Deloitte Tax identifies three tax risks to consider when managing your supply chain

This article, prepared by Deloitte Tax, identifies international tax implications when restructuring your organisation’s supply chain activities. For additional information contact Louise Vosloo (Lead Director –  International Tax) at lvosloo@deloitte.co.za or Janien Jonker (Senior Tax Consultant) at jjonker@deloitte.co.za.

“The best supply chains aren’t just fast and cost-effective. They are also agile and adaptable, and they ensure that all their companies’ interests stay aligned.”

(Hau L. Lee, US Professor of Operations, Information and Technology in Harvard Business Review, Oct. 2004)

Three tax risks to consider when managing your supply chain

Supply Chain Management (SCM) aims at fulfilling customer demands through the most efficient use of resources, which includes distribution capacity, inventory and labour. Merely locating the assets and risks of one’s supply chain in a favourable tax jurisdiction is not sufficient. The functions, together with the people, must be located in the chosen jurisdiction to manage these particular assets and risks. It is essential that the systems and processes, implemented and applied, support these functions in order to create a sustainable tax benefit.

Local tax authorities will attempt to defend their tax base at all costs. This may result in the local tax authorities seeking substantial taxable capital gains and/or transfer pricing adjustments when restructuring actions (which reduce the ultimate tax they would have received) are implemented.

Therefore, careful planning and documentation substantiating the reasons why certain steps were taken, are essential to ensure most tax risks are mitigated. Transfer pricing documentation also forms an important part of the documentation required. In the absence thereof, a substantial amount of time and resources may need to be set aside in the event that adverse assessments have to be defended.

The following are a few tax risks to consider with regard to supply chain management:

Low tax jurisdictions

It is interesting to note that whenever a South African group is considering a restructure of its current operations, Mauritius is almost always the first “low-tax” jurisdiction to be considered, and justifiably so. Mauritius has a wide treaty network and a low tax rate, and it provides relief for capital gains tax when shares are sold.

However, it is common knowledge that whenever a “low-tax” jurisdiction (e.g. Guernsey, Mauritius, Isle of Man) is part of a company’s group structure, it is frowned upon by SARS. This is no surprise, as there is most likely no other reason to have an entity in such a location, other than for the provided tax benefits.

Therefore, even though a favourable tax jurisdiction can be chosen, it asks for something in return – substance.

This could be illustrated as follows:

Company Z, a South Africa tax resident, sets up an entity (Company Y) in the Netherlands, to optimise its supply chain management by utilising the tax benefits provided for. The following activities should, inter alia, be executed by Company Y to ensure it has sufficient substance in the Netherlands:

• No strategic or policy decisions regarding business operations should be taken by Company Z.
• All board meetings should take place in the Netherlands.
• Staff must be suitably qualified and provided with suitable equipment, such as telephones and computers.
• Decisions should not merely be “rubber-stamped”, as though already taken by Company Z.

The substance and risk are components that impact significantly on the amount of profits that may be attributed to the company in the supply chain, in this instance Company Y. In addition, in the event that the decisions pertaining to the day-to-day operations of Company Y are taken by Company Z, SARS could determine that Company Y is being “effectively managed” from South Africa, and subject it to South African tax on its worldwide income.

Double taxation agreements (“DTAs”)

A country with a wide treaty network is an important consideration.

In terms of supply chain management, the two primary articles of any DTA to watch out for are the articles dealing with permanent establishments and business profits.

Even if an entity is set up in a favourable tax jurisdiction, it should be careful about not carrying out any activities in South Africa that could result in the creation of a permanent establishment in South Africa.

This could be illustrated as follows:

Company X is set up in the Netherlands, but contracts are negotiated and signed on its behalf by a person in South Africa. This would result in the creation of a permanent establishment for South African tax purposes for Company X in terms of the DTA entered into between South Africa and the Netherlands.

In light of the above permanent establishment creation in South Africa, the particular DTA further determines that the profits attributable to the permanent establishment would be subject to South African tax, thus possibly negating any tax benefits that may have otherwise been generated.

Controlled foreign company (CFC) considerations

Our CFC legislation currently acts as an anti-avoidance provision by imputing the income of a foreign company and subjecting such income to tax in the hands of its South African shareholders.

It contains the so-called “diversionary-rules”, and Silke on International Tax at paragraph 3.6.2.2. states the following in respect thereof:

These rules, which are essentially provisions targeted at tax avoidance, are aimed at deterring South African taxpayers from entering into transactions aimed at shifting income that otherwise would have been taxable in South Africa, out of the South African tax net and into a taxing regime that is more beneficial.

The diversionary rules need to be reviewed when goods are sold and services rendered to South African residents who are connected parties in relation to the offshore entity.

Conclusion

When restructuring one’s current supply chain activities, it is important to consider the international tax implications, as set out above. One cannot implement new supply chain functions by only considering the physical execution thereof.

We recommend that you thoroughly research, consider and apply possible solutions to suit your company’s unique operations, which can result in potential tax savings.

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Filed under: Finance, Risk Management, Taxation, anti-avoidance provision, capital gains tax, CFC, Controlled foreign company, Deloitte, Deloitte Tax, diversionary-rules, Double taxation agreements, DTA, international tax, international tax implications, low tax jurisdictions, low tax rate, Mauritius, SARS, Silke, South Africa, supply chain, tax, tax authorities, tax jurisdiction, taxable capital gains, Taxation, taxing regime, taxpayers, transfer pricing adjustments, treaty network, wide treaty network

Draft Tax Amendment Bill 2011– The focus on preference shares as a means of funding

Next Moves?

The Draft Taxation Laws  Amendment Bill, 2011  proposes in essence that if a share is classified as debt in terms of financial accounting rules it should also be classified as debt for tax purposes. This is particularly evident in the treatment of preference shares.

These Anti-avoidance amendments are proposed in clauses 20 and 21.. Dividends on preference shares are generally not subject to income tax, but the proposed amendments will result in preference shares redeemable within ten years now becoming taxable as income, without a subsequent deduction. Treasury is of the opinion that guaranteed preference shares are ‘disguised’ as debt and so the dividends should be taxed.

Preference shares have often been  favoured with new companies as a convenient financing tool, and are often attractive to investors as well. Black Empowerment entities in particular, who are generally more reliant on preference shares as a means of funding are would be detrimentally affected if this amendment is passed into law in this form.

Deloitte holds the view that it is incorrect to equate preference shares funding with debt funding. Fundamentally a preference share is different to a debt instrument because of the rights and obligations it creates. Our tax law is rife with examples where accounting and tax diverge. It is highly inequitable to treat a dividend payment as a non-deductable expense from the perspective of the taxpayer, but as taxable interest in the hands of the preference shareholder.

Ordinary treatment for third-party backed shares and closure of various dividend schemes Further anti-avoidance proposals relate to dividends received  from shares, where the shares are ‘backed’ by third parties, through put or call options (including contingent puts). If the proposals become law, dividends from these transactions may be treated as ordinary revenue (with possible exemptions). These proposals suggest that  a shareholder should  hold a preference share for no less than  ten years if the form of the share is to be respected.

This proposal could potentially result in double taxation for the individual taxpayer. Deloitterecommends that if this proposal is to be pursued that a method be introduced that would allow the taxpayer to claim the dividend tax as a credit against the normal income tax payable. Deloitte suggests that a share only be a third party backed share if the right of disposal or guarantee is in place at the time the share is acquired by the taxpayer, or forms part of the acquisition.

Nazrien Kader is the Service Line Leader of Taxation Services  and  Lead Director of Financial Services Taxation at Deloitte South Africa.

Filed under: Executive Leadership, Taxation, Draft Tax Amendment Bill, Funding, National Treasury, Preference Shares, SARS, Section 45 of the Income Tax Act, Taxation

Draft Tax Amendment Bill 2011– Intra-group tax concessions.

Section 45 of the Income Tax Act- next moves?

It is proposed that there be a suspension of section 45 of the Income Tax Act for 18 months, from 3 June 2011.

Section 45 of the Act allows the tax-free transfer of assets within a group of companies and has become a useful tool to achieve commercially driven group reform in a tax-efficient manner.  The suspension was issued without warning to taxpayers and does not provide for a window period to allow for current restructuring transactions to be finalised.

The original goal of section 45 was to ensure that the tax system did not create a barrier to intra-group transfers. National Treasury believes that section 45 has become a key acquisition tool, with it being used in so-called debt push-down structures, which was not its intended purpose. National Treasury also expressed the view that section 45 greatly facilitates the use of funnel schemes and excessive debt in the production of exempt dividend income.

Deloitte does not condone the suspension of section 45 in the form proposed, because of the following reasons:

• Section 45 plays an important role in the world of corporate acquisitions and allows taxpayers to fund their debt with deductible income. This stems from the unsatisfactory tax position in South Africa where taxpayers are denied any tax deductions for interest incurred on loans obtained to fund the buying of shares. If section 45 is not available to provide relief to the acquiror in respect of its funding requirements, a number of corporate institutions will become unaffordable.
• Deloitte  understands the National Treasury’s and SARS’s concerns with the use of funnel schemes that seek to erode the tax base. Therefore Deloitte recommends that the targeted anti-avoidance legislation be introduced to combat the issue. The failure to use the General Anti-Avoidance Rule (GAAR) means we are presented with legislative interventions which have the unfortunate effect of penalising the majority of taxpayers for the actions of an errant minority.
• Deloitte is of the opinion that the suspension of an important provision such as section 45 undermines tax certainty and impinges the credibility of our tax system.

Deloitte urges National Treasury and SARS to engage with taxpayers to salvage section 45. Possible options include prescribing certain debt:equity ratios to avoid companies being flooded with debt and permitting intra-group transactions where assets are transferred to book value as opposed to market value given the reduced scope for impermissible tax avoidance in these circumstances.

Nazrien Kader is the Service Line Leader of Taxation Services  and  Lead Director of Financial Services Taxation at Deloitte South Africa.

Filed under: Executive Leadership, Taxation, intra-group transfers, National Treasury, SARS, Section 45 of the Income Tax Act, Taxation