Department Response to Submissions on Revenue Laws Amendment Bill

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Finance Standing Committee

19 June 2001
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FINANCE PORTFOLIO AND SELECT COMMITTEES: JOINT MEETING
20 June 2001
DEPARTMENT RESPONSE TO SUBMISSIONS ON REVENUE LAWS AMENDMENT BILL

Relevant documents:
Revenue Laws Amendment Draft Bill, 2001
Explanatory Memorandum on the Revenue Laws Amendment Bill, 2001
12G. Additional industrial investment allowance in respect of industrial assets used for qualifying strategic industrial projects + Regulations under section 12G(7)
Departments’ Response to COSATU submission (Appendix 1)
Departments’ Response to SACOB submission (Appendix 2)
Departments’ Response to Submissions on PAYE on Directors’ Remuneration (Appendix 3)

SUMMARY
The Department of Trade and Industry and National Treasury provided responses to submissions made on the Strategic Incentive Programme, specifically in response to SACOB and COSATU’s submissions. It was noted that they had had a meeting with SACOB the previous day to address key concerns raised by SACOB in their analysis of SIP. These discussions had proven to be fruitful and broadened the understanding of SACOB with regards to certain aspects of SIP.

DTI outlined their reasons for using tax-based incentives in response to concerns raised by SACOB. DTI gave its meaning of a ‘strategic project’ as well as the necessity for imposing upper and lower brackets on investments. National Treasury explained the reasoning behind excluding the tourism sector from the Strategic Incentive Programme.

MINUTES
DTI and Treasury response to submissions on Strategic Incentive Programme
Prof David Kaplan, Chief Economist in the Department of Trade and Industry, outlined the government’s reasons for using tax-based incentives:
· Tax incentives ensure that profitable and sustainable projects receive the incentive
· The additional allowance as a result of the tax incentive provide impetus for firms to invest as quickly as possible
· Tax-based benefits have a greater extent of fiscal monitoring than cash-based incentives
Mr Kaplan went on to explain that strategic projects were those projects that made a significant contribution either in terms of increasing the competitiveness of the industry or making a contribution to employment, over and above the usual economic growth and employment associated with such investments.

He said that the reason why there was an upper limit of R600 million on projects was that the intention of the SIP programme was to enhance competitiveness of investment clusters, and thus spread the benefit of the investment across as many sectors as possible. The most important reason for imposing the lower limit of R50 million was that experience showed that projects between the R50 million and R100 million have greater job creation potential than projects of R100 million or more.

Mr Martin Grote (National Treasury) said that a tax-based incentive would not be the best way to boost the tourism sector, as it is labour intensive. Therefore the SIP programme would not be the ideal form of boosting the tourism sector.

Discussion
Mr Ken Andrew (DP) said that most people are appreciative of the enormous improvement in SARS. However SARS had the tendency to tighten screws with tax laws where it suited them, and where it suited them for tax-collecting purposes, SARS tended to do things on an ad-hoc basis.

Mr Louw from SARS stressed that SARS did not want to set themselves up for failure by imposing unrealistic timelines on their capacity to deliver

Mr Ken Andrew commended DTI and National Treasury on their comprehensive response to issues raised by SACOB and COSATU.

Appendix 1:
Response to COSATU submission on SIP: General comments by National Treasury, DTI and SARS

COSATU 1: Job retention and creation
Recognising the concerns raised by COSATU, we propose to change the employment criteria to reflect the following weights:

· 2 points for direct employment creation
· 2 points for indirect employment creation
· 2 points for purchases from SMMEs (this was previously 3)

This may entail a review of the thresholds necessary for projects to qualify as a strategic project or one with preferred status.

COSATU 2: Skills development and labour standards
The area of skills development already receives considerable attention from Government through the Skills Development levy and the training initiatives co-ordinated through the Department of Labour. The SMEDP and SIP include skills support programmes under which an enterprise can be reimbursed up to 50% of the training costs of an approved training programme, which is limited to 30% of the wage costs per annum.

COSATU 3: Countertrade / offsets
As indicated in the oral presentation, these will not qualify for the SIP.

COSATU 4: Spatial development
South African experience with spatial development programmes is unflattering at best. In designing the SIP criteria, spatial development criteria were not included, as it was felt that encouraging strategic projects would have significant benefits for the South African economy in general. To include a spatial component would unnecessarily complicate the adjudication process, without delivering significant or sustainable benefits to the economy.

COSATU 5: Composition of the adjudication committee
Addressed under SACOB 16.

COSATU 6: Project monitoring and accountability
Addressed under SACOB 16. As was indicated, the legislation has been amended to provide that the Minister must provide to Parliament a progress report in respect of the projects that received the incentive.

Appendix 2:
Response to SACOB: General comments by National Treasury, DTI & SARS

SACOB 1. Why a tax-based incentive?
The income tax code already contains a number of tax incentives for particular sectors, including mining and farming. It is thus peculiar that SACOB has not engaged with Government to explore the possibility of withdrawing these incentives, which would broaden the tax base and allow for potential reductions in the tax rates.

It is certain that businesses would prefer cash-based incentive programmes that have an immediate and direct impact on their cash flow. Government has decided on a tax-based incentive for strategic industrial projects for the following reasons:

· The tax-based approach will contribute to ensuring the projects receiving the benefit are sustainable, as projects must be profitable to receive value from the fiscal measure.
· Tax-based incentives (particularly in the form of a tax deduction) are only effective for profitable firms. Thus, the additional allowance will provide impetus for the firm to undertake the investment as quickly as possible after the Minister approves the project as strategic and to accelerate production in order to generate sufficient income against which to utilise the benefit.
· The tax-based measure ensures the fiscal stimulus is not diluted. Because the deduction can only be used against income from the particular project receiving the benefit or from other "industrial projects", as defined, the tax measure will have a more direct impact on strategic industrial projects than cash-based incentives, which benefits the company irrespective of where its other income is earned. Further, the tax benefit is more valuable to companies already involved in "industrial projects", as they will have existing taxable income against which to offset the tax allowance. To some extent, we seek to benefit companies already with an establishment in South Africa.
· Tax-based benefits are less susceptible to manipulation and fraud than cash-based incentives.

SACOB 2: Definition of strategic
SACOB would seem to have two problems here, viz (a) that there is no clear definition of strategic and (b) that all large investment projects will qualify for SIP status.

It should be noted that strategic applies to the investment project (hence SIP) and not to an industry as point 2 of the SACOB submission suggests.

Strategic investment projects are those projects which make a significant contribution to spurring economic growth and/or employment which is over and above the contribution that any investment makes in its own right to economic growth and/or employment. The contribution is either in terms of contributing to the efficiency and development of other firms i.e., increasing competitiveness more broadly and/or making a significant contribution to employment. Proxies for each are contained in the scoring system through which a firm does or does not qualify for SIP status. The proxy for a contribution to the efficiency and development of other firms is represented by the qualifying criteria and points scoring criteria in subsections 5(a) and 5(b) and the contribution to employment by the points scoring criteria in subsection 5 (c).

In terms of the draft legislation, the meaning of strategic can be gleaned from the following:
· The first test is whether the project is an "industrial project", as defined.
· Subsection (4) sets out fixed criteria to determine whether an "industrial project" can be classified as a "strategic industrial project".
· Subsection (5) then sets out the scoring criteria. If the applicant satisfies these tests, the project would be deemed to be a "qualifying strategic industrial project", and entitled to either the 50% or 100% ("preferred status") additional allowance, depending on the points obtained.

It is firmly intended that not all large projects will qualify as a SIP. DTI is currently engaged in discussions with a number of large investors and not all those investors would qualify for SIP status.

SACOB 3. R600 million project limit
Ideally we would not like to have any ceilings on the benefits a company can claim under the SIP programme. But given the R10 billion ceiling on deductions (or R3 billion in terms of tax losses), some limits are unavoidable. The money can for example be spent on 5 projects of R2 billion each or 20 projects of R500 million each or 40 projects of R250 million each. Given that the strategic intent of the SIP programme is to build up the competitiveness of investment clusters, we would prefer to spread the benefit around. For example, during the 4 year tax holiday from 1996 – 1999, DTI approved 40 projects with an investment level of R50 million or more and the average size of the project, in terms of qualifying assets was about R300 million. So the present ceiling is about twice this level.

SACOB 4: R50 million minimum level
The qualifying investment level was reduced from R100 million to R50 million for two reasons:

· The SMEDP programme has a declining rate of benefit as the investment level increases up to a maximum of R100 million. When the investment level goes above R50 million, the SIP becomes increasingly more advantageous than the SMEDP.
· Based on practical experience, DTI has established that projects of between R50 million and R100 million have significantly greater job creation potential than projects of R100 million or more.

SACOB 5 & 8: Limitation on qualifying assets
The definition of an industrial asset is linked to certain assets that already benefit from tax depreciation allowances in terms of the Income Tax Act of 1962. This approach maintains consistency in the application of the tax legislation, which eases administration and provides a framework of certainty for taxpayers. It was agreed with DTI that such restrictions should not impinge on the ability of the SIP incentive to encourage investment in strategic projects.

SACOB 6: Exclusion of the tourism sector.
A tax incentive based on the level of investment in industrial assets is not the most appropriate way to encourage the tourism sector, which is more labour intensive. Hotel buildings receive tax allowances in that they can be depreciated over a twenty-year period on a straight-line basis.

SACOB 7. Computer and computer-related activities

It is suggested that this is academically and practically restrictive. The reference in the Standard Industrial Classification codes includes hardware consultancy; software consultancy; Data processing; and Data base activities; Maintenance and repair of office, accounting and computer machinery. This classification is sufficiently broad to cover a wide range of possible strategic projects in this sector. In particular, it covers the major areas of software development.

SACOB 9: The treatment of R&D facilities
The objection appears here to be that R&D is an investment and desirable and as an activity it should qualify for inclusion.

A distinction should be made here. An investment, which has as its sole activity R&D would potentially qualify for strategic status, provided, of course, that it also satisfied the other criteria. So the concern would therefore be about R&D activities contained within other investment projects.

There are no precedents for government’s encouraging R&D through investment incentives. The main reason for this is that R&D is an intensely labour and not capital intensive activity. In South Africa and in the OECD too, considerably almost 90% of business sector R&D is wage and related labour costs – capital costs are less than 10%. But, second, in so far as new equipment is purchased for R&D purposes, as with all other new equipment, this will qualify for SIP equipment status.

In the Income Tax act, manufacturing buildings qualify for normal depreciation allowance. But, in the service sector generally, including building for R&D facilities do not qualify for normal depreciation allowances. Non-allowance in respect of buildings is therefore in accordance with the current principles of the Income Tax Act.

SACOB 10 & 11: Exclusion of programmes under SMEDP and SIP
A central principle guiding the development of the SIP incentive was that a project should not be able to qualify for this tax measure, while simultaneously receiving other investment allowances, including the SMEDP. Before making the investment decision, firms can elect which of these incentives are more appropriate for its particular circumstances and apply therefor.

SACOB 12: Effective date
The SIP project was first mooted by the Department of Trade and Industry during 2000 and alluded to by the Minister of Finance in the Medium Terms Budget Policy Statement. The tax measure was announced in the 2001 Budget in February. In this context, it is appropriate that the measure will only apply to projects undertaken after the date the legislation is promulgated.

From an economic perspective, when a fiscal measure is introduced one seeks to minimise the dead-weight loss associated with the incentive. In principle, one seeks to encourage investment projects that would not take place in the absence of the incentive. This principle would be seriously abrogated if the incentive were made retrospective. In fact, it would represent a complete waste of scarce public resources.

SACOB 13: Assessed losses
As with all other tax allowances, an assessed loss resulting from an additional allowance granted under section 12G may be carried forward indefinitely.

SACOB 14: Ring fencing
The allowance may be set off against income arising directly from the incentivised project or from any other "industrial project", as defined. This will contribute to ensuring the tax benefit is closely targeted to industrial projects.

SACOB 15: Commissioner discretion regarding withdrawal
The Commissioner is allowed to impose penalties up to 200 per cent of the benefit. Thus, there is some scope for discretion so the Commissioner can take account of the extent of the transgression when imposing penalties on errant companies.

Interest is imposed where the benefit is withdrawn in defined circumstances. If such circumstances prevail and the benefit is withdrawn the company has effectively received a "loan" from the fiscus on which interest should be paid. A discretion to waive the interest is therefore inappropriate.

SACOB 16: The adjudication process
Targeted tax incentives always entail some elements of subjective judgement. In developing the threshold and scoring criteria, care was taken to develop parameters that could be measured objectively and monitored on an ongoing basis, as far as this is possible. In addition, high standards of transparency and accountability have been included in the legislation in terms of reporting the Minister’s decisions regarding the awarding of incentives to Parliament, as well as progress reports on projects receiving the incentive. This will ensure that the Adjudication Committee and Minister consider applications for incentives carefully and monitor them closely to ensure the fiscal benefits are allocated to the most beneficial projects. In addition, copies of all these reports will be forwarded to the Auditor-General, thereby ensuring that officials will seek to attain the highest standards of integrity and professionalism.

Concerns have been raised regarding the composition of the Adjudication of the Committee. The Minister of Trade and Industry is ultimately responsible for allocating the incentive (after taking account of the recommendations of the Adjudicating Committee) and accountable to Parliament therefor. It is submitted that the Committee should be comprised only of Government officials, as it is likely that representatives of business will have conflicts of interest in assessing particular applications. Further, the Committee has the power to co-opt expertise in particular areas, which could include representatives of both organised business and labour.

The integrity of the adjudication process is secured by the ongoing transparency and accountability built into the legislation.

Appendix 3:
South African Revenue Service (SARS)
20 June 2001

COMMENTS ON REPRESENTATIONS ON THE IMPOSITION OF PAYE ON DIRECTORS’ REMUNERATION IN TERMS OF THE REVENUE LAWS AMENDMENT BILL, 2001
Response to the issues arising from the proposal to bring directors of private companies within the employees’ tax system by imposing PAYE on directors’ remuneration.

1          Reason for the proposal
At present directors of private companies are not subject to monthly Pay-As-You-Earn (PAYE) deductions on their salaries and other remuneration. In the past this has been justified on the basis of the practical problems that arise when–
- fixing a private company director’s final remuneration for a year of assessment; and
- subjecting advances paid to directors to PAYE.

The result of this concession is that private company directors need only settle the tax bill on their salaries when they make their provisional tax payments and finally on assessment.

This gives private company directors a substantial cash-flow advantage over ordinary employees. In addition, public companies have devised structures to permit their directors to take advantage of this cash-flow advantage.

In order to create equity between directors and ordinary employees, the Revenue Laws Amendment Bill proposes that the exemption from the payment of PAYE that directors of private companies enjoyed be withdrawn and that these private companies pay an amount of tax on behalf of directors based on the directors' remuneration for the previous year of assessment as a form of a minimum amount.

Concerns and alternatives raised
a) Limit to salaries
Directors of private companies should be divided in two categories–
- Directors in receipt of a monthly salary and a profit share or incentive bonus; and
- Directors of companies and close corporations that are owner managers of the business that do not earn a monthly salary but whose income is determined once the financial statements of the entity are finalised.

SAICA’s proposal is to make a distinction between these two categories and only taxing directors in the first category on notional amounts. This proposal is not acceptable. If such a system is introduced the directors in the first category will make use of the opportunity to restructure their salary packages to fall within the second category and only receive advances from the company during the year in order to still get the deferral benefit of paying provisional tax only.

b) Formula
Two practical difficulties concerning the application of the proposed formula were raised.

- Double tax.
Where the same amount is subject to PAYE twice because actual remuneration was received after the company had paid tax in accordance with the formula on a notional amount. (SAICA)

            Cognisance was taken of the practical difficulties identified and revised proposals have been included in the Bill. Paragraph 9 of the Fourth Schedule has been amended to provide that in determining the employees' tax deducted from the actual remuneration of directors, the amount of tax deducted in terms of the formula in respect of the year of assessment of the director must be taken into account.

The current formula to implement this proposal is the product of the consultative process, during which the first proposals in this regard were substantially modified to address the practical problems that were identified by commentators. This proposal is a workable one that will be monitored for unintended consequences for either taxpayers or the fiscus.

- Notional amount exceeds actual remuneration.
Cash flow difficulties will arise where the final amount of remuneration actually paid to the director in respect of a year of assessment is well below the remuneration of the previous year. The salaried director should not be placed in a worse position than a normal employee. (SACOB; SAICA)

The existing provisions of paragraph 10 of the Fourth Schedule which grant a discretion to the Commissioner to apply a different basis of determining PAYE to be deducted from remuneration, will also be applicable in the case of directors subject to PAYE. This will enable the Commissioner to direct that the PAYE in terms of the formula be determined on a reduced notional remuneration where the reduced amount can be justified by the employer.

A concern was raised that the application of paragraph 10 will place an administrative burden on both the Commissioner and business. As this is a relief measure to cater for hardship situations, which will not be automatically granted, the administrative implications should not be excessive.

A request was also made that a reasonable period should be built into the legislation within which SARS should respond to requests for a directive in terms of paragraph 10 of the Fourth Schedule.

SARS is hesitant to built in such a time frame at this stage as no time frames exist in the case of other actions such as assessments, objections, correspondence and existing requests for directives.

This is an issue that will be addressed on a more holistic basis by
-
re-opening the debate on our client charter;
the re-engineering of our work processes; and
improving our work-processes and service levels, measuring and implementing time limits which should apply to the different activities.

c) Systems
Systems changes will be required by companies to administer the payment of PAYE on amounts paid to directors. Many private companies which do not currently pay PAYE will have to register for PAYE for the first time. (SAICA)

The provisions will only apply with effect from 1 March 2002, which will enable companies sufficient time to introduce changes to systems and register as employers for PAYE purposes.

d) Election
Introduce a system where a director may elect to be subject to PAYE at normal rates or at a fixed percentage, e.g. 30 per cent instead of the normal deduction tables. (Mr. Ken Andrew)

The introduction of such a system will still result in a deferral benefit to directors and will create a precedent which may lead to requests from other groups of employees for similar treatment.

In addition, this proposal will not solve the concern raised that the director may still be taxed on a notional amount that may not be actually received ultimately.

e) Introduce a threshold
Recognise that small business companies and close corporations are in reality limited partnerships which are not subject to the provisions, by introducing a threshold. (PricewaterhouseCoopers)

The Fourth Schedule does not provide for thresholds for employees. The introduction of such a system will set a precedent which may lead to requests from other groups of employees to get the benefit of a similar threshold.

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