Revenue Laws Amendment Bill: briefing

Meeting report

FINANCE PORTFOLIO COMMITTEE
15 September 2000
REVENUE LAWS AMENDMENT BILL: BRIEFING

Documents handed out
Revenue Laws Amendment Bill and Explanatory Memorandum
Summary of Consultative process

Briefing team: Mr Pravin Ghordan (SARS Commissioner),Mr Kosie Louw (Legal Services Department: SARS), Mr Martin Grote (National Treasury)

SUMMARY
The Treasury highlighted the principles underlying the shift to residence-based taxation. Primarily they want to broaden the tax base. In making policy decisions they have been guided by what is ''good for overall society'' and not special interest groups.

Delegates from SARS explained the amendments to the Committee. Some important points are the following:
- the taxation of foreign pensions is a contentious issue. Currently foreign pensions and social security pensions are exempt from income tax. It is normal practice for a country using the residence basis of taxation to tax foreign pensions. However there has been opposition to this. SARS has built in a specific exemption on the taxation of foreign pensions for a period of 3 years to give them time to research the matter to enable them to make an informed policy decision.

- SARS has proposed the addition of an objective test to determine when someone is a resident of SA for tax purposes. This definition is in addition to the current subjective test determined by case law. If a person is performing services outside of the Republic for an employer for a continuous period of 183 days or longer, the person is exempted.

- Subject to certain requirements, the income of CFEs and foreign branches of companies which have been taxed at a rate of at least 27% in another country will be exempt from tax in SA. Where such income is taxed at a rate less than 27%, SA will tax the income at a differential rate.

- In respect of the depreciation of assets, SARS has built in what is referred to as a notional allowance. The notional allowance is used to establish a tax value for each asset. In terms of a notional allowance it is deemed that one has claimed the allowance.

- The definition of spouse as it has been used in the Estate Duty Act has been amended. There is a deduction built into this Act which says that where a marriage was dissolved by death and assets pass to the surviving spouse, all those assets can be deducted from the deceased's estate. Initially spouse was interpreted to mean a spouse in terms of the Marriages Act and did not relate to same-sex relationships. This interpretation has been said to be unconstitutional as it discriminates on the basis of sex and marital status. SARS has amended the provision so that such a deduction is now also allowed in same sex relationships.

MINUTES
Introduction by the Ministry
Mr Martin Grote stated that the philosophy behind the shift toward residence taxation is based upon equity and fairness. It is also important for efficiency, international consistency and competitiveness. In effect they will be broadening the tax base. It adds to certainty because there is no expensive dispute resolution necessary to decide if something is source income or not. Different sectors of the economy are treated in the same way.

Various parties had lobbied for special tax treatment. The National Treasury had listened to everyone's opinions and had tried to balance the various views. In light of this it is important to note that SA cannot afford to give in to pressures from special interest groups. The Treasury had to consider the effect of the new tax system on overall society.

Revenue Laws Amendment Bill: briefing
Mr Kosie Louw highlighted the important issues in the Bill:

Definitions
''gross income''
This definition is found in Section 1 of the Income Tax Act. It is considered the main building block of the Act and it has to be amended to reflect the change from source to residence taxation. Most references to source are deleted so that residents will now be taxed on their world-wide income. In respect of non-residents there has been no change. They will still only be taxed on income that is derived from a South African source.

''resident''
The Act currently makes various references to ''resident'' and ''ordinary resident'' but it does not provide a definition, case law did this. There is a test in the Act to determine if a company is a ''resident'' but the provisions in the Act relating to the test are inconsistent. Thus, SARS is introducing a definition of resident into the Act to bring alignment between the different provisions in the Act and to establish certainty. Two types of residents are distinguished. A resident can be either:
1) a natural person, or
2) a legal person

In terms of case law an ''ordinary resident'' has been defined as ''the place to where one returns from their wanderings''. This involves a subjective test. This rule has not been removed. SARS's proposal is in addition to this to cover those instances where the person has not been ordinarily resident in SA as envisaged in the definition made by case law.

The additional rule proposed by SARS is a time-based rule which involves a measurement over a period of 4 years. It sets out the periods of time for which the person must be physically present in SA for a period of 3 years preceding the year of assessment (if the person is not ordinarily resident in SA.) If the person complies with the time requirements then the resident falls into the tax net from the beginning of the fourth year. This test is objective.

A ''legal person '' is defined as being resident in South Africa if it is incorporated, established, formed OR (and not ''and'') effectively managed in SA.

Foreign income of individuals (foreign employment income)
In accordance with the principles of residence taxation, foreign income (active and passive) of a SA resident is taxable. A foreign tax credit will be granted in respect of taxes proved payable.

Exemptions:
1) Residents earning income abroad for a continuous period of 183 days
Previously Section 10(1)(o) of the Income Tax Act granted a tax exemption only to officers and crew members of a South African passenger ship if they complied with the time requirements for being outside of the Republic during the year of assessment. In 1999 this provision was extended to ships involved in marine mining.

Though all residents will be taxed on their world-wide income, SARS proposes that the exemption principle in this section be retained, but that the tax exemption be extended to include residents who are performing services outside of the Republic for a continuous period of 183 days or longer in the relevant tax year. The exemption applies if the person is performing services for an employer, whether the employer is a resident or not. It is set out in section 10(1)(o) and SARS has opted for the continuous 183-day rule.

Question: Mr Andrew asked what would happen if someone had to come back for a wedding or a funeral. Would this break the period?
Mr Louw replied that it would not. The concept must be continuous (not necessarily the actual physical period). An incidental break from the period does not count.

2) Foreign pension payments
This is a controversial issue. Currently foreign pensions and social security pensions are exempt from income tax. However, it is normal practice for a country using the residence basis of taxation to tax foreign pensions.

Various people have argued against this saying that a pension is static and taxing it will effectively reduce the pensioner's income. They have also said that it will discourage foreigners from retiring in SA. There are broad economic issues which SARS will have to examine. For example, should there be a deduction or not for the contribution paid to the foreign pension? Currently the contribution must be approved by the Financial Services Board.

SARS proposes a three-year exemption on taxation of foreign pensions to give them time to research the matter properly. The time period is not built into the Bill yet but it is noted in the Explanatory Memorandum. In the Bill it is still open-ended.

South Africans operating offshore
A South African resident can operate offshore in one of the following two ways:
1) either as a branch (not as a separate legal entity) OR
2) as a controlled foreign entity (as a separate legal entity)

Income of Foreign Branches
How does one tax a resident operating outside SA as a branch? If the country has a tax rate of 27% or more, and it has a similar tax system to SA, and it is a country designated by the Minister, then that branch income will be exempt from taxation in South Africa. SARS proposes that losses of foreign branches are not allowed to be set off against the South African income of the company. This is proposed to protect the South African tax base.

Question - Professor Turok (ANC) asked if this would not open the door to transfer price fixing on a grand scale. Mr Louw replied that they have built in safeguards to deal with this. They are called transfer rules.

Income of Controlled Foreign Entity
A CFE is an entity controlled by a South African resident where the control exercised is more than 50% (50% combined ownership of all residents) and the control relates to controlling (voting) rights. Currently the Act provides that passive income of a CFE is imputed in the same ratio as the participation rights of the resident.

Under the new residence system all income (active and passive) will be taxed (with certain exclusions). In terms of SARS proposal the income of a CFE will now only be imputed to a resident who together with a connected person holds at least 10% of the participation rights in a CFE.

Exclusions:
Where a CFE operates in a country with a similar tax system to SA with a tax rate of at least 27% then SA will not tax the income because the income of the CFE is already taxed at an acceptable rate (as with foreign branches).

Where the income of the CFE is taxed at a rate lower than 27% then the income will be taxed in SA as it arises but subsequent dividends declared by the company to the resident will be exempt.

However if the income complies with a legitimate business establishment test then the tax on the income will be deferred until a dividend is distributed. This exemption will not apply to certain forms of passive income.

Question - Professor Turok asked if this meant income which was never repatriated would never be taxed. Mr Louw agreed although this deferral approach applies only to proper business establishments. If it is not, the income will be taxed when it arises.

Trusts
A trust is a person for tax purposes. The rules in Section 25B of the Act deals with the regulation of taxing trusts. Currently the income from trusts can be taxed either in the hands of the beneficiaries or on the income depending on whether the income vests in the beneficiaries or not (for example a discretionary trust). The section also provides for deductions and makes provision for limitations of losses.

The residence basis of taxation makes the implementation of this section practically difficult (because trustees or beneficiaries can be scattered across the world).
SARS proposes deleting Section 25B of the Act and simply using the common law principles on how to tax a trust. However they propose that where the trust is in a loss situation, the liability of the loss cannot be passed on to the beneficiaries.

Question - Professor Turok noted that the term beneficiary was not defined. He commented that in the United Kingdom they have different definitions of the word for different purposes. Mr Louw replied that this was not necessary because it is covered by the common law. The principle used is that if the beneficiary has a vested right to income then it is usually taxed. Sometimes a discretion is given to the trustee to determine if the income flows to the beneficiary or not. The beneficiary does not always have a vested right.

Designated countries
The Minister will determine the designated countries on the basis of which countries have a 27% or higher tax rate and a similar tax system to SA. There was a third requirement in the draft Bill which has now been removed: that the country had to have a double taxation agreement with SA. Income from these designated countries which was subject to a tax rate of 27% or more in that country will be exempt. This exemption is proposed to ease the administrative burden which will come with the move to residence taxation.

Credit provisions
If one taxes a foreign source then double taxation can arise. In these instances SA will give a tax credit. The principle is that the source country has a primary right to tax. The resident country has an obligation to grant a credit in the case of double tax.

Questions: Professor Turok noted that the value of currency is different in different countries. How does one assess a tax rate of 27% in a rich country compared to a tax rate of 27% in a poor country and then work out a tax credit? The tax rate will have a different financial value in different countries. He compared an SA resident in Saudi Arabia to one in Zambia. How will assessing the value work?

Mr Louw replied that it was complex matter. As long as the income in the other country is taxed at an acceptable rate, specific rules such as conversionary rules to convert income have been built in. SARS has also built in as many exclusions as possible.

Mr Ramgobin (ANC) said that he was less concerned about the instances where the value of the rand was stronger than the currency of the other country and more concerned about the instances where the value of the other country's currency is stronger than the South African rand such as the USA dollar.

Mr Louw replied that USA has a similar tax system to SA therefore SA will not tax foreign income which has already been taxed there. The 27% rule applies.

Ms Joemat (ANC) asked what would happen if the tax rate in the other country was 15% (below 27%). Would the difference be taxed to get to the SA level.

Mr Louw replied that this was correct.

General issues
Deduction of interest incurred in respect of foreign dividends
The general deduction formula provides for the deduction of expenses actually incurred in the production of income. However, interest expenditure may be incurred in one year in respect of future foreign dividends. At the time the interest expense is incurred it may not be possible to determine whether the foreign entity will in fact declare a dividend and if it does declare a dividend, whether an exemption will apply to the dividend or not.

Therefore SARS proposes that the deduction of any interest expenses incurred in respect of foreign dividends will only be allowed to the extent that that foreign dividend income is included in the taxable income. If the deduction for interest expenses is allowed before the dividends are paid to the resident then this will cause a mismatch. Thus, the resident's claim for deduction of interest expenses will be delayed until repatriation of the dividend and the imposition of tax.

Exchange control limitations
If the country where the business operates has strict exchange control rules and does not allow the CFE to repatriate the foreign income then SA will delay the taxing until repatriation. This is in accordance with current practice and SARS proposed that this be retained.

Depreciation and write-off of certain assets
The Act provides for the writing off of certain assets used by a taxpayer for the purposes of his or her trade. However, if a taxpayer sells an asset for which a deduction has been allowed and he recovers the amount of the deduction, then the recovered amount is included in the income of such taxpayer.

These deductions must now be extended to assets used by a taxpayer for his trade outside of SA. In this regard SARS has built in what is referred to as a notional allowance. The notional allowance is found in many sections and is used to establish a tax value for each asset. In terms of a notional allowance it is deemed that one has claimed the allowance.

Thus, SARS proposes that if the asset was used in a trade outside of SA (which means that the income was previously not taxable but is now taxable) then only a proportionate amount of the depreciation (which relates to the period that the income is subject to tax) will be allowed and not the full depreciation of the asset.

Similarly, for the purposes of section 11(e), 11(o), 12B, 12C, 12D, 13, 13bis, and 13ter the depreciation of such assets (which were previously not taxable and is now taxable) is deemed to have been allowed in the previous years for the purpose of determining the balance of the depreciation allowance. Any amount of this which is recovered is not included in the income of the taxpayer in terms of section 8(4).

Clause-by-Clause Briefing (in the order listed in the Explanatory Memorandum)
Amendment of section 1 of the Estate Duty Act
The definition of ''spouse''
There is a deduction built into this Act which says that where a marriage was dissolved by death and assets passed to the surviving spouse, all those assets can be deducted from the first deceased's estate. The problem is that this only applies to marriages in terms of the Marriages Act.

Now there has been an instance where the survivor of a couple in a same-sex relationship claimed the deduction. The person argued that not allowing the deduction was unconstitutional as it discriminated on the basis of sex and marital status. SARS sought legal opinion and were advised that this was unconstitutional because it is discriminatory. Therefore this provision is amended so that deductions should also be allowed in same sex relationships.

Questions: Mr Booi (ANC) asked which wife this would apply to in the case of polygamy. Ms Joemat asked if they had considered cultural marriages such as Moslem marriages.

Mr Louw replied that the deduction would only be allowed once. It was possible that the amount of the deduction could be subdivided between wives. A new Act was going to be passed on marriages to deal with these issues. This Act will define the word ''spouse''. The difference between noting same-sex relationships and not other marriages was that gay marriages were completely illegal and therefore needed special concessions. The other marriages were not illegal.

Mr Louw (ANC) noted that there must be a reference to the new Marriage Act in this provision to make the Act apply to the section.

Mr Louw of SARS agreed that this was a good point but the problem was that the new Marriage law was not operational yet. Still, they had to make some kind of reference to it.

Amendment of section 1 of the Income Tax Act
Insertion of important definitions
This deals with the insertion of the definitions of ''gross income'', ''resident'' and ''legal entities'' into this Act. These definitions are important as they relate to the basis of taxation. These definitions had been explained earlier in the meeting .

Amendment of section 6 quat of the Income Tax Act
Granting foreign tax credits
- The provisions relating to a rebate for foreign tax paid have been extended to cater for income from a source outside the Republic. The amendment enables a resident to deduct all paid foreign tax from the total amount of income tax payable in the Republic.
- In the case of a partnership or a trust, the resident will be entitled to the credit of the proportional amount of tax which is paid by the partnership or trust.
- SARS proposes that the carry-forward period of excess credits be extended from 3 years to 7 years. The carry forward of excess credits against STC liability will fall away. [Previously excess credit could be set off against secondary tax on income.
SARS are now taking away this right but extending the carry forward period. This means easier administration.]
- Provision is made for the conversion of the amount of the foreign tax to SA currency. When someone pays foreign tax in a country with a low tax rate, it must be converted to a South African currency to claim it as tax in SA. The exchange rate on the day that the tax was paid in the foreign country will be used to do this.

Question: Professor Turok asked why they do not rather use the dollar equivalent to deal with conversion. SA is dealing with African countries more and more and it is difficult to compare currencies. Using the dollar equivalent would provide a stable basis for comparison. Mr Louw replied that they would think about it. He noted that in some instances this approach would work against the SA fiscus if the currency of the other country was worth less than the dollar.

Amendment of section 9E of the Income Tax Act
Exemption
Section 9E(7) is an amendment which provides for some foreign dividends to have a tax exemption. SARS identified a problem after this amendment was introduced for cases where a company receives a dividend which is exempt, and that dividend is distributed by the company to another company. For the first company, an exemption applies to the dividends. As it moves on to other companies, the dividend does not apply anymore. This was not the intention as they do not want to disqualify the later dividend from the exemption. Therefore they have introduced a specific exemption to provide that such dividends will not be taxable.

Question: Mr Andrew (DP) commented that if a company in the past had chosen to do business in South Africa specifically because of the tax regime here and they had made various business decisions on the basis of the tax regime, it is unfair to them if the tax regime has suddenly changed. Now they must suddenly pay residence tax in SA. He asked if there was not some way to accommodate such companies. Mr Louw replied that some kind of tax sparing could be introduced but that this related to a policy decision. Mr Grote said, "there is some rough justice''. He told Mr Andrew that the National Treasury would look at this issue and come back to the Committee.

Insertion of section 72A of the ITA
Reporting requirements
Section 72A describes the reporting requirements for the new residence basis of taxation. This is very important for SARS because it is the minimum amount of information to be provided to SARS to enable them to decide if an exemption should apply or not. This information is crucial for them to be able to make this decision.

Amendment of section 59 of the Taxation Laws Amendment Act
Air passenger tax
This applies to passengers on a flight from the first of November. The problem is that many tickets were sold for flights departing after this date before the Act was promulgated. These tickets do not include that tax and it will be practically difficult to collect the tax on these tickets now. They could possibly collect the tax from the passengers on the day of the flight but this is impractical. In light of this the Minister has agreed that this tax now applies to tickets sold on or after 1 August and it applies to flights leaving on the first of November.

There are other amendments which are either consequential, minor, or they relate to structural changes. Mr Louw read through these briefly (See memorandum).

The meeting was adjourned.