South African dividend stripping rules: Impact on liquidations and cross-border share buybacks
Changes made last year to South Africa's dividend stripping rules have effectively eliminated the ability of group companies to make use of the rollover relief provisions that historically have allowed qualifying liquidations or deregistration of group companies (both local and foreign) to be done on a tax-neutral basis.
As things stand, certain otherwise-exempt dividends declared to qualifying shareholders will be classified as 'extraordinary dividends' and recharacterised as proceeds for capital gains tax purposes upon the disposal of the shares. An extraordinary dividend is a dividend exceeding 15% of the market value of the distributing company's shares either 18 months prior to the disposal/liquidation or as at the date of disposal/liquidation, whichever is the higher.
Following lobbying by taxpayers, the National Treasury has indicated that changes will be made to narrow the range of situations in which the dividend stripping rules will override the group rollover relief rules to "cases where the corporate re-organisation rules are abused by taxpayers". Certainty on what exactly is meant by this, and what the new rules will look like, will only be available towards the end of the year.
Where South African companies or controlled foreign companies (CFCs) in relation to South African companies have recently declared large dividends, taxpayers hoping to benefit from group relief provisions should therefore not dispose of the distributing companies until they are confident that group relief is in fact applicable. Planned eliminations of group companies are consequently on hold pending resolution of this problem.
The dividend stripping rules also have interesting consequences in circumstances where a South African company (SACo) holds shares in a foreign company (ForeignCo) and divests itself of its shareholding in ForeignCo by way of a buyback of its shares by ForeignCo.
If a South African company (or a CFC in relation to a South African company) sells shares in a foreign company, any gain made on the sale may be exempt if the seller has held a certain number of shares for a qualifying period and the buyer is an unrelated party which is tax resident outside South Africa. The purchase price must be market related. If any of these criteria are not met, capital gains tax (CGT) will apply.
A route which in the absence of the dividend stripping rules could have been followed to avoid CGT in all circumstances is the share buyback route. This involves a prospective purchaser first subscribing for an interest in ForeignCo, with ForeignCo then applying the proceeds of the subscription to buyback SACo's shares in ForeignCo. The prospective purchaser would then own 100% of the shares in ForeignCo. Ignoring the dividend stripping rules, any portion of the buyback consideration which was treated under the tax law in the foreign company's jurisdiction as a dividend would in these circumstances generally also be classified as a tax exempt foreign dividend in the hands of SACo. As a result of the dividend stripping rules referred to above, however, if SACo holds a so-called 'qualifying interest' in ForeignCo, 85% of the portion of the buyback consideration, which constitutes an exempt dividend in the hands of SACo, is likely to be taken into account for CGT purposes in the hands of SACo. Depending on the circumstances, however (and clearly subject to the application of substance-over-form and other general anti-avoidance rules), this could still be more beneficial than a direct sale in which the full proceeds would be taken into account for CGT purposes.