Where a South African resident receives a distribution from a foreign subsidiary, the classification of such a distribution is crucial to determine the tax implications thereof in the hands of said resident. The same enquiry is relevant in a multi-national group where a controlled foreign company (“CFC”) as defined in section 9D of the Income Tax Act, 58 of 1962 (“Act”) receives a distribution from a foreign subsidiary (which may or may not be a CFC).
Essentially, it should be determined whether the distribution by the foreign subsidiary constitutes a “foreign dividend” or a “foreign return of capital”, as such terms are defined in section 1 of the Act.
In broad terms, if the distribution constitutes a “foreign dividend”, it should be exempt from income tax in the hands of the recipient in terms of the so-called participation exemption in section 10B(2) of the Act, inter alia, where:
- the recipient (alone or together with a connected person) holds at least 10% of the equity shares (as that term of defined) and voting rights in such foreign company;
- the recipient is a foreign company and the dividend is paid or declared by a company which is tax resident in the same jurisdiction. This exemption is relevant to a CFC which receives or accrues a foreign dividend; or
- the foreign dividend is declared in respect of a share which is listed on the JSE Limited.
The above exemptions are subject to various provisos not listed here.
If the distribution constitutes a “foreign dividend”, paragraph 43A, of the Eighth Schedule to the Act, in certain circumstances, apply to deem certain dividends (including foreign dividends as defined) received to be additional proceeds upon the disposal of shares by a company, comes into play. In particular, if the distribution is a foreign dividend, and the requirements of this provision are met, such foreign dividend would for example be required to be added to the proceeds upon a subsequent disposal of the shares in the foreign company that paid the foreign dividend.
If the Distribution constitutes a “foreign return of capital”, the recipient of the distribution will be required to reduce its base cost in respect of the shares in the foreign company by the amount of the distribution received (assuming such shares are held as capital assets). If the foreign return of capital exceeds the base cost of the recipient thereof, then a capital gain will be realised. However, such capital gain may be disregarded where the recipient holds (alone or together with a group company) at least 10% of the equity shares and voting rights in the foreign company and holds such interest for at least 18 months before the distribution.
If the distribution is equal to or less than the recipient's base cost, then this would not have any immediate tax implications. However, this may potentially have adverse capital gains tax implications for the recipient upon future disposal of the shares if a capital gain is realised on such disposal (as its base cost will have been reduced by an amount equal to its current base cost.
It is clear from the above that the nature of a distribution by a foreign company gives rise to vastly different tax implications and it is thus crucial to make a determination with reference to the pertinent definitions and to be able to support the tax treatment of the distribution.
In this regard, a “foreign dividend” is, most relevantly, any amount that is paid or payable by a foreign company in respect of a share in that foreign company where that amount is treated as a dividend or similar payment by that foreign company for the purposes of the laws relating to:
- tax on income on companies of the country in which that foreign company has its place of effective management; or
- companies of the country in which that foreign company is incorporated, formed or established, where the country in which that foreign company has its place of effective management does not have any applicable laws relating to tax on income (subject to certain exclusions not relevant on the facts under consideration).
A “foreign return of capital” is defined as being any amount that is paid or payable by a foreign company in respect of a share in that foreign company where that amount is treated as a distribution or similar payment (other than an amount that constitutes a foreign dividend) by that foreign company as contemplated in (i) or (ii) above. Excluded is any amount so paid or payable to the extent that the amount so paid or payable is deductible by that foreign company in the determination of any tax on income of companies of the country in which that foreign company has its place of effective management.
These definitions thus require firstly a determination of the country where the foreign company making the distribution has its place of effective management (which is a factual enquiry and is a separate topic for another day) and, secondly, how such distribution is treated under the income tax laws of such country and where there are no applicable income tax laws in the country of effective management, under the corporate laws of the country where the foreign company was established (notably as opposed to the country where the foreign company is effectively managed).
It is thus important to engage with professional advisors in the relevant foreign country to obtain their input and advice as to how the distribution is treated in such country as envisaged in these definitions in order to determine the nature of the distribution. On the face of it, this is a fairly simple enquiry but depending on the manner in which the income tax or company laws in the relevant foreign country are formulated, a straightforward answer may not always be forthcoming, which can leave the taxpayer in a difficult position. For example, certain jurisdictions do not specifically distinguish between distributions in the manner envisaged in these definitions and this then leads to difficulties in classifying a distribution and thus determining the appropriate South African tax implications for the recipient.
It is therefore advisable to consider and check this aspect prior to a distribution by a foreign company and to obtain formal advice in this regard to support the tax treatment of the distribution in the hands of the recipient of such distribution, should this aspect be queried at any stage. This is not only relevant to residents who received distributions from their offshore subsidiaries, but also who receive distributions in respect of their shares in other foreign companies (which may or may not be CFCs).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.