Second Revenue Laws Amendment Bill: response to hearings; Seychelles Double Tax Agreement

Meeting report

FINANCE PORTFOLIO COMMITTEE
1 November 2001
DOUBLE TAXATION AGREEMENT WITH SEYCHELLES; SECOND REVENUE LAWS AMENDMENT BILL: RESPONSE TO SUBMISSIONS

Chairperson: Ms Hogan (ANC)

Documents handed out:
Double taxation agreement between Seychelles and RSA
SARS – Comments on representations [.pdf file – Adobe Acrobat reader required]
National Treasury – Response to Public Comment – Appendix 1
Second Revenue Laws Amendment Bill (Second Draft)

SUMMARY
The Committee was briefed on the Double Taxation Treaty between South Africa and the Seychelles. The Treaty was adopted. SARS and National Treasury responded to the comments made by the public during hearings. Many of the policy issues remained unchanged but further relief was granted in certain areas.

MINUTES
Double Taxation Agreement
Mr van der Merwe (SARS) said that ratification had been delayed because the Seychelles had not delivered a letter to state that they are committed to move away from harmful tax competition. They have now done so and the treaty has been signed.

He referred to the following articles:
- Article 5: the normal period for a permanent establishment was cut from 6 to 12 months.
- Article 9 deals with associated enterprises. The article empowers tax authorities to counter abuses. Paragraph 3 says that a State cannot change the income of a person in terms of paragraph 1. Paragraph 3 limits paragraph 2 and 3 in that these paragraphs do not apply in cases of fraud, willful default or negligence.
- Article 23 eliminates double taxation.

Discussion
Mr Andrew (DP) asked what the process was for publication and comment on the treaty.

Mr Van Der Merwe said that before negotiating the treaty a notice is published in the Government Gazette requesting parties to make submissions. The Committee gets a preliminary hearing before signature. Once it is ratified it is part of the law.

Mr Andrew asked if stakeholders see a the final draft before signature to see if their concerns have been addressed.

Mr Van Der Merwe replied that they do not often receive representations. If they do, and depending on their nature, then discussions take place with the stakeholder. When negotiating with the other State, the representations could be included and the stakeholder is informed of the position of the other State.

Mr Grote (National Treasury) asked what the proper process was in SA because he is the Chair of the SADC Tax Committee and he had never seen the treaty before. He asked how transparent was the process.

Mr van der Merwe apologised if Treasury had not had sight of the treaty. It was an oversight.

Prof. Engel (National Treasury) said that the treatise provided exemptions and therefore Treasury would need to be involved from the very beginning. At this late stage it is a matter of ‘take it or leave it’. He asked what kind of role would the Committee want to play.

Ms Hogan said that it was too early to contemplate including this in the workload of the Committee. Maybe with the restructuring of the functions of the Committee there can be involvement from the beginning.

Ms Hogan read the motion of desirability for the NCOP members as well as the National Assembly Members. The treaty was unanimously adopted.

SARS Response to Public Comment on Second Revenue Laws Amendment Bill
Mr Louw presented SARS response to public comment on the . He indicated that he would leave out all the technical issues and dealt with the following issues raised during public comment:

Section 3 of the Income tax Act - Objection and appeal
No justification exists for subjecting the exercise of only certain discretions to objection and appeal and it also creates confusion (PriceWaterhouseCoopers submitted that all exercise of Commissioner’s discretion should be subject to objection and appeal)

This aspect does not form part of the Bill under consideration. There are a number of discretions which are specifically not made subject to objection and appeal which are generally exercised in favour of the taxpayer, for example, extensions for the submission of annual tax returns in terms of section 66(1) of the Income Tax Act. The matter was cleared with the State Law Advisor.

The failure to subject the exercise of each and every discretion in the Revenue Acts to an internal objection and appeal procedure, does not conflict with the constitutional right to just administrative action in terms of S33 of the Constitution, 1996 (Act No.108 of 1996) as read with the Promotion of Administrative Justice Act, 2000 (Act No.3 of 2000 - "the AJA"). The AJA prescribes how the powers that are given to administrators by other laws must be exercised, and gives members of the public the right to challenge administrative action that does not follow these rules and principles. For example, the Constitutional Court in the case of Metcash Trading Ltd V Commissioner, South African Revenue Service, And Another 2001(1) SA 1109 (CC) confirmed the constitutionality of certain provisions of the Value Added Tax Act, 1991, which provisions conferred discretionary powers on the Commissioner without subjecting such powers to internal objection and appeal, on the basis that whenever the Commissioner exercised discretionary powers conferred upon him, this constituted an administrative action which was reviewable in terms of the principles of administrative law and the Constitution.

Section 33 of the Constitution and the AJA does not prescribe that all current and new legislation
must be amended to give effect to the right to just administrative action, for example by ensuring
that all discretionary powers are subject to an internal objection and appeal process. This was the
purpose of enacting the AJA which provides for a review of such powers.

Section 4 Preservation of secrecy
The Income Tax Act is not the correct code to combat crime and SARS should only reveal privileged information on application to a High Court Judge in respect of matters of threat to public safety and State security.
(SACOB submission)
The penalty for a contravention of the secrecy provisions should be substantially increased to avoid possible abuse of the relaxation of the existing provisions.
(AHI submission)
Officials of the National Treasury who receive information should be required to take the oath of secrecy.
(SAICA submission)
Information should only be disclosed to the National Commissioner of the South African Police or the National Director of Public Prosecutions where the Commissioner obtained an order from a judge in chambers.
(SAICA; AHI submissions)
It must be expected that wrongdoers may be reluctant to declare ill-gotten gains for tax purposes if there is a risk that SARS will reveal their identities to prosecuting authorities.
(AH I submission)
If the Commissioner discloses information that is incorrect the Commissioner may become liable to damages.
(SAICA submission)

The confidentiality of information supplied by taxpayers remains a fundamental principle of taxation. However, SARS should be able to pass on information obtained which reveals evidence of a serious non-tax offence or of an imminent and serious public safety or environmental risk. This is also in line with international trends and in the general public's interest as such disclosure outweighs the potential harm to the taxpayer concerned.

The following amendments have been effected:
- Such information may only be disclosed after a judge of the High Court has approved an application for disclosure. This will provide sufficient protection to both taxpayers and SARS and upholds the right to privacy of a person.
- Self-incriminating evidence provided by a taxpayer may not be used against him/her in a court of law. This will uphold the taxpayer's constitutional right that he or she may not be compelled to provide self incriminating evidence.

The National Treasury and other bodies to whom information is supplied, will also be subject to secrecy.

Section 8 - Certain amounts to be included in income or taxable income
In the case of assets donated that leads to a donations tax liability there should not be a resultant income tax liability. (PricewaterhouseCoopers submission)

The disposal of an asset for less than market value could be subject to taxation under this section as well as under the donation tax provisions. (SACOB submission)

The principle that previously granted deductions or allowances in respect of an asset, are to be recouped where that asset is donated was introduced in the Income Tax Act in 1993. The imposition of donations tax on the donation is in terms of separate provisions of the Income Tax Act. The imposition of more than one tax triggered by an event is not foreign to SA’s tax system. On death both estate duty and capital gains tax are imposed, but based on different tax bases. As a further example PAYE and Skills Development Levy are both imposed on the same base, the remuneration of an employee.

Section 18A - Deduction of donations to certain public benefit organisations
The requirement that the PBO must solely carry on an approved public benefit activity in order for donors to benefit from a tax deductible donation is overly restrictive. (SACOB)

Is the intention that PBO's seeking section 18A recognition should conduct the approved public benefit activities in a separate entity vis a vis any other activities that may be conducted?
(SAICA)

The proposed amendment has been withdrawn.

Structured finance transactions
This matter will be dealt with next year. It involves complex issues and SARS do not want to make mistakes by rushing it. As far as rulings are concerned SARS feel that companies should get a ruling when the transaction is complicated and involves a certain monetary value. SARS will also require that all truncations no matter the value be reported.

Time and Manner of lodging Objections
SAICA submitted that rules under section 107A should be finalised and promulgated as soon as possible.

Two new sections will now be inserted. Section 107A which will provide for the enabling provisions to determine and promulgate the court rules. Section 107 B will provide the enabling provisions with regard to the wider settlement powers.

With regard to the court rules the intention is to promulgate them as soon as possible. However, they require further consultation on the matter before it can be finalised. A first draft was circulated for comment. A second draft will now be circulated whereafter they will hopefully be in a position to promulgate.

Court rules do not form part of the main body of the legislation and are always contained in secondary legislation. This is the case as far as Magistrates Courts and the High Courts are concerned. This is also so in the case of the existing Special Court Rules. These rules normally regulate issues of a procedural nature and the appropriate level of regulation is in terms of subsidiary legislation.

With regard to the write-off provisions and settlement powers, two points need to be made:
- The write-off of tax provisions which they intended to insert in each Revenue law, will now be withdrawn. The reason therefor being that discussions with the National Treasury revealed that the provisions currently in the Public Finance Management Act, 1999, which deals with the write-off of debt, will now also apply to taxes.
- The enabling provisions with regard to the settlement of disputes will be contained in section 107B. This is a very sensitive issue and much more research and consultation is required in this regard to determine the appropriate criteria, control and reporting rules.

It is questioned by SAICA why an assessment should be regarded as final vis-a-vis the taxpayer when an objection has not been lodged against an assessment or the disallowance of an allowance has been accepted by the taxpayer. However, the Commissioner can, even after allowing an objection, choose to review and revisit the same matter that was previously in dispute. This is inequitable and should be reviewed.

The power conferred on the Commissioner to review and revisit a matter after an objection has been allowed is based on the fact that not to do so would confer an unfair advantage on a taxpayer where an error has been made in allowing an objection.

This power was considered in Commissioner for In land Revenue V Hilewitz 60 SATC 86. In deciding the matter in SARS' favour, Wunch J. noted that in its absence; "Not only would a taxpayer have escaped from assessment where the Commissioner made a mistake but he would have done so also where a Receiver of Revenue or more junior official allowed an objection and the Commissioner wanted to reverse his decision or where, for example, a decision of the Appellate Division or some other court, given after an objection had been allowed, were to have shown that it should not have been allowed."

The constitutionality of this power was considered in Carison Investments Share Block (Pty) Ltd V Commissioner; SA Revenue Service 2001(7) JTLR 207 (W) where Navsa J. held that; "[T]his statutory power to revisit is in the national interest. Section 79(1) of the Act does not sanction arbitrary and capricious behaviour and is not unconstitutional. Statutes such as the one in question are to be found in comparable legal systems and the underlying rationale is accepted."

SAICA hopes that in terms of the rules the Commissioner will be compelled to make a decision on an objection within a prescribed period. Objections are often delayed for years.

While a number of periods for actions to be taken will be prescribed in order to speed up the objection and appeal process, it is not possible to prescribe a period for the consideration of an objection in view of the varying degrees of complexity of such objections.

Section 83 - Appeals to Special Court
In order for the Registrar of the Tax Court to exercise its functions independently and impartially would it not be preferable if the Registrar is appointed by the Ministry of Justice and remained an employee of that department? (SAICA)

In discussions with various role-players (including judges and tax practitioners) it was indicated to SARS that the flexibility of the current arrangement in terms of which cases are placed on the Special Income Tax Court roll should be retained. Since the administration of the Special Court is distinct from that of the High Court (handled by the Registrar of the High Court under the Department of Justice), it is unlikely that the appointment of the Special Court Registrar bythe Minister of Justice would guarantee the "independence" of the SpecialCourt Registrar.

The question of the "independence" of the Registrar was considered by the Special Court in ITC 1567 56 SATC 72 in which it was held that the perception that the Commissioner through the office of the Registrar had influenced the selection of members appointed to the Special Court was not justified. It was expressly found that the Registrar carried out his/her functions independently from the legal department of SARS.

Capital Gains Tax
Request that the date of implementation be postponed to 1 March 2002 so as to ensure that the legislation will be finalised by the date on which it takes effect. 52 out of the 86 paragraphs are amended. (SAICA)

This Bill attempts to rectify the consequences of a rushed process to legislate for a very complex new tax. Having to amend more than half of the provisions promulgated less than 4 months ago is, with respect, an embarrassment for the Minister and the country. (AHI)

Mixed and confusing messages are sent by government for example fundamental changes to CGT legislation are in the process after implementation date of the tax. (AHI)

It is an absolute overstatement to say that so many fundamental changes are now being made to the Bill that it will lead to such a level of uncertainty that a further delay in implementation is required. The reasons therefor being the following:

An extensive consultation process was followed to obtain the input from all interested parties. Refer in this regard to the Guide published on Budget Day last year, the two draft Bills published for comment and the extensive process of hearings via the Parliamentary Committees. They certainly did not follow the route of Australia where the tax was announced from an effective date with no Act in place. The overwhelming majority of the provisions and fundamental principles did not change at all and sufficient certainty exists to proceed.

Most of the changes are:
· of a textual nature;
· to provide greater certainty: and
· to provide further relief (corporate rules).

It is a natural phenomenon that refinements are introduced after new legislation has been implemented as it is never possible to anticipate all implications and consequences. Even today, after 90 years they are still refining SA’s income tax legislation on an annual basis. This is in line with international trends.

To now delay the issue further will cause more uncertainty which cannot be afforded.

CGT has negative implications on wholly owned investment subsidiaries of life companies and retirement funds because of different inclusion rates. Relief should be granted to assurers. (LO A)

Acceding to this request would undermine the classical tax system in use in SA. It is also difficult to see how this case differs from that of an individual who holds all his or her investments in a company especially in view of the trustee principle applied to long-term insurers. This company also holds its investments on behalf of the individual.

The insurer has deliberately decided to keep its investment portfolio in a separate legal entity, i.e. a company. What is now requested is that they must apply a look through approach and if the investment held in the company is for the benefit of the individual policyholder fund, they must apply the inclusion rate for individuals.

Paragraph 29 of the Eighth Schedule
The five day volume weighted average valuation on the five trading days prior to 1 December 2001 is not a true reflection of a period of normal trading circumstances. Suggest that the last five trading days in August 2001 be used or alternatively the ruling price on 28 September 2001. (LOA)

This is not accepted. The reasons for retaining the five day weighted average are as follows:
1. The JSE Allshare index is not significantly lower than it was for 1 April. The average of the index for the five days before 1 October is 6% lower than that for the five days before 1 April.2. CGT is a broadly based tax that covers many assets. Certain assets, such as gold, have increased significantly in value since 11 September. If the starting values for securities are to be adjusted upwards, the question arises as to whether these assets should be adjusted downwards.
3. If a synthetic adjustment is made to security values, artificial losses may be granted if the markets maintain their current levels or fall further.
4. In any event, time based apportionment, which looks to the cost of assets, and the kink tests which eliminate phantom gains or losses when there is a discrepancy between cost and market value, remain an option for taxpayers other than those that use the weighted average basis of valuing assets.
5. When the financial services industry requested an extension for the implementation date a point was made was that systems changes would have to be made and that the volume of transactions was such that it would not be possible to have systems in place after 1 April and reprocess transactions to determine capital gains or losses. This is equally true now and it would be a Herculean task to reprocess transactions from 1 October to date using a new set of starting values.

Customs and Excise
Mr Louw said that section 43 of the Customs and Excise Act that deals with goods that have been warehoused caused some concern for the Department of Trade and Industry. To accommodate their concerns the Commissioner has been given the power to extend the 60 day period that the department has to take delivery of goods before rental is charged for storage. The charging of rental can only take place after the Commissioner has taken a final decision on the matter.

VAT
Another member of SARS said that welfare organisations that are entitled to VAT relief will be published on a list. The List should be available at the end of November.The provisions on the IDZ zones are completed and in the new draft.

National Treasury Response to Public Comment
The Corporate Rules and CFEs were dealt with by Prof Engel who responded to public comment in a broad manner and under the following headings which he said were the main themes in the public comments:

Domestic Focus
Relief must be limited to domestic companies. Government is concerned about funds moving off shore and that it will be lost to SA forever. The criticism that this is too restrictive but treasury has opted to retain the rules that relief will only apply to domestic companies. The rationale is that the relief must spur growth in the SA economy not other economies.

Financial Instruments
The rule is that there will be no relief id restructuring with financial instruments. This rule is designed to facilitate the restructuring of operational businesses. This rule is retained but some relief is granted in the new draft. A controversial issue is that banks, insurance companies and financial service providers do net get any relief as yet.

18 month rule
This rule is imperfect but is the best workable compromise. A concern that is addressed in the latest draft is that taxpayers do not need to maintain the group for a 18 month period before the transaction takes place.

Nature and % level of shares involved
Treasury chose ordinary shares and participating preference shares because then the taxpayer shares in the risk. Comments suggested that this was too strict. Treasury has decided to retain this principle because other forms of relief often represent disguised cash-outs.

The level of ownership also remains the same in the latest draft. The 25% ownership level is required to form a company and for a share for share transfer. If a unlisted company the acquirer must get at least 50% of the shares. If listed at least 35%. The principle is that the acquirer must get control. In the listed context a concession is now given. If 25% of the shares is owned but this represents more shares than anyone else then the taxpayer will be entitled to the relief. The 75% threshold for intra group transfers is maintained because Treasury wants to make sure that relief is given where the economic link is such that the companies are almost one taxpayer.

Triangular Structures
Complex restructurings (including 3 or more companies) are not granted relief due to timing concerns. Treasury first wants to see how the basic rules work.

Controlled Foreign Entities (CFE)
Prof. Engel commented on three areas:
- the participation exemption
- CFE intra group relief
- the taxation of CFE treasury options.

Currency gains and losses
This is not contained in the Treasury response.

As far as the taxation of listed instruments abroad is concerned the Bill provides that the currency gains and losses of foreign listed shares will be picked up. The argument is that this is a disincentive for people to come here. This is true but the main concern is with the current domestic base. One cannot have funds moving off shore to partake in tax free foreign currency gains. Treasury understands the concerns so the Bill will only target specific instruments. This also reduces the complexity. But if the instruments are not taxed, funds will move off shore and this could impact negatively on the Rand.

On the issue of administrative concerns: As far as companies are concerned there will be an deemed sale on an annual basis to pick up the gains and losses. For individuals the gain or loss is only taxed once the individual leaves the currency. Treasury is still examining the issue but relief will be provided to address the admin concern.

There were no questions or comments. The meeting was closed.

Appendix A
NATIONAL TREASURY'S RESPONSE TO PUBLIC COMMENT ON SECOND REVENUE LAWS AMENDMENT BILL
Provided below are National Treasury's comments on outstanding tax policy issues raised during the Parliamentary hearing process and through written submissions. These policy issues mainly concern proposed changes to the taxation of company restructurings and foreign earnings.

I. AMENDMENTS TO THE TAXATION OF CORPORATE STRUCTURINGS
As previously staled, the Second Revenue Laws Amendment Bill contains a new set of comprehensive rules to facilitate domestic restructurings. These rules mitigate the potential cascading impact that capital gains may have on multi-tier structures. These rules also facilitate domestic restructurings typically employed by business for commercial growth. Rules of this kind are consistent with international practice. These rules mitigate taxes of all types associated with restructuring, including ordinary revenue taxes, the secondary tax on companies, and various excise duties.

A. Domestic Focus
The proposed company restructuring rules are almost exclusively limited to domestic parties. For instance, in a company formation, the newly formed company must qualify as a domestic entity to receive rollover treatment. Unbundling relief similarly applies only when the unbundling and unbundled companies are domestic entities with the additional caveat that the public shareholders must also generally qualify as domestic taxpayers. In essence, National Treasury focused its current aim solely at promoting onshore relief so as to promote domestic growth.

Critics of the legislation contend that the domestic limitation is overly restrictive, thereby inhibiting foreign investment. They also argue that CFEs should similarly receive company-restructuring relief because they are part of the tax net. National Treasury has opted to retain the domestic limitation for a variety of reasons. In the main, tax must apply to offshore transactions because taxpayers cannot reap the economic benefit of the South African infrastructure and then depart from the country with this accrued benefit without paying their fair share of tax. If South Africa does not impose tax on this moment of departure, the South African right to tax will be lost altogether. These rules are essentially the same as the deemed sale rules for expatriating individuals.

National Treasury also opted to exclude CFEs from restructuring relief because CFEs are only partially within the tax net. CFEs are taxable only on their active income. Thus, the shift of active assets from a South African company to a CFE represents the same concerns as concerns as a shift of gains to wholly foreign-owned entities. CFEs were also excluded because concerns existed that restructuring relief could be utilised as a tax-free mechanism to remove a foreign company's CFE status.

B. Anti-Finance Instrument Rules
The proposed company restructuring rules are designed to facilitate the company restructuring of operational businesses. Instead of utilising an "active trade or business" prerequisite used by many countries, the proposed rules allow for all forms of company structurings, except those restructurings that facilitate the transfer of financial instruments (a typical tax avoidance tool). The anti-financial instrument rules offer avoid disputes and uncertainty over whether a business is sufficiently active to qualify for relief.

Critics of the legislation contend that this anti-financial instrument rule is overly restrictive because many commercial reasons exist for shifting these instruments in a tax-free transaction. Admittedly, this anti-financial instrument rule is a rough proxy for business activity, but National Treasury believes this approach best serves certainty and enforcement. These rules are also consistent with section 9D, which create a stricter environment for financial instruments held offshore. Active business tests create not only problems for determining what constitutes viable activity, but also avoid concerns that subsequent unanticipated business failure could result in adverse tax consequences.

Having said this, National Treasury has opted to liberalise the financial instrument rules. Taxpayers can now transfer a 5 per cent level of financial assets of a going concern in tax-free corporate formations, intragroup transfers, and liquidations.1 Second, the anti-financial holding company rules have been revised. While the latest draft of the proposed legislation still prevents the tax-free transfer of companies containing mostly financial instruments, these financial holding company rules have been adjusted as follows:

1.The financial holding company definition has been relaxed. Under the prior definition, a financial holding company existed if that company held more than 50 per cent financial instruments in terms of market value or book value. The book measurements will be measured in historic book terms (i.e. book value before depreciation). Prior reliance on book value after depreciation artificially inflated the ratio of financial instruments because only active assets shrink in book value terms due to depreciation.

2. The new financial holding company definition contains look-through rules. Under these rules, shares of "more than 75 per cent" owned subsidiaries are ignored with the calculation being made based on the underlying assets of the holding-subsidiary group.2

3. Intragroup rollovers will be extended to allow for the intragroup transfer of shares of a company where the transferring member owns at least 25 per cent of the shares in the company transferred (as long as the company transferred does not constitute a financial instrument company). This rollover rule loosely mirrors the "foreign participation exemption" (see below). This form of relief will facilitate intra-group restructuring where group companies are shifted within the group.

One set of relief falling outside the current proposal is relief for financial instrument companies engaged in banking, insurance, or financial service activities, even though their financial instrument represent the core element of those businesses. National Treasury opted to put this relief on hold until the review of the banking industry's low effective rate is complete.
_____________________________________________________________________________
Footnotes

1 For instance, a taxpayer can qualify for complete rollover relief for up to R5,000 of
financial instruments if that taxpayer simultaneously transfer R95,OOO of other assets as part of a going concern.

2 Example. Facts. Company x plans to transfer all the shares of Target in a share-for
-share transaction. Target is a holding company that owns R5 of portfolio bonds and all the shares of Subsidiary with a R1OO value. Subsidiary owns active assets of R80 and R20 of portfolio bonds.

Result Target does not violate the anti-financial instrument company requirement.
The Target-Subsidiary group has only R25 of portfolio bonds versus R80 of active
assets. The Subsidiary shares are ignored.
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C. 18-Month Anti-Avoidance Rule
The proposed company restructuring rules contain a number of 1 B-month anti-avoidance rules. These rules generally require asset transfers within company restructurings to remain in place for an 18-month period. Company restructurings that do not remain in place for this 18-month period are subject to a series of anti-avoidance requirements that potentially trigger immediate gain and/or other possible adverse tax consequences.

The 18-month rule exists because taxpayers who enter into avoidance transactions typically do so for only short duration's. The 1 8-month holding period serves as substitute for tax avoidance (or business) purpose tests, which are impossible to police. The 18-month rule also provides taxpayer certainty, and SARS with manageable administrative enforcement. Much of the complexity in the proposal centers around these 18-month rules -transactions falling outside this period can move generally move forward unfettered.

Critics of the legislation contend that the 18-month period is too long. To them, this 18-month holding period requirement is unrealistic in a modern world where business opportunities emerge at an accelerated pace. Critics instead recommend a shorter period or a Commissioner waiver for unforeseen circumstances.

National Treasury ultimately chose to keep the 18-month period despite the above arguments to the contrary. National Treasury was well aware of the stakes at issue, having consulted with industry widely about the matter before carrying forward its proposal to Parliament. Most tax and industry experts felt that the one-year period was insufficient to prevent tax avoidance as a practical matter, but those same experts were concerned that a 2-year period was overly harsh. At one time, National treasury considered a special 1-2 year period. Under this formulation, companies would have had to remain in place for 1-year but could escape the second year upon Commissioner discretion.

Most industry leaders preferred the flat 18-month period because the 1-2 year mix contained too much uncertainty. Industry leaders were further concerned that Commissioner discretion would equally postpone legitimate transactions because Commissioner discretion entailed its own time consuming process. SARS was alternatively concerned that the discretionary power would become haphazard because this discretion required SARS agents to second guess the business legitimacy of particular transactions. Thus, while imperfect, the 18-month period continues to be the best workable compromise.

Nevertheless, National Treasury chose to alleviate some of the above concerns by re-examining the need for many of its initially proposed 18-month rules. Upon review, National Treasury believed that some of these 18-month rules could be removed. For instance, taxpayers seeking intra-group relief
previously had to maintain the group for an 18-month period before the intra-group rollover. This pre-18 month group aggregation is no longer required.

D. Nature and Percentage Level of the Shares Involved

1. Nature of the Shares Involved
The proposed company restructuring rules generally require shareholding relationships based on ordinary shares or participating preference shares (equity share capital). National Treasury chose to limit the proposed relief to these forms of shareholdings because these forms of shareholdings represent the full economic upside and downside of the companies involved.

Critics contend that company restructurings, such as formations, should additionally allow for relief where the parties involved use other forms of corporate instruments. For instance, they argue that the transfer of assets to newco companies upon their formation often occur in exchange for nonparticipating newco preference shares and/or long-term newco company notes. They accordingly conclude that the proposed ordinary and participating preference share relief is too limited to accommodate for commercial realities.

After much consideration, National Treasury chose to retain the ordinary and participating preference share limitation. While commercially utilised, other forms of relief often represent disguised cash-outs. A company note simply represents delayed cash with interest, not an underlying stake in company profits. Non-participating preference shares often similarly act as disguised notes.

National Treasury also shied away from voting power tests, preferring to retain the current focus on the underlying economics. Use of voting power tests can lead to easy avoidance because the multi-tier structure of companies can allow for disguised shifts in power with real control dictated by various complex side agreements. Focus on the underlying economics provides the most expedient answer. The parties who control the underlying upside and downside economic value in the common typically have comparable direct or indirect voting power as matter good business practice.

2. Level of Ownership
As previously discussed before the Portfolio Committee, the company restructuring rules contain a series of different ownership thresholds. Each of these thresholds are intended to represent different forms of ownership:

At Least 25 Per Cent Ownership ("Meaningful Interests'): In certain circumstances,
the party involved must hold at least 25 per cent of the shares to qualify for
relief. This level of ownership ensures that the party involved has a
meaningful shareholder interest in the company concerned because a 25 per
cent stake is sufficient to unilaterally block certain extraordinary company
transactions. This 25 per cent test is required for the transferor of shares in unlisted
company formations and unlisted share-for-share transactions, as well as intra-group
transfers of certain companies.

2. 50 Per Cent+/35 Per Cent Ownership ("Controlling Interests'):
The next level of ownership possibly required is "a more than 50 per cent" level for unlisted companies or a 35 per cent level for listed companies. This level of ownership represents a controlling interest. The level of ownership is lower for listed companies because practical control is easier to obtain in such circumstances. This level of ownership is required for acquiring companies to acquire their targets in a share-for-share transaction, and for parent companies to distribute their subsidiaries in an unbundling.

3. 75 Per Cent + Ownership ("Ownership Akin to Divisions'): The highest level of ownership required is "a more than 75 per cent" level. This level represents ownership that cannot be blocked by other parties, thereby leaving the subsidiary owned akin to a division. This level of ownership is required for companies to receive intra-group transfer relief.

Critics contend that the proposed restructuring relief over-emphasizes these ownership tests. They instead argue that value should be the key criteria with tax preferences to be provided upon reaching certain absolute numerical thresholds. National Treasury fails to understand the rationale of this argument. Why should higher valued share transactions be preferred over smaller valued transactions? Do higher valued transactions represent a greater potential for tax avoidance? Moreover, emphasis on value simply means the rules would be tilted for the bigger players.

Critics alternatively argue for lower thresholds, as follows:

1. Critics contend that a 10 per cent threshold is a more proper measure of a meaningful stake than a 25 per cent stake. This 10 per cent level should allegedly be sufficient because a 10 per cent level is the usual international demarcation for eliminating portfolio interests. National Treasury ultimately rejects this argument because a 10 per cent shareholder in a closely held company fails to have any significant rights under South African company law. It makes no difference whether that the 10-per cent amount differs from the standard portfolio holding.

2. Critics contend that the 35 per cent level for a controlling interest in a listed company is also too high because the 35 per cent level is hard to achieve. National Treasury ultimately adopted the 35 per cent level after consultation with industry, which revealed that the 35 per cent level was not uncommon on the Johannesburg Stock Exchange (a stock exchange which is thinner than its U.K. and U.S. brethren). However, the recent draft does provide some relaxation. Under the newest formation, control in the listed context can be achieved at a 25 per cent level as long as the party holds more shares in the company than anyone else.3

3. Critics lastly contend that "the more than 75 per cent" level is too high and that "a more than 50 per cent" level should be sufficient because only a more than 50 per cent level is needed for consolidating subsidiaries for accounting book purposes. While this argument is understood, financial consolidation does not create full division-like economic control.

E. Triangular Structures
At this stage, the proposed company restructuring rules are mainly limited to simple restructurings. More complex restructurings, such as three company restructurings, fall outside the system.4
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Footnotes

3 The most contentious threshold involves the new 35-per cent level of ownership required of a parent company to unbundle its listed subsidiary. This change
represents an increase from the prior 1 0-per cent level utilised for unbundlings under
section 60 of current law.

National Treasury believed that the 10 per cent threshold was insufficient to
distinguish the distribution of shares from the standard distribution of value to
shareholders occurring in a normal taxable dividend. The argument that unbundling should be allowed anytime a distribution unlocks value to its shareholders is
unprincipled because the purpose of the Secondary Tax on Companies is to induce companies to retain that value. National Treasury accordingly chose to limit
unbundlings to situations where a parent company's ownership in an unbundled
subsidiary was depressing that subsidiary's value (i.e., where the value of the parts exceeded the whole). In order for this depression in value to occur as a practical
matter, the parent company had to have a controlling interest in the subsidiary before the distribution.

In a related vein, National Treasury additionally chose to retain its 18-month precontrolling requirement in the subsidiary despite many comments to the contrary. This 18-month rule is believed necessary in order to maintain the integrity of the
control requirement. without this 18-month rule, taxpayers would have an incentive
to bump-up their interests in a company to a controlling level (thereby arguably
depressing value of the parts) solely to unbundle.

4 Example. Facts. Target is a listed company with 1 million shares outstanding.
Acquiring is a listed company with 5 million shares outstanding. Acquiring owns all the shares of Subsidiary. Acquiring proposes to acquire all the shares of Target in exchange for the issuance of 1 million of newly issued Acquiring shares.

Result. If Acquiring acquires all the shares directly, the transaction satisfies the
proposed share-for-share relief. However, the transaction fails to satisfy this rollover relief if the Subsidiary acquires the Target shares on Acquiring's behalf (a triangular reorganisation).
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Relief for triangular restructurings was generally omitted at this stage mainly due to timing concerns. National Treasury believed it was best to introduce a regime for basic transactions at this stage in order to ensure that the restructuring rules were issued in a timely fashion. Triangular and other more exotic forms of restructurings will be issued at a later stage once the basic regime is fully tested in order to ensure that these more complex transactions do not become a mechanism for tax avoidance. Rules of this kind presumably would attempt to treat multiple companies within a single group as a single party.5

II. AMENDMENTS TO THE TAXATION OF FOREIGN EARNINGS
As previously stated, the Second Revenue Laws Amendment Bill contains a number of major and minor changes in regard to the taxation of Controlled Foreign Entities ("CFEs").

In the CFE area, the most notable of these comments pertain to:
(i) The participation exemption,
(ii) CFE intragroup relief, and to
(iii) the taxation of CFE treasury operations.

A. The Participation Exemption
Under the participation exemption, a CFE can make a tax free sale of certain shares of a foreign company as well as receive tax-free dividends with respect to those shares. In order to qualify for the exemption, the CFE must have a 25 per cent shareholder stake in the foreign company in terms of ordinary shares and participating preference shares. In addition, a CFE must have held the 25 per cent stake for at least 18 months before the relevant sale (but this 18 month rule does not apply to dividends). Lastly, the foreign company sold must not qualify as a financial instrument holding company (i.e., not consist of financial instruments amounting to more than 50 per cent of the foreign company's market value or historic book cost).

The purpose of this exemption is to extend the current CFE dispensation, which exempts CFEs from immediate taxation of their active earnings and the sale of their active assets. Under the participation exemption, a CFE can sell certain foreign shares tax-free when those shares represent a meaningful interest in underlying tax-free active assets.
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Footnotes
5 Admittedly, some forms of "homemade" forms of triangular relief are available in the current proposal. Acquiring can enter into a share-for-share transaction, followed by an intragroup transfer of the Target shares. The gain on the shares would be
deferred until the target shares were sold or the Acquiring and Subsidiary companies were no longer part of the same group. If direct triangular relief is ultimately adopted, the "same group' requirement would probably be curtailed.
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1. The 25 Per Cent Stake and the 18 Mouth Rules
In the Parliamentary hearing process, some critics of the legislation contended that the participation exemption is too narrow. They specifically stated that the 25 per cent share threshold is too high and that the 18-month holding period is too long. In support of their argument, they contend that the legislation is out of sync with international practice, thus providing South African internationals with an incentive to move offshore. First, they argue that the United Kingdom, one of our greatest competitors, imposes no capital gains tax on sales by their CFEs regardless of the asset sold. Second, many companies with a participation exemption use lower thresholds and shorter holding periods.

Despite these arguments, we chose to maintain the 25 per cent share threshold and the 18-month holding period so that the foreign participation exemption maintains some parity with the domestic restructuring relief. As discussed, the 25 per cent threshold stems from South African domestic company law, and the 18-month period is the minimum holding period necessary to prevent artificial tax avoidance. Both tests ensure that the underlying shares sold represent a meaningful active interest in underlying foreign active assets.6

While we understand the need for a tax system to compete with international tax systems, care must be taken to ensure that our system does not fall victim to the "great race to the bottom." In addition, critics also fail to note that some of these systems have other requirements, not present in our participation exemption. For instance, some countries with participation exemptions require the company sold to have paid a minimum effective rate of tax.

As an alternative measure, some commentators suggest that we reduce the threshold to lower levels where other commercial factors exist, such as where the shareholding secures a valuable source of supply or where the shareholding is required to undertake a transaction with a foreign government parastatal. At this stage, National Treasury was reluctant to reduce these thresholds for situations of this kind (albeit sympathetic) because such reductions would most likely require Commissioner discretion rather than objective guidelines.

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Footnotes
6 In this vein, we also chose to maintain the requirement that the shares involved
consist of either ordinary shares of participating preference shares, both of which
represent a full upside and downside stake in underlying active assets. As has been rightly pointed out, this test of share ownership is narrower than the test for share
ownership for determining whether a foreign entity qualifies as a CFE. Under the CFE test, a foreign company qualifies as a CFE if more than 50 per cent of all
participating rights (which include all forms of preferred shares) are held by South
African taxpayers. we chose to maintain these differing share tests because the CFE determination is an anti-avoidance rule, requiring a broader category of shares to
prevent manipulation.

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2. Anti-Financial Holding Company Rules
As with the domestic rules, many commentators criticised the anti-financial holding company rules. These rules have accordingly been modified to track the domestic regime. As a result, CFEs can now sell the shares of a holding company if that holding company contains mostly active assets through its more than 75 percent owned subsidiaries.

B. Intragroup Exception
Section 9D generally taxes passive income (e.g., interest income from foreign bonds, dividend income from foreign shares, and rental income from tangible property). One exception to this rule is the intragroup exception introduced last year. Under this exception, interest, dividends, rents, and royalties between members of a CFE group are tax-exempt despite their passive nature. A CFE group is one in which all CFE members are more than 50 per cent owned by a single South African parent company.

This intragroup exemption effectively allows a South African group 10 divide operations into multiple foreign subsidiaries, consistent with international practice. For, example, a CFE can operate a factory directly or lease a factory owned by a related CFE. The leasing income for the related CFE in the latter circumstance would be exempt. As will be described in further detail below the intragroup rules also allow a group to reduce its debt costs by aggregating borrowings into a single CFE shell.

Critics contends that the intragroup exemption should be expanded to include all CFE intragroup sales of assets, much like the domestic intragroup rules. After all, if the income stream from intragroup instruments should be exempt so should the sale.

At this stage, National Treasury is reluctant to extend intragroup relief this far, especially with regards to the sale of passive intragroup holdings. Such relief would require comparable mechanics to the domestic intragroup rules, and National Treasury sought to avoid wholesale offshore restructuring relief at this stage for further analysis. As stated above, National Treasury issued the domestic restructuring rules in order to lay a basic foundational rubric. International relief requires complex further considerations.

Yet, National Treasury agrees that some modifications can currently be made that would make the rules more consistent with the current dispensation. Intragroup relief should include other forms of intragroup passive income, such as deemed interest income, section 241 deemed currency gains, and deemed dividend income. In addition, the sale of leased tangible moveable and immovable assets will be exempt if used in the active business of a related CFE.7

These changes come with one caveat. In making these adjustments, National Treasury will raise the intragroup share ownership threshold from the previous "more than 50 per cent" level to a "more than 75 per cent" level. This raised threshold is consistent with the domestic intragroup rules, which similarly employ a "more than 75 per cent" threshold. As will be described above, this "more than 75 per cent" level economically means that the companies involved are akin to divisions within a single shell. No reason exists to maintain foreign intragroup relief at a more liberalised level. Foreign restructuring relief should always maintain parity with domestic relief so as to prevent an undue artificial incentive to shift funds offshore.

C. Modification of the Banking, Insurance Company, and Financial Services Exemption
Section 9D generally provides that active CFE income is exempt from current South African tax. Income from passive interests (e.g., income from bonds and shares) are generally taxable even if those passive interests represent working capital. The purpose of this tax-exemption is to remove South African tax as monetary obstacle to international operations so that South African multinationals can freely compete with their foreign local rivals. This exemption does not apply to passive income because passive income fails to represent significant international competitiveness concerns.

CFE taxation of passive income does not apply, however, to situations where the income stems from a bank, insurance, or a financial services company. Income of this kind is no longer passive despite the passive nature of the underlying instruments involved because financial instruments represent core business assets in this instance. As such, these forms of holdings again raise international competitiveness, thereby triggering the need for exemption.
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Footnotes
7 Example. Facts. South African Parent owns all of CFE 1, which in turn owns all of
CFE 2. CFE 2, a U.K. company, plans to operate a car factory and enters into a saleleaseback transaction with CFE 1, a tax haven company, as a means of typical U.K.
financing. Upon completion of the sale-lease back, CFE 1 owns and leases the U.K. factory to CFE 2. CFE 1 subsequently sells the factory several years later at a gain.

Result. The sale of the factory by CFE 1 is exempt from tax because CFE 1 can rely on the activity conducted by CFE 2.
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At issue in this area is the proposed tightening of the banking, insurance, and financial services company rule. Under the proposal, a CFE cannot qualify for the banking exception per se if that CFE generates more than 50 per cent of its income from connected parties. The purpose of this anti-connected party rule is too prevent South African multinational from disguising their portfolio holdings by aggregating those holdings into a single finance subsidiary.8

The net effect of the above rules is two-fold. First, the intragroup exception for connected party income still allows for taxpayers to utilise a Finance Sub as a mechanism for reducing the cost of borrowing through aggregation. However, the passive portfolio income from the bonds and shares remains taxable because this form of passive income does not alter character merely because the passive instruments are lodged in a single location (versus dispersal throughout the CFE group). The banking, insurance, and financial services exemption was intended only to exempt active operations that compete for arm's length commercial customers.

Some commentators have suggested that the above treasury operation concern be revised by focusing on the level of business establishment required for exemption. Under this version, business establishment exemption would require the taxpayer to make a showing of employee staff size or value of tangible offshore assets. National Treasury rejected this suggestion as missing the point. Active treasury operations, even if sufficiently staffed with local employees and buildings, should not receive exemption for portfolio investments because these forms of investments do not raise competitiveness concerns. National Treasury refuses to incentivise the tax-free treatment of offshore liquid investments (over domestic liquid investments) through the name of treasury vehicle.9
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Footnotes
9 Example. Facts. South African Company owns four wholly owned CFE subsidiaries,
including Finance Sub. The purpose of Finance Sub is to reduce the group cost of borrowing by borrowing for all the group CFEs. Finance Sub borrows 30 million at a 7 per cent rate (whereas separate borrowings by each of the CFEs would have incurred a 9 per cent rate). Finance Sub re-lends R10 million to each of the other three CFEs at 7.5 per cent, generating 500,000 of interest income from each. Finance Sub also generates 100,000 in interest and dividends from portfolio bonds and shares.

Result. Finance Sub does not qualify for the banking, insurance, financial services exemption because more than 50 per cent of its income stems from connected
parties. However, the connected party income from the group CFEs are exempt under the intragroup exception.