Originally published in Legal Times, Friday May 11, 2012
With the recent announcement of the intention to introduce a uniform tax withholding rate of 15% for dividends, interest and royalties, the reduction of these taxes by foreign investors into South Africa will be an increasingly prominent feature in planning inward investment. Access to, and the use of, South Africa's double tax treaties will play an important role in the quest to reduce these taxes.
Given international case law developed on treaty shopping and related tax planning in recent years, as well as the recent overturning of India's attempts, in the Vodafone case, to tax profits realised through the disposal of an intermediary, the question arises as to what the likely stance of SARS will be in the event of perceived treaty shopping and the use of intermediary entities in the South African context.
Treaty shopping broadly entails interposing an intermediate company in an investment or transaction structure, where the intermediary entity will be able to avail itself of tax treaty benefits of the treaty between South Africa and another jurisdiction, thereby reducing withholding or other taxes that would otherwise have been payable by the ultimate investing entity.
Treaty remedies available to SARS vary and will depend on the terms of the specific treaty. A SARS challenge may be in terms of a Limitation Of Benefits (LOB) clause. These clauses are contained in some treaties and would seek to deny the treaty benefits in certain circumstances. Alternatively, the residence of the intermediate entity in the other treaty jurisdiction, or the beneficial ownership by the intermediary of the amounts received under the treaty, may be challenged.
Other specific anti-avoidance treaty provisions, such as the Associated Enterprise provisions, or expansive treaty provisions allowing domestic law anti-avoidance provisions to apply, may also be used. In extreme cases of extensive use (or perceived abuse) of a treaty, South Africa may seek to negotiate a protocol to the treaty or even a revision of the treaty in its entirety. Many treaties include a termination clause, in terms of which South Africa can terminate a treaty in the event of an unsatisfactory outcome to this process. Both of the latter options are, however, long-term remedies and would not impact on specific transactions.
Under the Income Tax Act, SARS can also seek to use the substance over form doctrine, as applied in the NWK case in 2010, or use the General Anti-Avoidance Rules (GAAR). South Africa's tax treaties, once Gazetted, become effective "as if enacted in this act".
Substance over form or GAAR?
The Model Tax Convention on Income and on Capital raises the question whether substance over form or general anti-abuse rules conflict with tax treaties. It points out that such rules are part of the basic domestic tax laws for determining which facts give rise to a tax liability. It states that, as a general rule, there will be no conflict between these rules and the provisions of the relevant double tax agreement.
For example, to the extent that the application of these rules results in a re-characterisation of income or in a re-determination of the relevant taxpayer who is considered to derive such income, the provisions of the double tax agreement will be applied, taking into account these changes. However, it goes on to state that while these rules do not conflict with double tax agreements, member countries should carefully observe the specific obligations enshrined in double tax agreements to relieve double taxation where there is no clear evidence that the double tax agreements are being abused.
As such, there is no reason why the GAAR could not be applied in circumstances where an investment structure into South Africa, or a cross-border transaction, constitutes an impermissible taxavoidance arrangement as contemplated in the GAAR. Philosophically, the application of the GAAR in these circumstances may be more difficult for SARS to pursue, as this will effectively amount to the use of South Africa's domestic law provisions to "override " treaty application.
Similarly, the principle that a taxpayer may arrange his affairs in a manner that is most tax-efficient (eg as held in the Conhage case) will be equally applicable in the structuring of international transactions and investment.
In our experience, SARS, to date, has been a lot more comfortable challenging perceived international tax-avoidance arrangements based on applicable domestic law provisions than under the treaties. Assuming a transaction or structure has sufficient substance and commercial purpose (ie it would not be vulnerable to a substance over form challenge), however, it will be interesting to see whether SARS would seek to follow the GAAR route or increase its focus on challenging the applications of treaty provisions under the treaties as the preferred remedy for perceived tax avoidance – for example, whether SARS will argue that an intermediate entity is not the "beneficial owner" of the relevant income, and on this basis, deny a reduction in the relevant withholding tax on that basis.
Given some of the constraints of using domestic law provisions to challenge the use of treaties, it is likely that one can expect increasing treaty-based challenges from SARS. While there has not been substantial precedent in the South African context of treaty shopping cases, South Africa is likely to follow international precedent in this regard.
It is clear that with the introduction of the higher withholding taxes, the incidences where SARS may challenge the application of reduced treaty withholding tax rates are likely to increase. Taxpayers that seek to structure their affairs in the most tax-efficient manner must comprehensively consider the likely means of attack by SARS in the context of investment and international transactions.
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