When you fill in your tax return this year, you will - for the first time - have to include all income earned anywhere in the world, and most of it will be subject to tax. We examine the implications of the residence-based tax announced in the last Budget.
In a nutshell, taxation on a residence basis means that any income you earn anywhere in the world, from any source, is likely to be subject to taxation in South Africa. It matters not whether you earn dividends from a company overseas, income from a unit trust investment, or royalties on a book about the mating habits of the aardvark, from now on you have to declare it on your tax form. That does not mean taxation is inevitable - there are a number of exemptions - but disclosure is mandatory.
The new law will affect nearly everyone with savings because there is an offshore element to most investments, from the local unit trust fund or life assurance endowment policy with underlying foreign investments, to the offshore unit trust fund. Not only will it have an impact on your savings, but, in many cases, it will add a new dimension to filling in your annual tax form.
You are seen as a resident by the taxman, and are subject to the residence-based tax, if you lived in South Africa for at least 91 days during the year of tax assessment and you were physically present in the Republic for at least 183 days in the preceding three years.
The key element of residence-based taxation for most people is the tax on dividends declared by foreign companies. Dividends received from local companies are still not taxed. The logic behind this is that local companies pay tax on their profits before they pay your share as a dividend.
Until January 1 this year, the local income tax system was based primarily on the "source" principle of taxation, which meant you were taxed only on income earned in South Africa. Until 1997 this was quite logical because South African residents were not supposed to have money offshore.
In 1997 the government started lifting exchange controls on individuals. The result was that it had to find ways of taxing offshore investments that would otherwise escape the tax net. The first step was to amend the Income Tax Act of 1962 to allow for the taxation of certain forms of passive income, such as interest, annuities, rentals and royalties. But the structure of foreign investments often meant that this passive income escaped the tax net, particularly when interest was declared as dividends by offshore unit trust funds.
So when Finance Minister Trevor Manuel announced the move from a source to a residence-based system with effect from January 1 this year, he also announced as an interim measure that dividends declared out of foreign profits on or after February 23 2000 would be subject to tax.
This in turn created a problem for South African companies listed on foreign stock exchanges. A good example is Old Mutual. While dividends declared by local companies and paid locally are tax-free, in terms of the new law dividends paid out to millions of Old Mutual shareholders would be subject to tax. To overcome this problem there is an exemption on dividends from companies that have their primary listing on a stock exchange in another country but are also listed on the JSE Securities Exchange (JSE).
Apart from this exemption there are a number of other exemptions from the tax. The most important of these are:
* Dividends declared by foreign companies where the South African resident taxpayer owns at least 10 percent of the shareholding of the company;
* Foreign pensions - at least for the next three years. In a memorandum attached to the legislation, the government says the taxation of foreign pensions is controversial. On one hand, the government claims it is international practice for the country of residence to tax foreign pensions; on the other, there are arguments that taxing foreign pensions would discourage foreigners from retiring in South Africa; that the income from a pension is static and that taxation would reduce the pensioner's income. Various other problems such as the deductibility of contributions to foreign pension funds and the taxation of lump-sum payments from these funds would have to be addressed; and
* Tax already paid. If you have already paid tax on the income earned in a foreign jurisdiction this can be offset against any tax due to be paid in South Africa. However, if the tax rate in the foreign jurisdiction is higher than in South Africa, the taxman will not be dipping his hand into his pocket to pay anything back to you. If you have a foreign business, you will also not be taxed on the profits if the income was subject to tax in a designated country at a statutory rate of at least 27 percent. Designated countries include states such as Britain and the United States, where our government knows that proper tax systems are in place.
What have you got?
All forms of income from investments - including interest, dividend payments and net rental income - received from anywhere in the world are liable for income tax in your hands as a South African resident.
The income tax may either be paid directly by yourself or indirectly by a life assurance or retirement fund on your behalf. Be aware that some foreign investments may also attract income tax abroad. Locally, they may also be subject to capital gains tax from April 1 this year and estate duty.
The tax exemption of R3 000 (R4 000 if you are 65 or older) applies to the total of your interest earnings both in South Africa and from a foreign source.
Here is a list of the foreign income sources most likely to affect you:
Foreign dividends:
Unlike any dividends you earn in South Africa, which are tax free, dividends you receive from foreign sources are taxable as income. The only exceptions are companies that are also listed on the JSE (for example, Old Mutual on the London Stock Exchange). If there is company tax of more than 27 percent in the country where the shares of a company are owned, then the country may be declared a designated country by the South African tax authorities. If withholding tax or income tax is deducted in the foreign country, that may be offset against the tax payable in South Africa.
Offshore unit trust funds (using your R750 000 foreign investment allowance):
If you are invested in an offshore unit trust fund that declares interest and/or dividends, these will be taxable in South Africa. Offshore funds in their distributions do not separate interest and dividends.
Many offshore funds are what are called "roll-up funds". With roll-up funds you are provided with additional units instead of interest or dividends. Under the old regulations these additional units were considered exempt from income tax. However, in terms of proposed new legislation, the units will be considered a capital gain and will be subject to capital gains tax rather than income tax.
Local asset swap foreign unit trust funds:
Income tax will be due on local asset swap unit trust fund investment earnings. The conduit form of taxation is used, which means that you pay the tax, not the unit trust company on your behalf. Unit trust companies will provide you with the following information:
* Non-taxable income: This includes dividends from local companies and from foreign companies that are exempt from income tax; and
* Taxable income: This includes interest and net rental income generated both locally and abroad; and dividends from non-exempt foreign companies.
Local asset swap life assurance investments:
Income tax on a local asset swap life assurance investment that is invested in foreign markets is the same as on any other local life assurance investment. There is no tax in your hands, but the interest and net rental income earnings of investments are taxed at 30 percent in the hands of the assurer. Any non-exempt dividends received from a foreign company will be taxable in the hands of the life assurance company.
Foreign life assurance investments (using your R750 000 foreign investment allowance):
Benefits or proceeds of life assurance investment policies invested in foreign markets are considered to be a capital benefit and are therefore not normally taxable. Whether this situation will remain is open to question. In South Africa the interest and net rental income earnings of investments are taxed at 30 percent, and foreign non-exempt dividends are taxed too, all in the hands of the life assurance company. None of these taxes applies to offshore life assurance policies, which makes them an attractive investment from the standpoint of tax efficiency.
Local asset swap retirement fund investments:
Income tax on local asset swap retirement investments that are invested in foreign markets is the same as on any other local life assurance investment. There is no tax in your hands, but the interest and net rental income earnings of investments are taxed at 25 percent in the hands of the retirement fund. Any non-exempt dividends received from a foreign company will be taxable in the hands of the retirement fund.
Property owned in a foreign country:
You are liable to pay tax on any rental income, less expenses, including interest payments on a mortgage bond.
Interest-earning bank deposits:
You will pay tax on any interest earnings from any source after the initial rebate.
Foreign asset protection trusts
In a last-minute change to the residence-based tax legislation, which was approved by Parliament in November, the South African Revenue Services decided to remove the stipulation that any foreign asset protection trust with South African residents making up more than 50 percent of its trustees should be classified as a "foreign controlled entity".
The stipulation would have made any income received by the trust taxable in South Africa if more than 50 percent of the trustees were South Africans. However, foreign trusts still do not escape the beady eye of the taxman. In terms of the Income Tax Act, any South African resident (called the settlor) who lends or donates money to a foreign asset protection trust will be liable in South Africa for tax on any income generated by the amount, and for capital gains tax when the new tax is introduced, as if the income was generated locally in the hands of the settlor.
This change toughens the original legislation because any assets transferred to a foreign asset protection by a South African resident will be taxable in the hands of the resident in this country. Previously, tax could be avoided in many cases by making sure that more than 50 percent of the trustees were non-South African residents.
Golden rules of tax and investment
1 Taxed may be better than untaxed
Do not stop investing, or change investments, because you want to save on tax or because you are unsure of the tax implications. A taxed investment can do better than an untaxed investment. Many investments will give you a real return after deducting both inflation and tax. Most investment product providers structure their products in the most tax-effective manner.
2 Consider tax last
Do not make tax the first consideration when you choose an investment. First consider such things as potential risks and returns. The returns after tax may be better than returns on a no-tax investment.
3 Work with taxation as it is currently structured
If you take account of future changes you might make a bad decision based on what you expect to happen. A good example is the way the taxation of retirement funds was expected to change in terms of proposals by the Katz Tax Commission in 1995. Many
people took early retirement in anticipation of the recommendations being implemented. Five years down the line nothing had changed and early retirement became a poor decision.
4 Beware of elaborate tax avoidance schemes
They often come back to bite you. You are entitled to structure your affairs to reduce your tax liabilities, but schemes structured to evade tax are illegal. Those that sail close to the wind, called tax "evoision" schemes, are liable to be revoked by tax regulators with retrospective effect.
5 Get advice
If you are involved in a complex foreign investment, get proper advice from an expert on international tax. Remember that taxation varies from one jurisdiction to another.
Health warnings
Be very careful about creating structures to avoid the payment of tax in South Africa on your worldwide holdings.
The taxman is asking an increasing number of questions about foreign investment holdings, and, as the saying goes: "A tax lie never dies." The taxman is becoming more efficient at tracking down tax evasion and will not hesitate to lay criminal charges against offenders - after penalties and interest have been levied.
You should be particularly careful with asset-holding instruments such as trusts and companies. If you operate an offshore trust in which more than 50 percent of the trustees are South African residents, or an offshore company that is more than 50 percent controlled by South African shareholders, the trust or company will be deemed a "controlled foreign entity". This means that any income generated by the trust or com-pany will be taxed in the hands of local shareholders or beneficiaries of the trust in the proportion to their interests in the trust or the company.
A so-called "blind trust", in which the "real" or "eventual" beneficiaries are not named, is being frowned upon by foreign offshore jurisdictions because of international pressure. And the taxman now wants to know if you are named as a beneficiary in a "letter of wishes" provided to the trustees of a trust, while not being named in the trust.
This article was first published
in the January 2001 issue of Personal Finance magazine. See what's in our latest issue