts have not yet been quantified but it is understood that the relevant arrangements will be in place by 1 July 1997. The following amendments authorised by circulars issued by Exchange Control on 13 March 1997 are applicable immediately:
Direct Investments by Corporates outside the Common Monetary Area
Corporate entities wishing to invest outside the Common Monetary area are permitted to transfer from South Africa up to R30 million per new investment. This amount is increased to R50 million per new investment in respect of investments into SADC countries. The investments contemplated must still be approved by the South African Exchange Control Authorities. Where the cost of the acquisition is greater than the amount permitted for remittance from South Africa, consideration will be given to foreign borrowings being raised with recourse to or a guarantee from South Africa. This implies that the local corporate’s balance sheet may be used in the negotiation of such a facility. To enable the Control to consider such a request, it would need to be furnished with details regarding the foreign borrowing i.e. denomination, amount, interest rate term etc. The Control has stipulated that the minimum term for such finance is two years.
The criteria acquiring the offshore acquisition to benefit South Africa remains applicable to the above investments.
The SADC countries are Angola, Botswana, Lesotho, Malawi, Mauritius, Mocambique, Namibia, South Africa, Swaziland, Zambia and Zimbabwe.
Foreign Portfolio Investments by South African Institutional Investors
Institutional investors (mainly long-term Insurers, Pension Funds and Unit Trusts), may now apply to the Exchange Control department of the Reserve Bank to avail of foreign currency transfers in 1997, of up to 3% of the net inflow of funds during the 1996 calendar year, subject to the overall limit of 10% of their total assets. It is important to note that remittances not affected in 1996 in respect of 3% of 1995 inflows, will no longer be permitted under any circumstances.
Qualifying Institutional Investors may, in addition to the 3% foreign currency transfers referred to above, apply to the Control to avail of foreign currency transfers in 1997 of up to 2% of net flow of funds during the 1996 calendar year, to be invested on registered Stock Exchanges in any SADC member country. This dispensation is also subject to the overall limit of 10% of total assets currently applicable to asset swaps.
Furthermore, the interpretation of the “Entity” in the case of Unit Trusts, has been amended.
A Unit Trust management company itself may now apply to the Control to acquire foreign portfolio investments by way of asset swaps for up to 10% of total assets under management.
Restriction on Local Borrowings
Local borrowings restrictions will only apply where the non-resident percentage interest in a South African entity exceeds 50%.
Requirement to Convert Foreign Currency
The period within which foreign currency must be sold to the Treasury or to an Authorised Dealer is extended from seven days to thirty days.
Current Account Transactions
The quantitative limits applicable to transactions covered in various sections of the Exchange Control Rulings have been abolished with immediate effect. Foreign Exchange will be made available for such transactions on the presentation of documentary evidence confirming the amount and the nature of the liability.
There is no longer a limit on the remittance of the following:
- Buying Commissions
- “Cash with order” payments for imports
- Import payments for computer packages and maintenance packages
- Director’s fees to emigrants and non-residents
- Importation of newspapers, books, philatelic and numismatic imports, correspondence courses
- Member’s fees to non-residents
- Medical and Dental expenses by South African residents
- Congress, seminar, conference and examination fees
- Renewal of passports, visas, degrees etc.
- Charges for repairs and adjustments to goods temporarily exported Advertising/exhibition/trade fair expenses
- Registration of drugs
- Entrance fee/examination fees
- Tender documentation
- Goods re-exported for repairs and adjustments
- Legal fees
- Alimony payments
- Technical service payments
- Export of advertising matter and trade samples.
As a further administrative reform, Authorised Dealers may now effect payments in respect of services rendered by non-residents without reference to the Exchange Control Authorities subject to the presentation of documentary evidence. However, no advance payments in respect of services to be rendered may be made. However, if the fees payable are calculated on the basis of the percentage of turnover/income, sales or purchases, the matter must still be referred to the Control for approval.
We are advised that services rendered includes management fees and purchase of technology.
Foreign Parent Company Share Incentive/Share Option Schemes
The Control has now formalised the requirement that a South African entity must apply to the Control for its employees to participate in a foreign parent company share incentive/share option scheme. The Control has indicated that the value of shares that may be retained in the foreign parent company, which was previously set at R10 000, has now been increased to R100 000.
The amount of R50 000 previously available to emigrants for local living expenses on visits to South Africa is increased to R75 000 per family unit per calendar year, at the rate of R3 000 per day per adult and R1 000 per day per child under twelve years of age. In addition the amount that may be released from blocked funds in respect of gifts, donations and third party payments to South African residents is increased from R50 000 to R100 000.
Students may now receive an annual allowance of R80 000 and, if accompanied by a spouse, R160 000 per annum. The allowance is regarded as an annual allowance as opposed to the monthly/quarterly allowance previously permitted. Furthermore, the annual travel allowance that may be granted to an unmarried student overseas has been increased to R20 000 and R40 000 to a married student.
In granting an individual a travel allowance, the foreign exchange may now be made available in any form i.e. notes, traveller’s cheques, telegraphic transfers etc. and may be granted up to 60 days prior to departure date. The amount of South African Reserve Bank notes that may be taken on departure has been increased to R2 000 per person and is not regarded as part of the traveller’s authorised travel allowance.
It has also been decided to amalgamate the travel facilities applicable to neighbouring territories and other countries, resulting in a general travel facility without distinction between countries. The Control has also dispensed with the daily limit restriction. This means that the travel allowance is now set at R80 000 per adult and R25 000 per child under twelve years of age, per calendar year.
Guarantees by Non Residents of the Republic – Exchange Control Regulation 3(I)(E)
It is no longer necessary to obtain Exchange Control approval to accept a foreign guarantee to support local lendings to a South African resident or an “affected person”.
With regard to local financial assistance provided to an “affected person”, the exemption from Regulation 3(i)(e) is applicable to the extent that the borrowings accorded do not exceed the limit calculated in terms of the formula ratio.
In the event that an “affected person” requires borrowings in excess of the formula ration, the matter would need to be referred to the Control and, if supported by a non-resident guarantee, this issue would need to be cleared with the Control.
Up to 15 Kruger Rand coins may now be exported to non-residents of the Republic, provided the foreign currency amount used to purchase the coins has been received in the Republic.
Maintenance payments of up to R2 000 per month may now be made to dependent relatives in foreign countries.
Recent Tax Cases
Not The Sunny Side of Tax
Readers will recall some years ago the alarm created by the “Solaglass” decision, in which the Appeal Court held that certain losses incurred by a group finance company were suffered because of the company’s part in assisting the trade of other group companies, rather than itself. In those days, Section 23(g) of the Act provided that deductible expenditure must be “wholly and exclusively incurred for purposes of trade” – that is the company’s own trade and the expenditure was there for non-deductibles. In a subsequent decision – the Sunnyside Centre case – the Supreme Court held that the mere fact that a Group company’s operation benefited the other companies in the Group was irrelevant, provided transactions were effectively at arms length and the Group company concerned was intended, to make a commercial profit. That decision, combined with an amendment to Section 23(g) which disallows expenditure only to the extent that it is aimed at other company’s trade, gave some relief.
Now, however, the Appeal Court has given judgement in Sunnyside and has largely restated its Solaglass line. More specifically, from a practical point of view, it criticised the laissez-faire and non-documented approach to decision making by the directors of the Sunnyside Group companies and held that the onus of proving that the particular transaction concerned was intended to make a profit, had not been discharged.
The transaction which gave rise to the appeal involved the borrowing by a Group subsidiary of capital against security of its property; the lending of that amount to the holding company; and the on-lending to a fellow subsidiary. Because the fellow subsidiary’s profitability was not sufficient initially to cover the full interest burden, a loss was initially suffered by the property owning/borrowing company. But the intention – according to the general (but unwritten) policy of the directors, was that each company was to make a profit so that subsequent interest flows would even the account and show a profit. The Appellate Division, however, turned the taxpayer down on the grounds of Section 23(g) in general and on the specific unwritten terms of that transaction in particular, which made the onus of proof of profit making intent, impossible to discharge.
The message is appallingly and brutally clear. In some cases, Group inter-company transactions must be more clearly and heavily documented than third party ones! Any such transaction which is not clearly documented as profit making runs the risk of tainting that company’s “trade” purpose and, under the current Section 23(g), of leading to a disallowance of a substantial (if not the whole) portion of inter-company related expenditure. We have been warned!
Shareholder Loans and Section 24J
In the October 1996 edition of In Touch we remarked upon a perceived problem which arises in terms of Section 24J where, typically, an incoming shareholder of a private company acquires the former shareholder’s loan accounts at a discount. Revenue’s favoured interpretation of Section 24J should result in that discount being brought to account in terms of the section, and, presumably subject to tax.
We have since entered into correspondence with the Commissioner’s office from which it emerges that:
- the Commissioner agrees that his favoured interpretation leads to this consequence in principle, but
- as there is no maturity date for a typical shareholder’s loan, the discount cannot be brought to account
- as there is no manner of calculating the annual accrual over the period to maturity.
This approach indicates that Revenue is anxious to avoid the consequences suggested by us, if that can be done within the framework of the legislation. We welcome that attitude but have some technical concerns that the escape hatch suggested by Revenue is in fact stuck fast! We will be taking these issues up with the Commissioner during the early part of this year and will report progress in due course.
Our advice to clients who find themselves in this situation, is to disclose the existence of the loan account in a note to the return and to calculate the yield to maturity on a 50 year maturity basis, noting the resultant accrual as a receipt of a capital nature.
Company Car Fringe Benefits
A media release indicates that the change in taxable value of a first company car will be from 1,2% of value to 1,8% where the vehicle is mainly used for business purposes. In other cases the first car will be taxed on 4% of value in the same way as second and further vehicles.
Erratum: The Increase of taxable value of a first company car to 4% instead of 1.8% of cost per month, will apply where the vehicle is primarily used for business purposes and the employee also receives a travelling allowance for another vehicle. The incomplete statement of Revenue’s media release is regretted.
Expatriate Employees – Return Airfares
It is not uncommon for a South African organisation employing foreign contract workers – “expatriate employees” – to include in the contract of employment the right to annual holidays in their home country with all airfares paid, for both the expatriate and his or her family. Although the Income Tax Act contains specific provisions in Section 10(1)(nB) exempting the expatriate from income tax on any benefit arising from the cost of transport at the commencement and termination of the contract, it is completely silent as regards transport during the course of the contract. Although a Revenue practice existed many years ago, acknowledging that vacation trips such as described above were not subject to tax, this ruling was issued before the introduction of the 7th Schedule to the Income Tax Act in 1986. Although it has not been deleted from the recently published ‘SARS Practice Manual’, correspondence that we have conducted with the Commissioner’s office over the past 24 months makes it clear that the practice does not apply today.
Our own view is that where a person remains ordinarily resident outside the Republic – which will always be a question of fact – an exemption for the costs of that person’s annual leave, together with his family if necessary, should be included in the Income Tax Act. Although it is inescapably true that the expenses of leave are essentially private in nature, the circumstances of a fixed term employment contract in a foreign country, are such that it would be unreasonable to tax the employee concerned. It is, after all, not substantially different from the situation of a South African based permanent employee, normally employed in Cape Town but on assignment to his employer’s offices in Johannesburg for a period of time, who is flown home over weekends. Under current law, this is not, we submit, subject to tax under the provisions of the 7th Schedule. The only technical difference between this and the expatriate situation, is that the expatriate does not have a normal working place, for that employer, in his country of ordinary residence.
Where the employee’s family accompanies him to South Africa, the moral argument for there being a lack of benefit becomes somewhat less convincing but remains sufficiently strong, in our view, to justify a specific provision in the Act permitting, tax free, one such trip for purposes of leave for each anniversary of the commencement of the contract of employment.
We have now had the opportunity to read the 4th Interim Report of the Katz Commission dealing exclusively with Capital Transfer Tax. There is insufficient detail in this report to pass serious comment here and the principal guidelines were referred to briefly in the Budget issue of In Touch. However, for the record and with some elaboration, here are the highlights:
Rate and Commencement Date
It is strongly recommended that the rate of Capital Transfer Tax should remain at the existing 25% (as applied to estate duty and donations tax). The Commission does not see it as its task to draft legislation and it appears that, contrary to popular belief, there is no draft legislation prepared by Revenue waiting in the wings for fine tuning. It therefore seems unlikely to us that legislation will be prepared and in place before this time next year.
Rebates and Allowances It has been recommended that the existing R1million rebate should not be reduced (but there is no recommendation for an increase) and that the existing deduction allowable for bequests to a surviving spouse, should remain unchanged.
It is likely – but not a foregone conclusion – that the existing estate duty and donations tax will be consolidated into a single capital transfer tax. The Commission considered whether the underlying philosophy of these taxes should be changed to tax the recipient (on bequest/donation received) rather than the dishonour (on bequest/donation made) but concluded that staying with the existing system was more practical.
The introduction of anti-avoidance measures for capital transfer tax is recommended. Oddly, although donations tax is currently subject to an anti-avoidance rule under the Income Tax Act, the estate duty legislation has never contained an equivalent to Section 103 of that Act. On the other hand, there is no intention to introduce rules aimed specifically at preventing the use of interest free or low interest loans or similar devices for the funding of trusts.
The most important recommendations affect the taxation of estate planning trusts and were widely predicted – that is:
- an “exit charge” when capital is distributed by a trust; and
- a periodic charge on assets held in trust, to compensate the State for the trust’s inherent immortality. Although this periodic charge was widely expected to be on a 10 or 15 year basis (the United Kingdom charges on a 10 year basis) the recommendation is that it be imposed every 25 years. There would, of course, need to be an extension of the existing “successive death” provisions so that if, for example, a 25 year generation skipping charge was followed shortly thereafter by a distribution of capital by the trust, that distribution would not again be subject to a full exit charge. The existing rules provide for a rebate if successive deaths subject to duty on the same assets, occur within 10 years of one another. It is difficult to comment on the impact of this generation skipping tax in real terms without having seen the detailed legislation. But assuming that it is to be levied at the normal rate of 25%, we can consider a typical trust whose asset management achieves a real growth in value of, say 5% per annum. This growth rate would result in R100 in original assets acquired by interest free loan becoming R162 over 30 years, and the imposition of the tax on the net R62 would garner R15,50 for the State. Overall, this is not disastrous and should not discourage planners from using trusts for all the good non-tax reasons.
SA Source Income and Taxation – An Update
Branch Profits Tax
Some doubts were expressed last year on the introduction of this 40% tax, as to its proper application. In particular, there was a concern that neither a “branch” nor an “agency”, both of which are subject to the tax, were defined. In the March Budget speech it was revealed that the word “agency” has been dropped from the branch profits tax provision, in relation to corporate accounting periods (years of assessment) ending on or after 1 April 1997. The question of what constitutes a “branch” remains unresolved at this stage but will probably be clarified when the proposals mentioned below are translated into law.
Tax Reform Proposals
The Katz Commission has turned its attention to South Africa’s international tax profile. The Commission’s fifth report is entirely devoted to the question of South Africa’s taxation of foreign investment into South Africa, and to investment offshore by South African residents (which has been previously restricted by exchange control regulations, to be greatly relaxed from 1 July 1997).
This short note deals firstly with the Commission’s recommendations on the taxation of “inward investment” to South Africa and thereafter with outward investment by SA residents. It is our view that these recommendations are likely to be adopted by Government and that legislation giving effect to them will be enacted effective early July 1997.
South Africa operates an essentially “source based” system which – with some exceptions – does not attempt to tax residents on non South African income but taxes non-residents on income arising in South Africa. However, the task of determining exactly where income arises – particularly when there is a multiplicity of income earning activities spread around the world, and an organisation’s presence in South Africa may be purely transitory – is not easy. Until now, South Africa has had few codified provisions to assist the SA Revenue Service in its task but the Commission has now recommended the following major departures:
- A distinction between active and passive income. It is proposed that only the active income of non-residents arising in South Africa should be taxed.
- A definition of active income framed in the same terminology as is used by the United Nations’ model tax treaty for permanent establishments (PE’s) and including any passive income which is effectively connected with a PE. The UN treaty model is largely similar to that of the OECD model convention, with the major exception that the UN version treats a facility for the delivery of goods as a PE, whereas the OECD model does not. It is also recommended that the reference to a fixed place of business in the UN model should be replaced by a reference to a “business facility suitably equipped” so as to recognise the mobile nature of the “virtual office”.
- A minimum period of 3 months (cumulative throughout the year) below which a PE “facility” will be seen as having insufficient permanence or regularity.
- Recognition of the apportionment of income between a variety of possible income earning sources (the South African courts currently look for a dominant source in order to fix where income arises). It is proposed that the business profits article of the UN model be largely adopted into domestic law and read with the source/PE provision for this purpose. Although the Commission’s report does not expressly address rental as a category of income, the inference is that rental from real estate and moveables will be active income subject to normal South African income tax unless it derives from the rental of moveables which are not let by a PE.
The position of passive income (i.e. anything which is not active income) flows from South Africa to non-resident investors is to be largely unchanged, other than for the position of interest – the proposed rules are summarised below:
The Commission recommends that a final withholding tax of 10% should be imposed on interest payments from South African debtors to “connected party” non-resident creditors. Portfolio investment interest (to non-connected persons) would be exempt from all taxes.
It is recommended that a final withholding tax at a flat rate (probably no different to the current 12% preliminary withholding tax) be introduced. Royalties effectively connected to a permanent establishment would be subject to normal tax.
Dividends are currently exempt from tax in the hands of shareholders under the South African taxation system and will remain so. The Secondary Tax on Companies (STC), which is a tax on the corporation distributing the dividends, is expected to remain in place for the immediate future but will undoubtedly be replaced in due course by an imputation system (such as Advance Corporation Tax in the UK). It is not proposed to introduce any withholding tax on dividends.
Outward investment by SA residents
The proposals suggest a distinction between active and passive income as outlined in the preceding paragraph. “Passive” income accruing to an individual ordinarily resident in South Africa or to a company effectively managed in South Africa will be taxable, whereas “active” income from a foreign PE (as defined) will continue to be treated as non-taxable non-South African source income. Where foreign source active income is derived through a foreign company owned by the South African investor, its repatriation by way of dividend would remain exempt. However, where such profit is extracted by way of interest, the essentially passive nature of interest income (below) will result in such flows being taxable. Royalties on the other hand may be effectively connected with the operation of a foreign permanent establishment and on that basis may represent active income. The position of rentals is not clear but should logically be treated as active income.
Because dividends are essentially exempt from income tax (under current rules which are proposed to remain unchanged) it would be easy to metamorphose foreign passive income into dividends through the medium of a foreign investment company. The Commission therefore recommends the extension of the existing “foreign investment companies” deemed source provisions’ of section 9A. These in future will be referred to more generally as “CFC” (controlled foreign corporation) rules and essentially require a CFC to identify its passive investment income and for the South African shareholder to report those amounts as South African taxable accruals, irrespective of the declaration of a dividend out of the company. Those familiar with the US tax law will recognise this as something similar to the notorious “sub-part F” provisions. The Commission’s recommendation is that this direct attribution system should be followed, rather than any attempt made to remove the tax exemption for a portion of dividends received from the foreign company. Taxing the dividends would still leave the opportunity for deferral of South African tax on foreign passive income.
“Passive” income in the form of interest and royalties will generally be taxable in the hands of a South African resident/company. As indicated above, it is our belief that rental of foreign property should be treated as active income (and thus exempt) but the Commission’s view is by no means clear.
Dividends on foreign shares will remain tax exempt in South Africa.
The Commission did not address the situation of offshore trusts in which a South African resident may be a discretionary beneficiary. Interest earned by such trusts, which would be taxable under the new rules if the assets were owned by the taxpayer directly, may or may not be caught by the proposed CFC rules, depending whether these are extended to cope with the position of trusts. Although the Commission shied away from the extremely complex provisions of, for example, the Australian CFC and foreign trust rules (which look through trusts), it seems inevitable that the rules must tax foreign income derived by foreign trusts with South African resident individuals, if they are to be of any significant effect.
The Rules of the Game Are Changing – The US/Tax Treaty
For many years international investment into or out of South Africa – where it existed at all – had to be routed by way of third countries either to disguise the connection completely or to achieve a result which was not fatally expensive from a tax cost point of view. The latter reason arose by virtue of the limited network of double taxation treaties which South Africa had with other countries and which became even more restricted when the USA and Canada abrogated their treaties with us at the height of sanctions in 1985. But this is rapidly changing. We now have treaties in force with some 27 countries and many more in the wings – either waiting for promulgation or still under negotiation. The most significant of these new treaties is that with the United States which was signed in February and which is likely to come into force from January 1998 (more of that later).
As is the case with multi-national commerce elsewhere in the world, the South African international tax advisor is now working in an environment where the rules are clear (if complex) and the revenue authorities in South Africa and the states with which we trade can be expected to make use of “exchange of information” procedures to obtain an holistic view of what a particular taxpayer is actually doing. So smoke and mirrors – which had a sanctions justification but frequently favourable tax side-effects – no longer work. Which does not mean to say that tax havens, offshore financial centres and “treaty shopping” do not still have their place – but they will generally work only where there is real substance in the presence of the taxpayer in one of these jurisdictions. Any South African multi-national group with a structure set up in the days of sanctions which has not had it reviewed to see whether it will stand up to the cold light of day, should do so now.
Turning to the SA/US treaty, this is a reasonably standard document but contains a few curiosities.
Possibly most importantly, it recognises STC as a tax for which credit will be given in the USA when SA corporate profits are made directly subject to US tax (although there is some technical difficulty in the wording of the credit provision which inadvertently refers to a “tax on income”, having previously categorised STC as a tax on its own). It is also made completely clear that the limitation of the rate of tax on dividends does not apply to STC. The “permanent establishment” (PE) definition is substantially longer and more detailed than that in most other treaties and in particular makes it clear that sales outlets which do not attain the status of a full branch; mineral exploration activities lasting for longer than 12 months; and service activities lasting for longer than 183 days in the aggregate for the same customer, all constitute a PE which will give rise to a tax liability in the country concerned. The treaty is also more explicit than most in relation to the determination of the profit of a permanent establishment and the apportionment or allocation of expenses to a PE.
Interest and royalties beneficially received by the resident of a particular state will be taxed only in that state.
On the personal services front, a similar rule to that referred to above, applies to individual professionals who are present in a country for longer than 183 days and, for employees, the standard “183 day rule” found in most treaties relates to the fiscal year (which in South Africa is 1 April to 31 March, and not 1 March to 28 February, as is commonly supposed). But none of these 183 day periods affect the position of sportsmen and entertainers who may be subject to tax in the country in which the event etc takes place, irrespective of the period they are there, unless the remuneration concerned does not exceed US$7 500 or its equivalent.
Finally, in an extremely unusual provision, the treaty makes provision for the deductibility by an expatriate employee of his home country pension fund contribution, against his expatriate employment income.
All of this detail is critical knowledge for any organisation doing business with the USA but all multinationals working into or out of South Africa need to keep abreast with those treaties which affect them and to establish whether the changed regulatory framework contains trick or treat.
The Botswana budget was delivered on 10 February 1997 and the country achieved a 7% real growth rate in GDP in the prior year. 6,8% real growth is projected for 1997/8. The top personal tax rate has been reduced to 25% at an income bracket of P80 000.
With effect from 1 April 1997 the Sales Tax will be extended to cover selected professional services such as accounting and auditing fees, legal expenses, management and consultancy fees, architectural, engineering and similar fees, real estate commissions, car rentals, freight charges (other than rail), and the labour component of motor vehicle maintenance. There have been some detailed changes in Capital Transfer Tax and Capital Gains Tax law and in the valuation of fringe benefits.
Fixed Property Transfers
In 1996 an amendment was introduced as Section 16(3)(a)(iiA) to provide that VAT (and VAT credit) on the supply of fixed property would be triggered only to the extent that payment is actually made. This means that within a group of companies or other related parties, a property transfer need not result in any VAT consequences if the amount due is left outstanding permanently on loan account. However, it must be remembered that an obscure provision of the Act (Section 2(4)(a)) will trigger a charge to VAT if an amount due to a vendor is ceded or made over in such a way that the vendor would otherwise never pay VAT on the transaction concerned. This provision was introduced originally to deal with the cession of book debts by a cash basis vendor but also applies where, possibly in a Group reorganisation, a loan account outstanding on a fixed property transaction is ceded to another company.
This is a potential trap for the unwary and one is inclined to recommended that inter-company property transactions be paid for and VAT output tax and input credit – which are in any event neutral – accounted for at the time of the transaction.
Foreign Currency Fluctuations
It often happens that a South African entity charges VAT – at the full 14% rate – to a foreign entity. If that billing is, say, $114 (including VAT) at a time when the Rand rate of exchange is R4,80 to the dollar but payment is made and arrives in South Africa when the rate has moved to R4,50 to the dollar, what is the VAT treatment?
Although the Revenue department’s view differs, we believe the treatment to be completely straightforward:
- VAT is triggered and becomes due according to specific timing rules – generally the date of issue of an invoice noting that the amount is due. The rate of VAT and, it is submitted, all other issues in relation to VAT on particular transactions are determined with reference to that date, irrespective of the date on which the VAT return and payment must be lodged and made respectively. Accordingly, the VAT due in the example above must be the rand equivalent of $14,00 on the date of invoice, namely R67,20.
- When payment is received, the rand equivalent of the $14,00 amounts to only R63 at the new rate of exchange and the loss (or gain in other circumstances) is in our view no more than a loss or supply of money and hence not subject to any VAT charge or adjustment. In particular, the gain or loss does not fall into the provisions of Section 21 of the VAT Act dealing with discounts and other price adjustments.
- From an income point of view the gain or loss will almost inevitably be of a revenue nature and should be accounted for on that basis (query Section 24I). The one uncertainty in our view is the particular exchange rate to be used on the date concerned. There is neither law nor revenue practice on this point but it is suggested that the spot rate on the day is appropriate.