The president of South Africa (SA) and his Chinese counterpart, Xi Jinping, recently met to strengthen bilateral relations and create sustainable investment opportunities between the two countries. It comes as no surprise, as China is SA’s largest trading partner and both countries are members of the BRICS group of developing countries. China has invested extensively in the mining, infrastructure and construction industries of SA.
In light of the relationship between the two countries, it is important for Chinese investors to take note of the investment opportunities available in SA, and to also ensure that investments are efficiently structured to optimise returns. Tax planning is an important aspect of the investment decision making process. Equally important is that the investor’s tax planning strategy not only be optimal and efficient for present purposes, but be sufficiently resilient to deal with rapidly changing international tax policies. Internationally, tax authorities are focusing more on issues concerning base erosion and profit shifting (BEPS) and anti-avoidance measures. The South African Revenue Service (SARS) is no exception, and is the regional leader and an aggressive role player on issues concerning BEPS on the African continent. Below are some issues that Chinese investors should take into consideration when deciding to invest into SA.
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Offshore structuring
Investors may invest directly from China into SA, or via an offshore intermediary company. When investing directly, the double tax treaty concluded between China and SA provides relief on withholding taxes on dividends, interest and royalties. This may not be the case with an indirect investment via an offshore intermediary company.
Historically, Chinese companies generally made their offshore investments using a Hong Kong structure, via either the British Virgin Islands (BVI) or Bermuda. Although such a structure may be beneficial from a Chinese tax perspective, it is generally neither optimal nor efficient from an SA tax perspective, as SA does not have double tax treaties with the BVI or Bermuda. The result is that there is likely to be substantial tax leakage on payments from SA to the intermediary company in the BVI or Bermuda, which would erode the ultimate benefits of the structure. As a large number of Chinese investments into SA are in mining and infrastructure, investing via a jurisdiction without a favourable treaty with SA could also give rise to capital gains tax on the disposal of shares held in an SA company that holds substantial immovable property situated in SA.
Commercial substance
It is not enough that a suitable offshore structure is considered – a structure must also have commercial substance and be the beneficial owner of any dividends, interest and royalties received from SA, failing which the treaty relief could well be denied by SARS. A company with one administrative employee sitting in an office with no authority to make any commercial decisions is unlikely to have sufficient commercial substance, or be regarded as the beneficial owner of income received from SA. A company set up solely, or mainly, for the purpose of availing of double tax treaty relief, with no other commercial rationale, would equally also not suffice as having commercial substance.
Factors to consider
In deciding on an offshore intermediary company, it is not sufficient to simply undertake an exercise of comparing withholding tax rates to determine which jurisdiction would provide the optimal return on an investment. An investor must consider the “real” relief that would be availed of through the use of an intermediary company, as well as the costs and risks associated with establishing the offshore intermediary company.
For example, a Chinese company that invests in an SA property development or new mining company is unlikely to return a dividend in the short or medium term, as such operations are capital intensive. Setting up an offshore intermediary company in a jurisdiction with a favourable double tax treaty with SA on dividends would result in an immediate outflow of cash for the setting-up costs and annual maintenance costs for the running of the intermediary company, while no benefit will be realised until such time as the investment yields a dividend. The cashflow consequences, costs and benefits of an offshore structure must accordingly align with an investor’s business strategy in the long run.
Funding of investment
SA has cross-border transfer pricing rules, which require connected party transactions to be based on arm’s-length principles. This means that an SA company would have to determine what amounts it would have been able to borrow in the open market – i.e. its lending capacity – and on what overall terms and conditions, and at what price (i.e. interest rate). A failure to comply with the transfer pricing rules would result in adverse tax implications for the SA company.
In addition, SA has recently implemented limitations on interest deductions in relation to certain non-residents, and in the context of highly leveraged transactions. The debt and equity funding in relation to any investment needs to be considered and carefully planned. Furthermore, adverse tax implications may arise on currency exchange differences as a consequence of the volatile SA rand. In addition to the tax aspects related to funding strategies, payments to non-resident funders need to be approved by the South African Reserve Bank in terms of the country’s exchange control regulations. Every investor wants the highest return achievable on an investment. With careful tax planning, this is achievable.
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Bernard du Plessis is a tax executive at ENSafrica. He can be contacted on +27 83 458 2161 or by email at bduplessis@ENSafrica.com
Mathabo Magolego is a senior tax associate at ENSafrica. She can be contacted on +27 82 787 9990 or by email at mmagolego@ENSafrica.com
