Secondary Tax on Companies
1644. Revised taxation on distributed profits
July 2008 – Issue 107

 

 

More or less tax?

A number of important changes were made to the secondary tax on companies (STC) regime last year. These changes were referred to by the revenue authorities as "phase one" of the intended reform of STC. Essentially this entailed the broadening of the tax base and the reduction in the rate of STC from 12.5% to 10%, effective from 1 October 2007.

 

The revenue authorities released a Media Statement on 20 February 2008 (Revised Taxation of Distributed Profits: Conversion of the Secondary Tax on Companies (STC) to a Shareholder Dividend Tax" - 20 February 2008) that deals with "phase two" of the reform of the STC regime, essentially the replacement of STC with a final dividend withholding tax on shareholders at a rate of 10%. Comments were invited, to reach the revenue authorities before 31 March 2008.

 

The revenue authorities have also recently issued a discussion document (Dividends versus Return of Capital: Revising the base for Taxable Distributions) that deals with the distinction between return of capital and distribution of profits. The discussion document proposes the introduction of a concept called "contributed tax capital".

 

STC: Phase two

STC is currently a tax on companies. As part of phase 2, STC will be converted to a final dividend withholding tax on shareholders. The implementation of this second phase is contingent on the revision of a number of Double Tax Agreements (DTA) between South Africa and certain other countries that limit the withholding tax on dividends to 0%.

 

Most DTAs reduce this withholding tax to 5% where the foreign shareholder owns a specified percentage of the local company’s share capital. Foreign shareholders who can rely on these DTAs will accordingly benefit under the proposed new regime. The DTAs at issue are Australia, Cyprus, Ireland, Kuwait, The Netherlands, Oman, Seychelles, Sweden and the United Kingdom.

 

Current system

Under the current system, STC may be payable at different points of the dividend distribution cycle. Thus, STC may be paid at the first level by the first company that distributes the underlying profits. The subsequent dividends associated with these profits are exempted by the STC credit system. The STC credit system calculates STC on the net amount of any dividend declared.

 

The net amount is calculated by the deduction of dividends accrued (dividends in respect of which STC has been paid) against dividends declared during a dividend cycle. Alternatively, dividends distributed by local companies to other local group companies are exempted from STC. STC in this instance only applies at the level where dividends are declared to individuals, non-resident and non-group companies.

 

Proposed system

By contrast, it is proposed that dividend tax only be payable at the point of declaration by the company to an individual or non-resident shareholder. That is, dividend distributions to a local company will be exempt from the proposed final dividend withholding tax. This approach will of necessity require the company paying the dividend to identify the status of the recipient shareholder.

 

For example, assume that the shareholders in Company C are individuals, non-residents and local companies. Company A distributes dividends to Company B, which in turn distributes those dividends to Company C. Company C in turn distributes the dividends to individual, non-resident and corporate shareholders. Dividend tax will be payable at the point of distribution of the dividend by Company C to the individual and the non-resident shareholders, while the dividends distributed to the corporate shareholders will be exempt.

 

Distributions to entities which are fully exempt from tax will be exempt from dividend tax. Even though public benefit organisations are partially exempt from tax, the discussion document states categorically that they will not be subject to the proposed dividend tax. Recreational clubs, however, will be subject to the new tax.

 

Proposed system: STC credits and double taxation

The major issue that has arisen in regard to the proposed new dividend withholding tax regime is the treatment of STC credits that have not been utilised at the time of the change over. As mentioned above, under the current system, STC credits are claimable against dividends declared in the determination of the amount upon which STC must be accounted for by the company declaring the dividend.

 

It is argued by the revenue authorities that there is no place for STC credits under the new dividend withholding tax regime, as the withholding tax will only be payable when the final dividend is paid to an individual or non-resident shareholder. The Media Statement concludes therefore that: "after careful consideration it has been decided that STC credits accumulated prior to the implementation of the new system will be forfeited".

 

This is very concerning as the non-recognition of STC credits will result in double taxation. For example, Company A has declared a dividend to Company B and has paid STC in respect of the dividend declared. Company B then on-distributes the dividend to Company C and claims an STC credit thereby deducting the dividend accrued to it against the dividend declared. The dividend is then on-distributed to the individual and non-resident shareholders.

 

STC is accordingly only paid once under the old system. Assuming that the new system is implemented before declaration of the dividend by Company C, the dividend withholding tax will once again be payable on the dividends received by the shareholders. Therefore, the dividend will effectively be taxed twice! SARS’s justification for this is that "retention of transitional STC will give rise to multiple administrative complications" and that taxpayers have until 1 January 2009 to declare dividends and use credits against these dividends.

 

Dividends vs return of capital

The tax system seeks to tax only profits and not return of initial investment. Distributions out of share capital and "untainted" share premium (i.e. share premium not arising out of capitalised income) will not be subject to dividend tax under both the old and new system.

 

The revenue authorities have proposed that all distributions be treated as taxable dividends unless parties specifically withdraw funds from share capital or share premium, now to be referred to as "contributed tax capital". The concept of profits will no longer be used.

 

This is because, according to the discussion document, the concept of profits is an accounting/company law concept which gives rise to different considerations to the tax concept of profits. That said, it is difficult to think of any situation where the considerations are different. Under the new system, "Contributed tax capital" would be limited to shareholder contributions of cash or assets to the company. Cash contributions should not give rise to any complications, but the same cannot be said for the contribution of assets.

 

Assets would be recognised based on the tax value of the asset contributed, and not its market value, whereas company law/accounting focuses on value.

 

The following example is provided in the discussion document:

Newco is formed. The shareholder subscribes for shares and in consideration for the shares pays R90 in cash and transfers land with a value of R110. The land was purchased for R60. As the shareholder has disposed of the land for R110, it derives a capital gain of R50 that is subject to CGT. Under the proposed regime, Newco will have "contributed tax capital" of R200, being the cash of R90 and R110 for the land (the shareholder’s cost of R60 plus taxable capital gain of R50).

 

As an aside, it appears that the same result would have been achieved had the market value approach been used. The discussion document recognises that the proposed approach "admittedly has administrative difficulties" and notes in this regard that "if the recipient company is listed or widely held, it would be difficult for the receiving company to trace the tax cost of the contributions made by the smaller contributing shareholders (such as a contribution of shares of the target company in an asset-for-share type transaction)".

 

To this one could add that the shareholder may not wish to disclose his or her tax cost of the asset contributed to the company and other shareholders. The proposed introduction of the concept of "contributed tax capital" will also impact amalgamations, share issues, liquidations and unbundlings. In addition, it is proposed that contributed tax capital be allocated per class of shares.

 

While such a regime was in fact introduced by the Revenue Laws Amendment Act, 2007, the discussion document notes that this was merely an ad hoc measure "that fails to address the underlying cause of the problem". This new measure is necessary, according to the discussion document, as capital has in the past been shifted amongst different shares to artificially reduce taxes on distributions. To prevent shifting of capital between classes, a percentage ceiling will be applied. The contributed tax capital allocated to any share within a class would not exceed the pro rata percentage of that share in relation to the total class of shares.

 

SARS also proposes the introduction of ordering rules where the contributed tax capital is deemed to be distributed last. In other words, a shareholder will be deemed to withdraw the initial underlying investment only after the growth has been withdrawn. As mentioned above, comments in regard to the dividend withholding tax proposal set out in the Media Statement were required to be made before 31 March 2008.

 

Webber Wentzel Incorporating Mallinicks

 

IT Act:S 64B,

IT Act:S 64C

 

Editorial comment: Refer item 1621. These are only proposed changes

 

Liquidation: STC on capital reserves

Until 1 January 2009, any capital profits included in a company’s reserves attributable to the period prior to 1 October 2001, may be distributed free of STC to shareholders if the company is being liquidated. Capital reserves distributed thereafter will attract STC. It is therefore important to align plans to liquidate companies and tidy up group structures prior to the 1 January 2009 deadline. A proper analysis of reserves, including the split between revenue and capital reserves, must form part of the overall planning process. The same comments apply in respect of pre-1993 revenue reserves.