Efficient or inept? Corporate income tax rate and restructuring rules

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Candice Gibson

Introduction

On 12 April 2018 the Davis Tax Committee (DTC) released a media statement announcing the publication of four additional final reports and the conclusion of its work based on its terms of reference (for further details please see “Davis Tax Committee releases final reports“).

This update examines certain aspects of the report on the efficiency of South Africa’s corporate income tax (CIT) system, with particular reference to the reviews undertaken in respect of the efficiency of the CIT rate and corporate restructuring rules (CRRs).

On 31 October 2016 the DTC formed a CIT sub-committee to prepare a CIT report setting out the DTC’s position. To ensure that the recommendations made in the report were practical, the DTC took into consideration South Africa’s present economic position as well as its outlook. The DTC recognises that in the context of low economic growth, taxes must be raised in a manner that causes as little disruption to economic growth and employment as possible.

Efficiency of CIT rate

In 1997 the Katz Commission specified that a residence-based system of taxation in South Africa would carry the danger of promoting the export of South African human capital and contributing to an undeveloped South African multinational sector. However, despite the commission’s recommendations, a residence-based system was introduced into South Africa’s income tax system for the years of assessment commencing on or after 1 January 2001.

The relevance of the residence-based system of taxation stems from the definition of ‘resident’ as defined in the Income Tax Act (58/1962), particularly when it comes to the identification of the residence of a corporate, which is dependent on whether it is incorporated, established or formed within South Africa or where it has its place of effective management. With the increase in globalisation and the mobility of capital, the concept of a place of effective management is capable of being manipulated, enabling a corporate’s residence to be a matter of deliberate choice rather than one of circumstance, especially in the digital economy. Therefore, should the CIT rate be seen as too high in comparison with other jurisdictions, corporates will be motivated to move their place of effective management to jurisdictions with lower tax rates.

South Africa has seen a decline in the CIT rate from 40% in 1994 to the present rate of 28%, which has been consistent since 2010. As noted from the CIT rate movement during the past 24 years, the CIT rate responds quickly and negatively to the economic conditions faced by South Africa. Therefore, the CIT sub-committee noted the importance of taking into account the economic climate when deciding whether to adjust the CIT rate. Although it remained at 28% following the 2018 budget speech, the minister of finance acknowledged that the rate was still high by international standards. This could have an impact on the competitiveness of South African corporates in a market which is already highly competitive in nature.

Arguments for and against decreasing the CIT rate have been set out in the CIT report. In this regard, the CIT sub-committee indicated that international tax competition has played a significant role in applying pressure within competitive jurisdictions, which as a result has caused the decrease in CIT rates in other jurisdictions to attract multinational corporates. Another argument put forward in favour of decreasing the CIT rate was that corporates would have less incentive to shift their profits outside South Africa with the aim of eroding their tax bases. Further, evidence has shown that there is a higher level of compliance in jurisdictions with lower tax rates. Earlier in 2018 the South African Revenue Service announced that approximately 21 million CIT returns were outstanding. The DTC’s argument that jurisdictions with lower CIT rates see a higher level of compliance may be of interest to the National Treasury for the 2019 budget.

Arguments against a decrease in the CIT rate must also be considered in order to make the most appropriate recommendations going forward. The significant contribution of corporate revenue to the fiscus in South Africa means that without some level of certainty that a reduced CIT rate would be effective in stimulating growth and thus increasing the overall tax base and collection of taxes, a resultant reduction in revenue would need to be compensated for elsewhere. From an international perspective, it appears that the best approach may be to leave the CIT rate the same while using other efforts to widen the tax base (eg, introducing restrictions in respect of deductions and allowances), as well as bringing new forms of income into the tax net. The National Treasury appears to have adopted this approach.

DTC’s recommendations: CIT rate

The DTC made the following recommendations regarding the CIT rate in South Africa’s present economic circumstances.

  • Any change to the CIT rate must be made with appropriate circumspection, as it may involve considering not only the applicable rate used by trade partners, but also South Africa’s neighbouring states. This process must be undertaken in a holistic manner, considering different allowance and exemption regimes;
  • Regarding the competitiveness of corporates within different jurisdictions, the European Commission indicated in a 2011 press release (Competitive Tax Pricing) that a government lowering its tax rates to increase competitiveness within the market may not necessarily lead to an increase in its productivity. Further, jurisdictions that attract foreign direct investment by offering lower tax rates are not necessarily more competitive than jurisdictions with higher tax rates – therefore, the competitiveness of a tax system cannot be judged simply on rates. In order for South Africa to compete in competitive markets, it should focus on the quality of its tax system by ensuring that tax evasion is reduced;
  • Other policy changes (eg, those in respect of labour, immigration and power supply) would need to be reviewed for tax to be a factor that might assist in promoting economic growth; and
  • Taking into account the country’s present economic position, the DTC did not recommend a decrease in the CIT rate at the time of the report’s publication. However, CIT rates should be reviewed regularly in light of other factors and policy decisions.

Efficiency of CRRs

One reason for the introduction of the CRRs in 2001, taking into account the policy objectives of competitiveness, was to promote the domestic restructuring of South African groups of companies (as defined in Section 41 of the Income Tax Act) in order to promote growth. The second reason was to alleviate unintended hardships caused by the enactment of capital gains tax, which was also introduced into South Africa’s tax system in 2001. The CRRs not only provide relief from the tax consequences of capital gains tax, but also defer the incidence of income tax, donations tax, dividends tax, transfer duty, securities transfer tax and value-added tax.

In terms of the corporate restructuring rules, the CIT sub-committee has raised concerns, especially with regard to the specific anti-avoidance provisions that apply to transactions between connected persons. The main issue raised is the volume of anti-avoidance provisions which create unintended difficulties to ordinary commercial transactions. The anti-avoidance provisions are addressed in more detail below. The concerns identified and addressed in the CIT report in respect of the CRRs include the following:

  • The ‘rules-based’ nature of the CRRs makes them mechanical:
    • Should a taxpayer not meet the detailed and specific requirements of the provisions, relief is unavailable. This defeats the object of the CRRs, which aim to promote domestic restructuring by granting relief from the tax consequences that would otherwise result from a restructure;
    • The CRRs are mechanical rather than conceptual in nature, which causes difficulties when the CRRs interact with other sections of the Income Tax Act which do not fall within the restructuring provisions. The mechanical nature makes the provisions quite complex and restrictive as the CRRs attempt to cater for every scenario that could arise when dealing with a corporate restructure; and
    • The CRRs do not cater for liabilities in the context of corporate restructures with the focus being on assets and the relief granted in respect of those assets. This results in other provisions of the Income Tax Act still finding application to liabilities, such as the debt reduction rules provided for in Section 19.
  • The complexity and volume of anti-avoidance provisions contained within the CRRs:
    • Over the years, the CRRs have been amended and refined to prevent their abuse for tax avoidance purposes. However, this continuous amendment makes it difficult to comply with the requirements. The question which the DTC faces is whether the CRRs’ efficiency has been hindered by fear of their abuse; and
    • Section 45 was highlighted as the “most burdensome” CRR in the context of anti-avoidance, as it has been used in several avoidance schemes – one of which relates to debt pushdown schemes involving the claiming of substantial amounts of interest deductions leading to large tax losses. There are two main types of anti-avoidance measure that apply to Section 45 transactions:
      • An 18-month deemed sale rule which prevents the disposal of an asset within 18 months after acquiring the asset in terms of Section 45. Therefore, if the asset is disposed of within the 18-month period, it will result in a ‘deemed sale’ on the date that the Section 45 transaction took place, and the profits from the disposal cannot be set off against any accrued loss. The CIT report notes that taxpayers view the 18-month anti-avoidance rule as unnecessarily strict and unfair and that it does not contribute to fiscal neutrality. In addition, the 18-month period has been criticised for being too long and unrealistic in a modern world where business opportunities emerge at an accelerated pace; and
      • De-grouping charges which trigger a deemed disposal should one of the companies engaged in the Section 45 transaction leave the group (referred to as the six-year de-grouping charge). Further, where consideration is received by the group as part of a series of transactions with the purpose of transferring the assets tax free, the CIT sub-committee indicated that the de-grouping charges had been criticised for inhibiting commercial activity and creating undue burdens on taxpayers.

DTC’s recommendations: CRRs

The DTC made the following recommendations with regard to CRRs and anti-avoidance provisions.

  • Since the fundamental principle underlying the CRRs is for the transferee to ‘step into the shoes’ of the transferor, the CIT sub-committee suggested that it would be more appropriate to reformulate the rules so that they are principle-based as opposed to rule-based. Therefore, instead of trying to cater for every scenario, the provisions should set the framework within which the underlying principles must be allowed to operate and develop through interpretation and practice. This approach would need to be examined with a view to streamlining the CRRs to ensure more flexibility and adaptability;
  • From a policy perspective, the DTC is of the view that the de-grouping charge is in line with underlying policy and the DTC cannot therefore support the proposal that the six-year de-grouping charge be reduced to 18 months. However, the CIT report recommended that a period shorter than six years be considered following a review;
  • The DTC further acknowledged that the calculation relating to de-grouping charges are complex in nature and may need to be simplified; and
  • CRRs should be purposive rather than rules-based in nature. This recommendation stems from the literal interpretation of the de-grouping charge in Section 45, which creates situations where a de-grouping charge may be triggered in circumstances that were never intended. For example, a change in shareholding further up the corporate structure could trigger a de-grouping lower down, where the companies that were originally required for the Section 45 transaction are still intact. The DTC therefore recommended that Section 45 be revisited with a view to allowing and encouraging group restructures. The DTC is of the view that any abuse in respect of the CRRs could be countered by making use of the general anti-avoidance provisions.

The CIT report will be presented to the minister of finance. However, as the DTC is only advisory in nature, it remains to be seen whether its recommendations with regard to the CIT rate and CRRs will be considered and implemented going forward.

For further information on this topic please contact Candice Gibson at Cliffe Dekker Hofmeyr by telephone (+27 115 621 000) or email (candice.gibson@cdhlegal.com). The Cliffe Dekker Hofmeyr website can be accessed at www.cliffedekkerhofmeyr.com.

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