Crossing borders, crossing fingers: Cross-border funding tax considerations in a South African M&A context

General considerations 

While there is a plethora of different instruments available to investors providing funding to a South African business, these can generally be summarised as constituting either debt or equity for tax purposes. While not strictly tax-specific, South Africa has an exchange control regime in place, governed by the South African Reserve Bank (“SARB”), which must be complied with when introducing offshore funding into SA. 

For equity funding, it is critical that the share certificates held by a non-resident in a South African company are endorsed ‘non-resident’ on acquisition. If not, the SARB may prohibit the SA company from remitting dividends to its non-resident shareholders.  

Foreign debt funding is also required to be put on record with the SARB, to enable the SA borrower to make outbound loan repayments to its foreign lender.  

The SARB places certain limits on the rate of interest that can be charged by a foreign lender to a South African borrower, regardless of the arm’s length interest rate determined through a transfer pricing benchmarking study.  

Regarding thin capitalisation, it is important to note that South Africa does not have a ‘safe harbour’ debt to equity ratio. The ratio is currently measured on the ‘arm’s length’ principle through our transfer pricing rules, which include considerations such as the borrower’s capacity to carry debt on a standalone basis, and whether an independent third party would lend the borrower the same amount on the same terms. The onus is on the SA borrower to provide evidence (generally through benchmarking studies) that the amount of debt and the terms thereof satisfy the arm’s length conditions.  

Where the South African Revenue Service (“SARS”) is of the view that debt funding is not arm’s length, it may make transfer pricing-related adjustments. These can impact both corporate income tax, as well as withholding tax.  

Equity considerations 

South Africa levies a dividend withholding tax (“DWT”) at a default rate of 20% on dividends paid to non-residents. This rate can be reduced through the application of a double tax agreement (“DTA”)¹. This DWT applies to dividends declared in relation to both equity and preference shares, regardless of the accounting treatment thereof. This is on the assumption that the shares do not constitute a ‘hybrid equity instrument’.  

While this article does not delve into the complex topic of hybrid instruments, it is worth noting that where equity funding bears the characteristics of debt funding, there is a risk that any dividends paid on such instrument may be reclassified for tax purposes as taxable interest income in the hands of the shareholder.  

Certain solvency and liquidity requirements must be met in terms of company law prior to the declaration of each dividend. Dividends are not deductible in determining the SA company’s corporate income tax liability.  

A return of ‘contributed tax capital’ (“CTC”) to a shareholder generally falls outside of the ‘dividend’ definition, and as such, should not attract DWT. However, there may be capital gains tax implications for the foreign shareholder in this instance.  

The transfer of SA shares or foreign shares listed on a South African exchange is also subject to securities transfer tax (“STT”) at a rate of 0.25%. In general, this tax is ultimately borne by the purchaser, and incoming foreign shareholders should therefore be aware of this additional cost. The issue of new shares generally is not subject to STT.  

Debt considerations 

South Africa levies an interest withholding tax (“IWT”) at a default rate of 15% on interest paid to non-residents. As with DWT, this rate can potentially be reduced by an applicable DTA, provided that certain documentation requirements are adhered to.  

Assuming that the thin capitalisation and transfer pricing requirements (noted earlier in this article) have been met, interest is generally tax-deductible in the SA borrower’s hands. However, interest deductions may be denied in instances where SARS is of the view that the interest is ‘unproductive’², or where the debt is utilised to acquire shares³.  

In addition, South Africa has a set of domestic interest limitation rules, as set out in section 23M of the Income Tax Act⁴. These rules generally apply to cross-border funding provided to SA companies by a non-resident parent or group company, where the foreign lender is either not subject to IWT, or is subject to a reduced rate of IWT on the interest received from the SA borrower. In such instances, the related interest deduction in the SA borrower’s hands is limited to the sum of interest income and 30% of its ‘adjusted taxable income’⁵, less any interest incurred on non-section 23M debts.  

The portion of interest disallowed as a tax deduction in terms of these limitation rules is deemed (for tax purposes only) to be interest incurred in the immediately following year of assessment and can be carried forward indefinitely. It is important to note that SA’s transfer pricing rules take precedent over section 23M – therefore these interest limitation rules must only be applied after the application of the transfer pricing rules and any required adjustments arising therefrom.  

To further complicate these limitation rules, ‘interest’ for these purposes also includes foreign exchange gains and losses. The deduction of foreign exchange losses can therefore also be subject to these limitation rules.  

In certain instances, foreign lenders may need to write off, waive, or forgive debt funding extended to SA companies. These situations can potentially lead to a taxable recoupment arising in the SA borrower company’s hands, dependent on the purpose for which the debt funding was used.  

In terms of our hybrid rules, lenders should also be mindful that where a debt instrument is more akin to equity funding, there is a risk that the related interest incurred will be reclassified as a non-deductible dividend in specie in the hands of the borrower.  

The takeaway 

There are a number of somewhat complex tax considerations for foreign funders of South African businesses to navigate. In addition to tax, there are also company law and exchange control regulations which must be considered.  

It is strongly recommended that professional tax advice be sought in the planning stages of a potential acquisition or funding transaction, to avoid unnecessary tax leakages, penalties or fines.  

Authors: 

Greg Boy, Associate Director

Graham Molyneux, Partner