FAQ: Is the s10B dividend exemption applicable to a resident with a 49% interest in 2 foreign Co.’s?
Q: My client owns a 49% equity stake in 2 foreign companies, namely Lesotho and Zimbabwe.
Both businesses operate within their respective Republics, which are their main places of business for all practical purposes. He is the only South African shareholder in both companies.
As my client owns more than 10% of the issued shares, but less than 50%, will dividends received from these companies be exempt in terms of s10B of the Income Tax Act, or will the 25/40 apportionment still apply to determine the exempt portion? Is this interpretation accurate?
A: The determination of whether the foreign dividends would be exempt and under which subsection of sec 10B is fact specific and would depend on the terms and conditions surrounding the shares of the respective companies. You would therefore have to consider this guidance in making your determination and it is not possible to give you decisive guidance in this regard.
In giving you this guidance, it is assumed that the individual shares do not constitute a ‘listed share’ as defined in sec 1 of the Income Tax Act (No. 58 of 1962) (hereinafter referred to as ‘the Act’). It is further assumed from the information provided that the shareholder is a natural person and that the dividend constitute a ‘foreign dividend’ as defined in sec 10B(1) read with sec 1 of the Act. You are advised to, before determining the exemptions for the foreign dividends, turn to the relevant DTA’s to determine if South Africa has taxing rights on those dividends. For purposes of this guidance it is assumed that South Africa has taxing rights on the dividends.
In order to derive at the exemption provided for by sec 10B(2)(a) (the so-called participation exemption), there are three hurdles that need to be overcome. Should the exemption in terms of sec 10B(2)(a) not be available, you would have to use sec 10B(3) (the ratio exemption) to exempt the dividends.
First hurdle – Proviso to sec 10B(2)
The said proviso states the following:
‘Provided that paragraphs (a) and (b) must not apply to any foreign dividend to the extent that the foreign dividend is deductible by the foreign company declaring or paying that foreign dividend in the determination of any tax on income on companies of the country in which that foreign company has its place of effective management: Provided further that paragraph (a) must not apply to any foreign dividend received by or accrued to that person in respect of a share other than an equity share.’
The first proviso to sec 10B(2) effectively states that the sec 10B(2) exemptions does not apply if the foreign dividend would constitute a deduction by the foreign company in determining its foreign tax liability in the country where it is effectively managed. You would therefore have to consider the tax acts of Lesotho and Zimbabwe to determine if the dividends would be allowed as deductions to those companies. The second requirement states that the above two exemptions may only apply to dividends received from an ‘equity share’. An ‘equity share’ is defined in sec 1 of the Act as follow:
‘means any share in a company, excluding any share that, neither as respects dividends nor as respects returns of capital, carries any right to participate beyond a specified amount in a distribution’. (own emphasis added).
The reference to ‘neither’ in the above definition has the effect that a share would not qualify as an ‘equity share’ if it is a share that in respect of both dividends and returns of capital does not carry a right to participate beyond a specified amount in a distribution. The shares must therefore allow the shareholder to participate in the profits to an unlimited extent or to participate in the distribution on liquidation. Therefore, should participation rights be limited in respect of only dividends or returns of capital, the share would still qualify as an equity share.
Second hurdle – sec 10B(4)(a) and (b)
Sec 10B(4) states the following:
‘(4) Subsections (2) (a) and (2) (b) do not apply in respect of any foreign dividend received by or accrued to any person—
(i)(aa) any amount of that foreign dividend is determined directly or indirectly with reference to; or
(bb) that foreign dividend arises directly or indirectly from,
any amount paid or payable by any person to any other person; and
(ii) the amount so paid or payable is deductible from the income of the person by whom it is paid or payable and—
(aa) is not subject to normal tax in the hands of the other person contemplated in subparagraph (i); and
(bb) where that other person contemplated in subparagraph (i) is a controlled foreign company, is not taken into account in determining the net income, contemplated in section 9D (2A), of that controlled foreign company,
unless the amount so paid or payable is paid or payable as consideration for the purchase of trading stock by the person by whom the amount is paid or payable; or
(a) from any portfolio contemplated in paragraph (e) (ii) of the definition of “company” in section 1.’ (own emphasis added).
The Explanatory Memorandum to the Taxation Laws Amendment Bill, 2011 provides the following example to explain the workings of sec 10B(4)(a):
‘Facts: SA Company 1 pays interest on a loan provided by Foreign Company. Another company (SA Company 2) owns 15 per cent of the ordinary shares in Foreign Company. The dividend paid in respect of the preference shares held by SA Company 2 is determined with reference to the interest payable by SA Company 1 in respect of the interest bearing loan from Foreign Company.
Result: The foreign dividend paid to SA Company 2 is not subject to the participation exemption because this dividend is determined with reference a to deductible amount of interest payable by SA Company 1.’
Sec 10B(4)(b) simply states that the participation exemption and country-to-country exemption will not apply to dividends received from a foreign collective investment scheme.
Third hurdle – sec 10B(5) and (6)
Sect 10B(5) determines that the exemptions provided for in sec 10B(2) do not extent to payments made from foreign dividends that were received by or accrued to any person. Sec 10B(6) basically determines that the exemptions in sec 10B(2) and (3) would not extent to foreign dividends paid for services rendered or that is received as a result of employment or the holding of an office but that it would still apply if the foreign dividend is received from a ‘restricted equity instrument’ as defined in sec 8C of the Act held by that person or if it is paid in respect of a share held by that person.
In order for sec 10B(2)(a) to apply, the proviso to sec 10B(2), sec 10B(4) and sec 10B(5) must not be applicable. Should the person not qualify for the sec 10B(2)(a) exemption, sec 10B(3) (the ration exemption) would have to be used to exempt the foreign dividends.
Disclaimer: Nothing in this query and answer should be construed as constituting tax advice or a tax opinion. An expert should be consulted for advice based on the facts and circumstances of each transaction/case. Even though great care has been taken to ensure the accuracy of the answer, SAIT do not accept any responsibility for consequences of decisions taken based on this query and answer. It remains your own responsibility to consult the relevant primary resources when taking a decision.