Companies
1702. The new passive holding company regime
February 2009 – Issue 114

As an anti-avoidance measure, the taxation of passive holding companies ("PHC") will come into being at the time that dividends tax is introduced. The driving force behind the introduction of this legislation is a perception that high net worth individuals can avoid dividends tax by housing their portfolio investments in a company and reinvesting the dividends.

Further, it appears to be a concern that income tax at individual rates can be deferred or reduced by investment of surplus cash by individuals via investment companies. It is contended by the legislature that the interest, having been taxed at 28% can be reinvested and the after-tax residue will only incur additional withholding tax when and if it is eventually distributed. The Revenue Laws Amendment Act, 2008 introduces the new passive holding company regime in the form of a new section 9E of the Income Tax Act No 58, 1962 (the Act).

The definition imposes three basic tests:

Not an "excluded company"

The list of excluded companies covers listed companies, companies in the same group, banks, insurers, approved public benefit organisations, clubs, foreign companies and the new venture capital companies.

Income test

The passive income of the company is greater than 80% of the sum of the gross income of the company and the gross income (other than passive income) of all other companies that form part of the same group of companies (as defined in section 41 of the Act).

In this context

· "passive income" is the gross income derived from financial instruments. This excludes rent, royalties and capital gains other than in relation to financial instruments.

· "gross income" is as generally defined for income tax purposes, excluding royalties and dividends from companies in which the company holds more than 20% of the equity and voting rights.

Ownership test

At any time of the year five or fewer natural persons who are residents together with connected persons in relation to such individuals must have held more than 50% of the participation rights.

Taxation of PHC

A PHC is taxable on its dividend income at the rate fixed annually by Parliament. In addition, a rate of taxation will be fixed by Parliament in respect of its other income. It has been indicated that the rate of tax on dividend income will be 10% and 40% on other income. In this respect the taxation rates for other income are as would apply to a trust. The disadvantage that a PHC will have compared to a trust is that it is unable to mitigate the tax on capital gains by distributing the gains to the members in the same year of assessment.

Taxation of dividends paid by PHC

Dividends paid by a PHC to its shareholders will be exempt from the dividends tax to the extent that the sum of that dividend and all dividends paid on or after the date of implementation does not exceed the sum of:

· dividend income taxed at the rate prescribed for taxing PHC dividends; and

· the taxable income taxed at the rate prescribed for other PHC income.

Administrative provisions

SARS has power to estimate the amount due if it considers that PHC tax has not been paid in full. Interest and administrative penalties may be imposed in respect of late payment or underpayment.

Every person that controls or is regularly involved in the management of the overall financial affairs of a PHC or an unregulated intermediary that is liable to withhold tax and that is a shareholder or director of that company is personally liable for the dividends tax, additional tax, penalty or interest for which that company is liable.

Potential impact

Trusts will be taxed at the same rate as a PHC on their income. It is considered unlikely that PHCs would be considered attractive to high net worth individuals, even in the absence of the proposed new legislation. The main reason is that investment in financial instruments is typically made to generate capital growth. The estate duty implications of this growth would generally militate against the widespread personal ownership of investment companies.

PricewaterhouseCoopers

IT Act:S 9E

Editorial comment: In view of the fact that the implementation date of this new provision is indicated as late 2010, it is possible that there may be amendments to these provisions before that date.