Draft Taxation Laws Amendment Bills, 2012:

Hearing Response to Committee

Process for the TLAB, 2012

• February 2012

– Budget Speech

– Release of Budget Review

• Website release (6 July 2012)

• Informal SCOF committee process

– 31 July briefing

– 22 August taxpayer hearings

– 31 August anti-avoidance media release

– 11 September

• Formal introduction to National Assembly Debate (late October)

– National Assembly debate

– National Council of Provinces

– Presidential signature

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Outline of Main Issues

• Foreign dividend conversion schemes

– Schemes involving actual shares/dividends

– Share derivatives

– Dividend transfer mutations

• Debt/equity postponement

– Debt deemed to be shares/dividend yields

– Deferral of deduction for interest/royalties incurred for the benefit of

exempt persons

• Financial sector issues

– Mark-to-market taxation for banks/brokers (effective date delayed

until 2014

– Long-term insurer transition into policy review

– REIT phase-in

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Foreign Dividend Conversion Schemes

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Foreign Shareholder Dichotomy

• Dividends received by foreign shareholders

– 15% rate

– Treaty relief (5% or 10%)

• Gains

– Capital and ordinary gains foreign persons are tax-free

• Hence, the sale of a share by a foreign person is tax-free

versus a dividend, which is taxable. The incentive is to

convert dividends into exempt gains.

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Example

• Foreign person owns a share with a R100 value on 11

September.

– The share is expected to generate a dividend of R15 on

12 September (having a R85 long-term value and R15

pregnant dividend value

• Dividend, followed by sale

– The dividend of R15 is taxable in the hands of the foreign

person at a rate between 5% and 15%

– No tax on the sale of the share at R85 by Foreign person

• Sale, followed by a dividend

– No tax on the sale of the share at R100 by Foreign

person

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Conversion Schemes

• Cessions

– Foreign shareholder sells the right to the dividend before actual

receipt

– The cash consideration received is proceeds from tax-free gain

• Share lending

– The Foreign shareholder lends the share

– The dividend on the borrowed share is receive by an exempt person

– The cash consideration for the dividend is exempt

• Share repurchase agreements

– The foreign shareholder sells the share

– The dividend is paid while in an exempt persons hands

– The foreign sells receives tax-free cash for the dividend plus a

comparable share (less the dividend)

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Conversion Scheme Proposal

• All “in lieu of” consideration for the dividend will be treated as a deemed

dividend

• The deemed dividend is taxable in the foreign person’s hands

• The rule applies only if the sale occurs after dividend declaration

• Issues

– Dividend in specie is a hard rules for domestic parties and impacts

pricing models

• Response document: Treat as a normal cash dividend with

withholding

– Effective date currently all in lieu of payments from 31 August

• Response document:

– Effective for transactions entered into from 31 August

– All in lieuof payments after September

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Share Derivatives

• Investors increasingly rely on derivatives as an investment tool over

direct holdings in shares

• Structure

– Foreign person acquire a single stock future or a contracts-for-

difference in respect of a share

– Local Broker acquires the share as a hedge and pays the dividend

onto the foreign person via a derivative adjustment

• Under current law,

– Local Broker receives the dividend tax-free

– Foreign receives the dividend derivative adjustment in respect of the

derivative as a tax-free amount

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Share Derivative Proposal

• Initial Proposal

– Dividend adjustments in respect of a derivative will be subject to the

dividends tax

• Revised proposal

– Dropped

– The dividends tax requires knowledge of the counter-party to

determine tax status; however, counter-party knowledge is lacking for

share derivative trades on SAFEX

– Argument is that economic generally different and lack of intent (but

no always)

• Long-term concern

– A tax preference now exists in favour of derivatives over direct

holdings that will push investments toward derivatives

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Dividend Transfer Mutations

Payor Payee

Dividend

cessions

Nil Exempt

Manufactured

Dividends

(-) (+)

• Dividends cession

schemes

– Exempt (e.g. pension or

foreign) passes its

exemption to transferee

• Manufactured schemes

– Deduction is paid to an

exempt entity (e.g.

pension or foreign)

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Technical Correction: 2011 Closure of

Dividend Cession Schemes

• 2011 Proposal

– Sought to close the transfer of schemes by pension funds to export

exempt dividends to otherwise taxable transferees

– Technically covered dividends from all purchased shares

• Initial 2012 proposal

– Required dividend recipient to own share

– Resulting in tax for all shares held in trust/CIS

• Revised 2012 proposal

– Dividend cessions without the underlying share

– Share lending dividends/share repos

– Trusts used to accomplish the same result

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DEBT/EQUIY

Debt/Equity

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Tax Paradigm of Debt Versus Shares

Payor Payee

Debt (-) (+) but no tax

for foreigners

and pension

funds

Shares 0 0 normal tax;

15% DT for

individuals,

5 – 15% DT for

foreigners, and

0% DT for

pension funds

and domestic

companies

• Interest schemes:

– Payments to foreign

persons, pension funds

by taxpayers

• Dividend schemes

– Loss making or exempt

entities pay domestic

companies

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Debt Versus Shares: Key Commercial Features

Debt

• Redeemable within a reasonable period

• Fixed Claim on Cash Flows (e.g. based on time-value of money)

• High priority on cash flows/collateral often required

• No management control over payor unless default

Shares

• Generally non-redeemable

• Variable claim on cash flows (payments based on profits)

• Low priority on cash flows/no Collateral required

• Management control.

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“Hybrid Debt Instruments”

Proposal (Sections 8F and 8FA)

• Two-fold regime

– Rules focusing on the nature of the instrument itself (the corpus)

• The proposal characterises the debt as equity if the debt has –

– features indicating that redemption is unlikely within a

reasonable period (i.e. 30 years);

– Redemption is conditional upon solvency or liquidity of the

issuer; or

– features requiring a conversion into shares

– Rules focusing on the nature of the yield

• The proposal characterises the yield as dividends if the yield is

– not determined with reference to the time value of money

– the yield is conditional on solvency or liquidity

– The yield is payable in shares

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Hybrid Provisions Deferred

• Process:

– Section 8F and 8FA have been pulled from the Bills (because of the 2014

effective date in any event)

– To be reintroduced next year

• Section 8F issues (e.g.)

– Liquidity and solvency (especially if debt is issued as part of business rescue)

– Convertibility

– Inadvertent timing

– Deemed conversion triggering a taxable event

• Section 8FA issues (e.g.)

– Uncertainty of the meaning of time value of money

– Insolvency or liquidity limit

– Listed debt payable in shares if shares are a market value subsititute

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Suspended Interest/Royalty Deductions

Sections 23L

• The tax system largely looks to actual payment/receipt and

incurral/accrual partially to match accounting.tax and partially to prevent

avoidance

• Interest

– Section 24J spreads income/deductions based on economic yield

versus payment

– The rule operates as an avenue for avoidance with exempt payees

• Royalty

– Royalties are incurred before payment

– However, withholding is based on cash under the revised rules

• Proposal

– Interest and royalty deductions are deferred until cash payment (or

due and payable) if an exempt payee is involved (e.g. pension fund

and foreign investors)

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Section 23L Postponed

• Section 23L is postponed like sections 8F and 8FA until next year for

further discussion

• Proposal negatives impacts standard zero coupon bonds issued to

pension funds and foreign residents

• Proposal can be undermined if the payor makes an artificial payment to

payee

• However,

– Concerns exist in respect of pay-when-can loans (e.g roll-up funds);

– Connected person transactions; and

– Cross-border withholding exists only at time of payment, not

incurral/accrual

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Business (Financial

Intermediaries and Vehicles)

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Annual Fair Value Taxation: Background

(sections 24J(9); new section 24JB)

Income tax systems generally impose tax on a realisation basis

A growing trend is towards notional realisation of gains and losses in respect of

liquid financial instruments. i.e.

a. Listed and over-the-counter shares

b. Listed and over-the-counter bonds and

c. Derivatives in respect of the above

Accounting (IFRS IAS 32/39 or IFRS 9) is the key driver behind this trend.

Banks and other large financial institutions have adopted this method in their

systems and expect similar tax treatment.

Two problems

Compliance burden of maintaining two separate systems (one for IFRS and

one for tax)

Audit much harder to follow books no longer have any bearing to tax (e.g.

extensive reconciliations)

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Annual Fair Value Taxation: Background

IFRS fair value assets will be taxed annually on gains/loss:

Trading assets; and

Assets to be treated at fair value to prevent mismeasurement

The new rules essentially place financial assets and liabilities into an IFRS

framework for all gain/loss purposes

The new regime applies to:

Banks (including local branches of foreign banks)

Brokers (i.e. authorised dealers)

The new regime does not apply to unhedged intra-group derivatives

A one-off transitional charge will apply

Transitional charge to be spread over 4 years

The charge applies to the deferred tax difference currently existing between

tax and accounting

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Effective Date Deferred

• Effective date of mark-to-market proposal for banks/brokers

deferred until 2014

• Risk areas

– How to tax dividends in respect of shares held for

trading?

– How to deal with mark-to-market accounting outside IAS

39 but within IFRS?

– How to deal with arbitrage for those inside and outside

the system?

– Other entities seeking entry (certain financial asset pools)

– Comprehensive convergence in respect of other assets

– Overbreadth in terms of capital assets

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Mark-to-market of long term policyholder funds

(Sections 29A and new 29B)

Background

Insurers as “tax” trustees of policyholder investments must not only collect income tax but

must also properly allocate tax to each policyholder investment.

Insurers achieve this allocation amongst policyholders by applying continual mark-to-

market approach (subtracting notional tax from the gain or loss policyholder investments on

a continual basis)

Any change in effective capital gains tax rates for policyholder funds creates complications

for insurers as trustees (especially if higher rates apply only from a later date)

Proposal

The realisation principle for the taxation of disposals is becoming outmoded for financial

institutions, including insurers.

It is proposed that a deemed disposal and re-acquisition approach be applied to all

policyholder fund assets that mimics mark-to-market taxation on 29 February 2012

Other than dual-linked funds

The gain or loss is spread over 4 years

Annual mark-to-market system deleted pending larger review

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New Deduction Formula for Long-term

Policyholder Funds

• Old Individual Policyholder formula

– I + R + F/I + 2.5R + 4.75F + 4.75L

• Purpose

– Deductions for indirect (and selling/administration expenses) should

be limited to amounts dedicated to the production of gross income

– The old formula took into account an implicit capital gain charge

• New formula

– Taxable income; over

– Taxable income plus dividends (less withholding taxes) plus capital

gains without partial inclusion

– Fully effective from 2013 onward

• Liability transfer formula moved from 50% down to 30% because new

formula will produce a larger percentage deduction for insurers

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Larger Review of Four Funds Formula

• Four funds system

– Comparison with unit trusts (CISs)

– Low-income fund

– Application to risk products/mixed products

– Notional asset allocations

• Deductibility of investment expenses

– Investment expenses not generally deductible

– CIS use of deductions against profits

• Liability shift at year-end

• Differences between general larger insurers, dual-linked funds and risk

insurers

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Real Estate Investment Trust (REITs): Background

(sections 1 (“REIT” definition) and 25BB)

Property investors directly invest in immovable properties for rental streams or indirectly

through property investment entities

A steady rental stream acts as a substitute for interest income, and growth in the

underlying property as relatively stable method of achieving appreciation.

Ownership in property investment schemes is highly liquid

Two main types of property investment schemes exist that operate as international REIT –

the Property Unit Trust (PUT) and Property Loan Stock (PLS)

Both the PUT and the PLS are subject to the same listing requirements for the

purposes of the JSE.

Only the PUT is subject to FSB regulation

Two different tax dispensations

PUTs have an explicit flow through of rentals and an exemption for capital gains

PLSs have a “homemade” flow-through via dual linked units with debenture interest

Debenture interest really operates as disguised “deductible” dividends that will violate

the new debt equity rules (sections 8F and 8FA)

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REIT Proposal

It is proposed that a unified approach for the property investment schemes will be adopted

for financial regulatory and tax purposes.

The new entity will be called a Real Estate Investment Trust (REIT) in line with the

international norms.

The purpose of the proposed REIT regime is to treat investors roughly similar to the

situation in which these investors invested in immovable property directly (flow-

through).

New regime

All distributions will be deductible if the entity mostly (i.e. 75%) generates rental and

similar income (or REIT dividends from subsidiaries)

Capital gains from immovable property will be exempt

Financial instruments will generate ordinary revenue (other than REIT interests)

REIT classification to be maintained by JSE rules

All REIT yields will be taxed as ordinary revenue (with foreign persons exempt from

dividends tax until 1 January 2014)

Removal of dual-linked share set to begin from 2013

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REIT Coverage

• Initial proposal

– REIT itself

– Controlled subsidiaries

– Now also 20 per cent or greater subsidiaries

• 2013 and beyond

– REITs wholly owned by pension funds

– REITs wholly owned by long-term insurers

– Incubator REITs to be traded over-the-counter

– Regulation of unlisted REITs absent and regulation of listed REITs

uneven between PLSs and PUTs

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