Tax residency and deemed disposals

In 2001, South Africa, like many other countries, introduced capital gains tax aimed at levying capital gains tax on the gain made from the disposal of certain assets. When a South African tax resident company redomiciles abroad and changes its tax residency to another tax jurisdictionsuch company ceases to be tax resident for South African income tax purposes (regardless of whether the assets of such company are still located in South Africa or whether the company still continues to do business in South Africa or not).  

Generally, the cessation of South African tax residency is deemed to be a disposal for capital gains tax purposes and triggers capital gains tax. The Act deems the South African tax resident company to have disposed of all its assets for a consideration equal to their market value. As a result, the deemed disposal is subject to CGT at the prevailing tax rates. 

In 2003, South Africa introduced so-called “participation exemptions, which exempts any foreign dividends declared by non-resident companies to a South African tax resident holding at least 10 per cent of the equity shares and voting rights in such companies from income taxand includes the exemption from CGT gain on the disposal of equity shares held by a South African tax resident holding a least 10 per cent of the equity shares and voting rights in a non-resident company. The policy rationale for participation exemptions is where a South African tax resident has a meaningful interest in the non-resident company paying the dividend was to encourage capital inflows and to provide an incentive for South African tax residents to repatriate foreign dividends to South Africa. 

The issue 

Government has noticed an increased use of participation exemptions by South African tax resident shareholders. These erode the South African tax base in instances where a South African tax resident company changes its tax residency to another tax jurisdiction and shares in that company are subsequently sold by South African shareholders, which qualify for a participation exemption. Allowing South African resident shareholders to benefit from a participation exemption on disposal of the shares in a non-resident company that was a resident company when the shares were acquired is against the intended purpose of the participation exemption. It was aimed at encouraging capital inflows and to provide an incentive for South African tax residents to repatriate foreign dividends or capital gains back to South Africa on a tax neutral basis. 

Proposed amendments effective 1 January 2021 

It is proposed that changes be made in section 9H of the Act to deem a South African tax resident shareholder who holds shares in a South African tax resident company that changes its tax residency to another tax jurisdiction to be deemed to have disposed of all its assets at market value on the day before it ceased to be a South African tax resident and to have reacquired the assets at market value on the day of the exit. 

It is currently unknown how the Government proposes to monitor compliance in this regard. 

This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your legal adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

“Booking” capital losses on shares is not that easy

There is a number of techniques that taxpayers use to reduce their capital gains tax (CGT) exposure on long-term share investments. A common practice is to utilise the annual exclusion of R40 000 provided for in paragraph 5 of the Eighth Schedule of the Income Tax Act[1] by selling shares that have been bought at a low base cost, at a higher market value and then immediately reacquiring those shares at the same higher value, thereby ensuring that the investments’ base cost is increased by as much as R40 000 per year. If the gain on those shares is managed and kept below the annual R40 000 exclusion, taxpayers receive the benefit of a ‘step-up’ in the base cost of the shares to the higher value for future CGT purposes, without having incurred any tax cost.

 

A reverse scenario is to build up capital losses for off-set against any future capital gains and taxpayers are often advised, especially during times of market volatility, to ‘lock-in’ capital losses created by the expected temporary reduction in share prices. This involves selling shares at a loss and then immediately reacquiring the same shares at the lower base cost, but with the advantage of having created a capital loss – a technique known as ‘bed-and-breakfasting’.

 

Without placing an absolute restriction on ‘bed-and-breakfasting’, paragraph 42 of the Eighth Schedule limits the benefit that could have been obtained from the ‘locked-in’ capital loss. The limitations of paragraph 42 apply if, during a 45-day period either before or after the sale of the shares, a taxpayer acquires shares (or enters into a contract to acquire shares) of the same kind and of the same or equivalent quality. ‘Same kind’ and ‘same or equivalent quality’ includes the company in which the shares are held, the nature of the shares (ordinary shares vs preference shares) and the rights attached thereto.

 

The effect of paragraph 42 is twofold. Firstly, the seller is treated as having sold the shares at the same amount as its base cost, effectively disregarding any loss that it would otherwise have been able to book on the sale of the shares and utilise against other capital gains. Secondly, the purchaser must add the seller’s realised capital loss to the purchase price of the reacquired shares. The loss is therefore not totally foregone, but the benefit thereof (being an increased base cost of the shares acquired) is postponed to a future date when paragraph 42-time limitations do not apply.

 

Unfortunately, taxpayers do not receive guidance on complex matters such as these on yearly IT3C certificates or broker notes, since these are generally very generic. Therefore, taxpayers wishing to fully capitalise CGT exposure on market fluctuations are advised to consult with their tax practitioners prior to the sale of shares.

 

[1] No. 58 of 1962

 

This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)