Second Revenue Laws Amendment Bill: hearings

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Finance Standing Committee

22 October 2001
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Meeting report

 

FINANCE PORTFOLIO COMMITTEE
23 October 2001
SECOND REVENUE LAWS AMENDMENT BILL: HEARINGS

Chairperson: Ms Hogan (ANC)

Documents handed out:
Second Revenue Laws Amendment Bill
Naspers submission - Appendix 1
Life Offices Association submission – Appendix 2
PriceWaterhouse Coopers submission

SUMMARY
The Naspers submission dealt exclusively with controlled foreign entities (CFEs). Their position is that the capital gains of a CFE must not be taxed in SA. PriceWaterhouse Coopers submission was in three parts and dealt with International Tax, Corporate Formations and CGT. The Life Offices Association only made a submission on two aspects of the Bill. The first was on double taxation and the second was on the valuation date value for listed instruments.

MINUTES
NASPERS submission
Mr Pasak, Executive Director: Naspers, was present. The Naspers submission was read to the committee by Mr David Lermer, Director: International Tax at PWC.

The Naspers submission dealt exclusively with controlled foreign entities (CFE) under section 9D.
Naspers called for CFEs to be excluded from paying tax in South Africa. The participation exemption is recognised as being a relief but it was submitted that it is not wide enough, it is complex and provides no certainty to taxpayers. It was said that Naspers would not be the multi national it is today if the present CGT regime was in place in the past. The submission used international examples to show that SA will be more harsh than its trading partners and that this was not good for competition. The UK example is cited that excludes CFEs from the capital gains regime.

Mr Lermer summarised the Naspers submission as follows:
There must be no tax for CFEs. If it is decided that CFEs must be included then the participation exemption requirement must be decreased from 25% to 10%. The route advocated by Naspers is the UK approach that excludes CFEs from the CGT regime. To give effect to a balanced approach and address tax leakage, SA residents that hold passive income portfolios through CFEs should fall under CGT.

PriceWaterhouse Coopers (PWC) submission
The PWC submission was in three parts:

Part A – International Tax
Mr Lermer read from PWC's written submission (see document).

Part B – Corporate Formations
Mr Ferreira (Director: Tax and Legal Services) indicated that he was not reading from the written submission but would broadly outline his concerns.

He said that PWC when advising clients makes extensive use of the existing relief. The feature of the old legislation was that there was significant SARS intervention. PWC would go to SARS with an intended scheme and SARS would then say it is fine. Now there is new relief. Major clients want this relief to be used to the extent that the old relief was used.

He identified two problems with the old relief:
- CGT came into effect with no relief measures.
- there was a potential prejudice to the SA tax base in that assets could be disposed of to non residents and no tax was payable. This was especially true as a result of the change to a residence-based tax system.

What was expected was amendments to the old relief but rather new relief is proposed. The new relief is superficially more extensive but in operation, it is stricter and claustrophobic. The relief that is provided is of a roll-over nature in that the gain is taxed in the acquiring company upon disposal. There is also relief from transfer and stamp duty. A feature of the new relief is that SARS has no discretion. Either you are liable to pay tax or you are not liable.

The new relief is restrictive in order to counter tax avoidance and abuse. The 18 months holding period is an example. Assets get clogged up for 18 months. This a long period. It was submitted that this period should be reduced to 12 months. Taxpayers should be in a position to show SARS that the transaction is not intended to avoid tax and then it should be allowed. The old relief did not have this period but SARS monitored the activities of taxpayers. There is an international precedent for the holding period and therefore 12 months should be settled for coupled with a discretion given to SARS.

If a trust disposes of an asset there is no relief. Relief is granted to individuals but not to special trusts who are just representatives of the individual.

The relief excludes non residents. This was understandable but in SA there are migrant companies that have left SA but are still listed on the JSE. These companies make up 35% of the JSE capitilisation. If there is investment in SA, relief should be granted subject to certain guarantees.

There are many branches in SA. So if there is a movement of assets between branches there is no relief.

Mr Ferreira submitted that the minimum share holding requirement is too high. The new legislation should not gather dust but it should be used for daily business transactions.

The new relief except for intra group transfers is compulsory. The taxpayer has no right to refuse the relief and rather pay the tax.

Ms Hogan asked why a taxpayer would want to refuse the relief.

Mr Ferreira said that the whole process could get messy and the taxpayer might simply not want the 18 month holding period to apply.

Prof. Engel (Drafting Team) said that the relief is indeed mandatory. SARS chose this to keep the administrative burden lighter. It was easier to make it mandatory. It would be a morning's work for a tax attorney to arrange the affairs so that the relief does not apply.

Mr Ferreira continued and said that it is necessary that the old relief and the new relief is synchronized because from 1 November 2001 until the new relief takes effect there will be no relief.

Many groups used the old relief with a future plan in mind. Mr Ferreira used an example of an existing client that is undergoing a staggered unbundling. The new relief prevents this. The unbundling amendments preclude partial unbundling but in practice staggered unbundling is needed. Liability might be incurred for an unbundling and then the taxpayer has to wait a while to reduce its liability before doing another unbundling. Mr Ferreira requested that partial unbundlings be allowed.

Part C – Capital Gains Tax
Mr Ferreira said that when a company embarks on a share buy-back the shares are cancelled in terms of the Companies Act. He requested clarity on how CGT works in practice in this instance.

Another situation where clarity is needed is when there is a release of debt between connected parties. There seems to be a problem with the interaction of income tax and CGT.

The discretion exercised by the Commissioner in terms of the income tax regime is subject to an objection and appeal procedure. This should be the same for CGT.

Mr Louw replied that SARS does not want all the discretion to be subject to objection and appeal. Certain types of discretion are for the benefit of the taxpayer. Where the discretion involves a degree of interpretation, the Commissioner is subject to the objection and appeal process.

Mr Ferreira handed over to a colleague from PWC to deal with paragraph 43 and 84 of CGT. Paragraph 43 deals with the taxation of foreign gains and paragraph 84 with the taxation of foreign currency transactions. The submissions on these points were read from the written submission.

It was submitted that the intention of the amendment to paragraph 43 was not to provide any advantage for foreign as opposed to local investment in the financial markets.

An example was used to illustrate the concern with this section: An executive is transferred to SA long enough to become a resident. He holds shares in the UK company that employs him. If the person leaves SA, there will be a deemed gain from the date he became resident to the date he left SA. Under the old provisions the gain would be based on the foreign gain translated at the deemed disposal. The new amendment says that the gain will be based on the Rand cost of the shares at the date he became a resident and the Rand disposal proceeds on the date he ceases to be a resident. The person will never realise an economic gain in Rands because he has returned to the UK. To seek to tax the depreciation of the Rand against the foreign currency is not justifiable in terms of the rationale behind the introduction of CGT. To avoid this PWC suggests that paragraph 43 only be applicable to persons who are ordinarily resident in SA.

The concern with paragraph 84 is that the relief previously in 84(3) is no longer included. The section stated that the Minister when making regulation will not treat a person as having a capital gain or loss in certain circumstances, one of which was where assets were acquired or expenditure incurred in the same foreign currency. This would occur, for example, where a person on vacation drew funds from his foreign currency account to incur daily expenses or where immigrants with obligations in their own country use funds in that country to settle obligations. These regulations will not come before the committee therefore it has to be highlighted now. The absence of the relief will result in extensive record keeping for the taxpayer and will result in unintentional or intentional non-disclosure. SARS will need considerable resources to audit these returns. SARS has indicated that the position has to be considered but it is the view of PWC that foreign currency gains must be excluded from CGT.

Life Offices Association (LOA) submission
Two members of the LOA taxation committee presented the submission covering two aspects:

Double Taxation
The presenter said that policy holder assets attract CGT. If life assures hold the assets directly then the rate of tax is 7.5%. If the assets are held through a subsidiary then the rate is 15%. Most assets are held by subsidiaries.

He said that the LOA was not sure if this will be changed in the future. If it is not changed then the existing rationalisation rules of section 39 of the Taxation Laws Amendment Act 20 of 1994 will not be available to taxpayers after 1 December 2001. The LOA proposes that the date be extended to 1 October 2002 to allow taxpayers to restructure.

Valuation date value for listed instruments
Mr Claasen (LOA) submitted that the period used for the valuation - namely the last 5 days of September - is not a true reflection of normal trading due to the terrorist attacks. It was suggested that the last 5 days of August be used if the VWAP is to be used. Alternatively the ruling price on 28 September 2001 should be used.

In the written submission of the LOA Annexure B illustrates the price movement for the top 10 shares.

Mr Andrew commented that the 11 September attacks caused windfall losses and that it was unfair to suggest that taxpayers experienced gain because of that event. He asked if SARS intended to make adjustments to the date being used to determine the value.

Mr Louw said that SARS did look at the situation. The JSE has confirmed that the methodology of the VWAP is fine. Up to the 1 October 2001 there has already been an improvement in the market. Two methods can be used to determine the gain. The first is the market value method and the other is the time-based apportionment method. If the second method is used then 11 September has no impact on calculating the profit. If the value must be determined by using an artificial date then a dangerous precedent will be set. Artificially bumping up the value does not take into account future developments. There could be another disaster and people could be claiming artificial losses. Mr Louw said that he will come back to the committee with a more detailed response.

The meeting was adjourned.

Appendix 1
Naspers Ltd Representation to the Portfolio Committee on Finance
Capital Gains Tax on Controlled Foreign Entities

1. It is submitted that capital gains of controlled foreign entities ("CFEs") should not be subject to tax in South Africa.

2. The legislation in its present proposed form with the introduction of the participation exemption goes some way to dealing with this. However, the proposed exemption is limited, complex and could be subject to varying interpretations that, in turn, will fuel further tax uncertainty.

3. During the course of the presentations to the Committee by National Treasury, we have heard how tax legislation can create a commercial hurdle to South African business and that in setting policy a balanced approach is required. We welcome this approach as it is crucial to recognise that tax legislation differs widely from country to country and where South Africa, as an emerging market, puts in place legislation that is more harsh than its trading partners, South African business is put at a commercial disadvantage.

4. It is critical to note that the Naspers Group would simply not be the multi-national that it is today if capital gains tax ("CGT") in its present form had been in existence in prior years. In letters to Treasury, we listed two examples of actual prior offshore transactions that would have resulted in substantial CGT in excess of R800 million in total, had CGT been in place at the time. Naspers would not have entered into these transactions had CGT already been in place. The South African holding company simply did not have nor is it expected to have in the future this level of cash to pay such tax liabilities.

5. Had these transactions not taken place, South Africa would not have had the benefit of various international transactions that we have entered into. These international transactions have raised significant income and economic advantages for the country. Some of these are set out below:

a. We control pay television operations across Africa, Europe and Asia. Through this control, we are able to impose our operational and technological systems on these operations. In addition, via this control, we are able to ensure that items such as decoders are manufactured in South Africa and exported to these operations. In this manner, exports to foreign controlled operations totaling R520 million have been generated over the past three years. The important criteria here is our ability to control these offshore pay-television operations, which allows us to ensure that their requirements are sourced from South Africa and not from other markets.

b. In addition, the support by our group of South African manufacturers has enabled them to develop other export markets and to compete with foreign manufacturers.

c. We estimate that export of decoders by South African decoder manufacturers resulting from this amount to approximately R900 million over the past thee years.

d. In summary, without the combination of the purchasing power of the Naspers group, foreign and local, and their support of South African manufacturers, exports to the value of Rl .4 billion would not have occurred.

6. The participation exemption proposed in the current Bill goes some way toward alleviating the existing CGT burden on CFEs, and would have dealt with most of the actual transactions of the group alluded to above. However, it is important to bring to the Committee's attention the fact that one of the greatest catalysts to economic growth for a business is a legal, tax and administrative framework in which to operate that is both simple and certain. Although the proposed Bill does give certain tax relief in the form of the participation exemption, the legislation is limited to certain shareholdings, is exceedingly complex and unwieldy.

7. This fetters business transactions in that the South African holding company must police each transaction of its offshore subsidiaries to ensure that it does not create a tax charge in the hands of the South African company. This creates an extensive administrative burden on companies and can create conflicts of interest at the Board level of foreign investee companies, if South African tax in the ultimate South African investor company has to be taken into account in the commercial decision making of the foreign investee company's Board of Directors.

8. Furthermore the 25% threshold is too high in that it does not take cognisance of the need for business to enter into strategic investments to secure distribution lines, manufacturing resource, market share, access to technology, foreign Government contracts etc. The holding period requirement of 18 months is similarly overly restrictive in the fast pace of modern international business.

9. From our research it is clear that South Africa's legislation in its current and proposed form remains harsh in comparison with certain of South Africa's trading partners. For example the UK, one of South Africa's largest trading partners, has excluded CGT from its controlled foreign company ("CFC") legislation. Although there were rumours that after some 18 years of existence, capital gains would be included in the UK CFC legislation, the legislation was not changed. In addition most of our regional competitors, for example Botswana, do not have CFC legislation.

10. In this regard, we refer to Annexure A to this letter, which contains a comprehensive (although not exhaustive) summary of many of our treaty partners, detailing whether they have controlled foreign company ("CFC") rules or not.

11. We have split the countries into 3 groups, namely Developing, Developed (less dominant) and Developed (dominant). The following is apparent from the Annexure:

Many of the developing countries do not have CFC legislation.

Many of the developed (less dominant) countries have CFC legislation, but do not target intra-group transactions through the CFC rules.

With a few exceptions, only the developed (dominant) countries have CFC legislation that are comparable to the South African CFE legislation. However, the UK, a major trading partner of South Africa, has excluded capital gains from its CFC legislation.

In addition, the UK Inland Revenue recently issued a consultative document in July 2001 with proposals for either deferral of gains by UK companies of 20% shareholdings if reinvested in qualifying assets, or complete exemption of such gains.

Many of South Africa's European trading partners have exemptions, subject to certain conditions, from capital gains tax ("CGT") on capital gains from the sale of substantial shareholdings (i.e. participation exemption) (e.g. Austria, Belgium, Denmark, Germany, Netherlands and Switzerland).

12. It is also important that we do not fall into the trap of always benchmarking against the most developed economies in the world and, on many fronts, creating a more onerous regime, when it is more appropriate to benchmark against other emerging markets.

13. From our on-going discussions with several multi-national groups it is clear that the use of exemptions, as opposed to the capital gains falling outside the scope of the CFE legislation, is fraught with difficulty. This is because there is no guarantee that the exemption will cover all the relevant commercial transactions, and it is not possible to mirror the available relief used in every foreign jurisdiction. As a result, mismatches (to the South African group's detriment) will occur. We have identified cases where, for example, gains in a foreign sub-group are not taxed but fall to be taxed in terms of SA's taxation on capital gains in CFEs.

14. In these circumstances we believe that the most appropriate and practical steps is to follow the UK's lead and not include gains in our CFE legislation.

Specific request
15. We believe that overall, even after taking into account the proposed participation exemption, there is sound evidence that South Africa's CFE legislation will remain more onerous than that of other countries with which South Africa has trading relations and those emerging market countries with which South Africa competes for foreign investment.

16. We accordingly urge the Committee seriously to consider, and request further discussion on, the complete exemption from tax on the capital gains of CFEs. At the very least, we recommend that a transitional period be allowed in which CGT is excluded from the tax computation of CFEs.

17. Alternatively, if the participation exemption route is to be followed, then we request that the threshold be reduced to a level that recognises the commercial reality and need for strategic investments. It is suggested that a percentage threshold of not more than 10% of the equity share capital, votes or control of the strategic investment is needed.

18. The legislation could include a proviso that the relief is only granted where there is a demonstrable business link between the CFE and the strategic investment. For example, the strategic investment could be linked to the creation of taxable income for the South African group in South Africa, thus building on Government's objective to increase the tax base in South Africa.

19. The holding period requirement of 18 months should similarly be reduced to, say,
12 months to recognise the pace of modern international business. A 12 month holding period requirement is not out of line with international precedent.

20. Please note that the participation exemption only deals with shares and therefore there is, in any event, a need to expand the existing relief found in Section 9D(9)(f) and (fA) to include capital gains. It is understood that this issue is dealt with in the representations of PricewaterhouseCoopers and so is not repeated here, other than to give full support and agreement to this proposal.

Conclusion
21. We believe that the most appropriate and practical steps to follow are the UK's lead and not include gains in our CFE legislation.

22. We have suggested proviso's or exclusions from the suggested general exemption for CFEs to avoid abuse by ensuring that the exemption will not be available to South African residents holding passive portfolio investments via a CFE.

23. In our view the above relieving provision will go some way towards leveling the global playing field for South Africa's multinationals.

Annexure A
Country CFC-rules Targeting of intra-group transactions
through rules
Developing
Argentina No No
Botswana No No
India No No
Singapore No No
Czech Republic No No
fran No No
Israel No
Malaysia No No
Portugal Yes No
Brazil Yes No, Transfer Pricing
Hungary Yes Yes
Korea Yes No, Transfer Pricing
Mexico Yes No, Transfer Pricing

Developed (less dominant)
Switzerland No No
Austria No No
Belgium Yes No
Denmark Yes No
Finland Yes No
Indonesia Yes No
Norway Yes No
Sweden Yes No
Australia Yes Yes
New Zealand Yes Yes

Developed (G7)
Canada Yes No
Japan Yes No, Transfer Pricing
Italy No No, but introducing similar rules to the current SA rules
France Yes Yes
Germany Yes Yes - inter affiliate sales
United Kingdom Yes Yes
United States Yes Yes - certain related party sales and services
Income

Appendix 2
LOA SUBMISSION: REVENUE LAWS SECOND AMENDMENT BILL, 2001

Introduction
Madam Chair, honourable members, thank you for the opportunity to address the Committee on some issues concerning the proposed amendments to CGT.

The LOA has over the past few months had several discussions with representatives from SARS and the Department of Finance on numerous issues. We wish to thank Mr. Kosie Louw and his team for the productive way in which these discussions took place. Some of the issues have already been addressed in the draft that is currently before the Committee, while others will remain on our agenda for future meetings with these departments. As a matter of interest, we attach as Annexure A a copy of our minutes of the most recent meeting held on 12 October 2001.

During the implementation of CGT we identified several aspects that needed clarification.
As already mentioned, a number of these resulted in some of the proposed amendments
currently before you. We believe that, with time, more refining will be necessary and the
LOA is committed to providing inputs on improving the legislation.

However, there are a few issues that we wish to highlight and that we believe require some further debate. We accept that, due to time constraints, it might not be possible to address this in the current process, but with some enabling provisions the Department of Finance could do further research on these subjects.

Double taxation or cascading
In our previous submission we pointed out the effect CGT could have on structures with multiple layers of entities. We also emphasized the negative implication CGT has on wholly owned investment subsidiaries of life companies and retirement funds because of the different inclusion rates. We proposed certain workable solutions to SARS, but we believe that they were not properly investigated due to time constraints. This, together with the treatment of "financial instruments" in clause 46 of the Bill before you, may cause structural difficulties for the life assurance industry.

The proposed corporate action rules contained in clause 46 do not address all the possible scenarios. The blanket exclusion of "financial instruments" from most of the provisions is of concern because it will impede the conduct of business by life assurers as well as other legitimate financial service businesses. Furthermore, the current rationalisation provisions available to taxpayers (in section 39 of the Taxation Laws Amendment Act No.20 of 1994) are to be withdrawn on 1 December 2001 (see clause 178). Given the negative double taxation effect of CGT on multiple layers within group structures, we foresee that groups will need to reorganise their multiple layers in future.

There is limited time available to use the existing rationalisation provisions especially as many taxpayers may only become aware of the proposed removal of these provisions after the Gazetting of the Bill before you. Rationalisations effected by life assurers (and other financial service groups) after 1 December 2001 will trigger the payment of CGT and stamp duty where financial instruments are involved. This is because they will not qualify for relief in terms of the provisions of clause 46 of the Bill before you, since they are mostly invested in "financial instruments

We therefore suggest that the proposed cut-off date for rationalisation applications (clause 178) be extended to 1 October 2002. This will give taxpayers sufficient time to reorganise group structures (with the approval of SARS and upon such conditions as SARS may determine) and will also give SARS further time to investigate alternatives together with other role-players to eliminate or at least reduce the cascading effect inherent in CGT.

Valuation date values for listed financial instruments
Much has been said already of the negative effects of the 11 September 2001 events in the USA on stock markets in general. The current Bill before the Committee contains an amendment regarding the way in which the valuation date values for listed financial instruments must be calculated (clause 83). It also provides a discretion for SARS to amend the result of such determined values in certain circumstances. We accept that using a weighted average trading price as a basis is fair. However, we believe that the five days used in SARS's calculation are not a true reflection of a period of normal trading circumstances. Attached as Annexure B is a summary of some movements in the prices of the top 10 listed shares on the JSE Securities Exchange (according to market capitalisation) as well as two information technology shares. Column A sets out the value determined according to the proposed amendment as published on the SARS website. A taxpayer using these values as base cost will be subject to CGT on all growth above these values. Column D indicates the percentage movement in the prices over the five days used by SARS and it emphasizes the point that these days could not be regarded as normal. Even worse is the fact that, based on the ruling price on 28 September 2001 (Column C), taxpayers started off with a CGT liability before any trade on 1 October 2001 as indicated in column E. The movement as set out in Column G indicates how sensitive the values are if the five days are moved by one day, i.e. 21 September 2001 is ignored and 1 October 2001 is added.

Conclusion
We believe that the Committee should give serious consideration to this issue and change the rules governing the valuation date value. We suggest that an effective date in the past be used as a basis for the valuation date values since this should eliminate any fears of possible manipulation. Should the use of a 5 day volume weighted average calculation method be important, we suggest that the last five trading days in August 2001 be used (refer column H of Annexure B), otherwise the ruling price on 28 September 2001 could be a suitable alternative (refer column C of Annexure B).

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