DIVIDENDS TAX: COLLATERAL DEFINITION ISSUES

[Clauses 7(1)(c-g)(i)(k()(m)(zJ)(zO), 15(1)(b-c), 18, 19, 24(1)(d), 28(1)(I), 34(1)(a), 60, 67(1)(f-g), 68(1)(g), 70(1)(c), 72(1)(f-g), 96, 98, 113(1)(i), 117(1)(a and c), 119(1)(a-c), 120, 122 and 123(1)(b); Applicable provisions: Section 1 and 64D of the Income Tax Act, Paragraph 74 of the Eighth Schedule)]

I. Background

South African and foreign companies may distribute cash or in specie assets to their shareholders. These distributions may constitute a dividend or a return of capital.

Dividends distributed by resident companies generally attract Secondary Tax on Companies (“STC”) at company level at a flat rate of 10 per cent. The STC system is to be replaced with a Dividends Tax at shareholder level. Dividend distributions made by non-resident companies are referred to as “foreign dividends” and are included in gross income, subject to certain exemptions.

Return of capital payments fall under a different system of tax than dividends. Return of capital payments are subject to the Capital Gains Tax. The same capital gain rules apply to both domestic and foreign return of capital payments. As a result of changes made in 2010, the main distinction between a dividend versus a return of capital distribution is based on whether the distribution comes from “contributed tax capital.” Distributions drawn from contributed tax capital qualify as a return of capital while distributions from other sources qualify as dividends.

34

II. Reasons for change

The new Dividends Tax and comprehensive changes to the Companies Act legislation have forced core definitions to be revisited. In 2010, new definitions for domestic and foreign dividends were enacted along with a new definition of equity shares.

While these recent changes are fundamentally correct, the piecemeal nature of these changes creates incongruities and potential anomalies. The relationship of domestic and foreign distributions is also somewhat unclear. A streamlined set of definitions is accordingly required for a cleaner landscape.

III. Proposal A. Overview

Three sets of definitions are proposed. Under the first set, payments from domestic companies by virtue of their shares will be treated either as dividends or return of capital.

Under the second set, payments from foreign companies by virtue of their shares will be treated either as foreign dividends or foreign return of capital. The third set clarifies the share and equity share definitions.

B. (Domestic) dividends and return of capital

Core aspects of the (domestic) dividend and return of capital definitions provide roughly the same trigger. Both sets of transactions arise from amounts transferred roughly by a domestic company by virtue of the company‟s issued shares or similar interests, regardless of whether the transfer arises by way distribution or repurchase of the company‟s own shares. Both sets of transactions exclude the issue by a company of its own shares and general buybacks of a company‟s own shares (i.e. where the seller on the open market cannot readily identify the purchaser).

The one distinction between (domestic) dividends and that of a return of capital payment relates to contributed tax capital. Return of capital payments must be drawn from the paying company‟s contributed tax capital (i.e. a tax account stemming from shareholder investments measured in tax terms).

C. Foreign dividends and foreign return of capital

The proposed foreign dividend definition will essentially rely on the foreign income tax law characterisation of the payment of the country in which the company payor is effectively managed. If the country of the company payor does not have any applicable laws in relation to the tax on income, the foreign company law characterisation will prevail. Nonetheless, regardless of any foreign law characterisation, excluded from this definition is the redemption of participatory interests in a foreign collective investment scheme (effectively matching the exclusion of current law).

This definition also takes into account the existence of certain foreign entities that are not recognised as companies for South African company law purposes (e.g. Dutch co-operatives). Certain amounts paid by these entities will lose their status as a foreign dividend to the extent that these amounts are not deductible by that entity under foreign income tax

35

principles that determine the taxes on income in the country in which that entity is effectively managed.

The definition of a foreign return of capital definition will also be added. This definition roughly mirrors the foreign dividend definition but only includes the residual (that is, non-dividend distributions in respect of shares or similar equity instruments made by the foreign company). Like the foreign dividend definition, the status of a foreign payment depends upon foreign income taxation (or foreign company law characterisation if the country in which the payor resides lacks an income tax).

D. Share and equity share definitions

The term “shares” and “equity shares” is frequently used throughout the Income Tax Act. In 2010, the term “equity shares” was defined as “any share or similar interest that does not carry any right to participate beyond a specified amount in a distribution.” The equity share definition is fundamentally correct but will be changed to include “similar equity interest” as opposed to “similar interests” to clarify that the definition cannot exclude debt. Reference to

“similar equity interest” is meant to cover interests in entities that are similar to companies, such as a member‟s interest in a close corporation or a co-operative.

In addition, a “share” definition is proposed. This definition will mirror the “equity share”

definition with one caveat. The “share” definition applies regardless of whether the share or similar interest “carries any right to participate beyond a specified amount in a distribution.”

E. Removal of the shareholder definition

The shareholder definition focuses on both the share register and beneficial ownership. This duality creates confusion because the person named in the share register is not necessarily the beneficial owner of the share (for example, a regulated intermediary). Consistent with the overall philosophy of the Income Tax Act, the focus should solely be on the beneficial owner of the shares. It is also accordingly proposed that the shareholder definition be deleted (because the definition treats both registered and beneficial owners of shares as

“shareholders”). The focus should always be on the beneficial owner of the share (that is,

“the holder” or “the person who holds the shares”), not the registered owner.

F. Collateral changes

The above terms are frequently used throughout the Income Tax Act. As a result, the use of the term “dividend” will be clarified as to whether the term is intended to cover domestic versus foreign dividends or a combination of both. The term “distribution” will similarly be clarified as to whether the term includes both dividends and return of capital or simply one kind of distribution. The terms “equity shares” and “shares” are also being reviewed throughout the Income Tax Act to ensure appropriate use. Due to the deletion of the term

“shareholder”, the concept will instead be denoted by the use of the words “holder or “hold”

to denotes beneficial ownership.

36

IV. Effective date

The proposed amendment in respect of dividends and return of capital will generally be effective from 1 January 2012. However, the revised foreign dividend definition will be effective from 1 January 2011.

_____________________