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Disposal of foreign equity shares – proceed with caution
When conducting international corporate transactions, taxpayers should dispose of their equity shares in foreign subsidiaries or equity investments resulting in a taxable capital gain – directly or indirectly through a foreign subsidiary. This is because what looks like a simple transaction, capable of being executed in a tax neutral manner, could very easily result in adverse tax implications for the disposing shareholder. Taxand South Africa illustrates the risks and pitfalls associated with disposing of foreign equity shares.
The case study used below to illustrate the risks and pitfalls of disposing of foreign equity shares involves a foreign holding company A, which has two wholly-owned foreign subsidiaries B and C. The disposal of equity shares in A is subject to capital gains tax (CGT) in the hands of the disposing person, unless the participation exemption applies to exempt any gain arising from the transaction from CGT. Broadly speaking the participation exemption applies where the equity shares in A are disposed of for an amount equal to or exceeding market value, and the person disposing of these shares (whether alone or together with another group company):
- Held an interest of at least 10% of the equity shares and voting rights in that foreign company
- Held the interest for at least 18 months prior to the disposal
- Disposes of the shares to a person that is not a resident or a CFC for South African purposes
In assessing tax risk, taxpayers often stop at this point of the enquiry, assuming that if they comply with this exemption, the transaction will be tax neutral. There is, however, a second level of resultant disposals that need to be considered for CGT purposes and which could result in effective double taxation of any gain arising on the transaction. A company is a CFC for South African tax purposes if South African residents hold more than 50% of the participation rights, and can exercise more than 50% of the voting rights in the foreign company.
Where A, B or C cease to be CFCs for South African tax purposes, each company is deemed to have disposed of all of its assets at market value on the day before the day it ceases to be a CFC. In this case study, this situation arises where, as a result of the disposal of shares in A to a non-resident, A, B and C cease to be CFCs as they are no longer controlled by South African residents. The resultant taxable capital gain of A, B and C must then be attributed to the controlling South African shareholders of A in accordance with the provisions of section 9D of the Income Tax Act.
The Income Tax Act, however, provides some relief. The deemed disposal rules described above do not apply if, in our example, a person disposes of an equity share in A (a CFC), the capital gain is exempt under the participation exemption and as a direct result (A) or indirect result (B and C) of this disposal these foreign companies cease to be CFCs.
The result of the deemed disposal rules is an effective double taxation. In this case study, should the disposal of the shares in A not qualify for the participation exemption, the South African resident shareholders in A (that hold at least 10% of the participation and voting rights in A) will be subject to tax on both the gain arising from the disposal of the A shares, and the attribution of net income from A, B and C, on the gain resulting from the deemed disposal of these assets. Although these taxable amounts are derived from the same underlying economic value, they are included in the taxable income of the shareholders of A by way of different legal mechanisms. No credit mechanism exists to prevent this economic double taxation.
In planning the disposal of foreign equity shares it is therefore essential to ensure that the disposal of the shares in A is exempt under the participation exemption, and that any foreign companies that cease to be CFC do so directly or indirectly as a result of this tax exempt transaction.
Multinationals should note the disposal of shares in foreign companies requires detailed planning and the exercise of caution to prevent potentially nasty surprises. Piecemeal disposals in foreign companies are extremely risky.
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