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APRIL 2014 – ISSUE 175

CONTENTS

CARBON TAX 2296. Incentives for renewable energy

EXEMPTIONS 2300. Employee share schemes

COMPANIES 2297. Mining and prospecting

EMPLOYEES’ TAX 2301. Employer provided low cost

housing

CUSTOMS AND EXCISE

2298. Search and seizure provisions unconstitutional

SARS AND NEWS 2302. Interpretation notes, media releases and other documents

DEDUCTIONS 2299. Empowerment costs CARBON TAX

2296. Incentives for renewable energy Carbon emissions incentives Certified emissions reduction exemption

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Section 12K of the Income Tax Act, No. 58 of 1962 (the Act) provides for a tax exemption on any amount accrued in respect of the disposal of any certified emission reduction (CER) credit derived in the furtherance of a qualifying clean development mechanism. To stimulate the uptake of Clean Development Mechanism (CDM) projects in South Africa, income from primary certified emission reductions, which was exempt from income tax from 2009 to 2012, will be extended to 31 December 2020. This is in line with the adoption of the second commitment period of the Kyoto Protocol. The VAT Act does not provide for exemption from VAT on the disposal of a CER credit. It is arguable that the disposal of CER credits should be viewed as a supply of services for VAT purposes and that, on exportation of CER credits, this service is zero-rated for VAT purposes. Energy efficiency incentives Industrial policy projects additional allowance This is an incentive in relation to industrial policy projects, including greenfield and brownfield manufacturing projects. One of the qualifications for eligible projects is the use of improved energy efficiency and cleaner production technology. Measurement and verification (M&V) of savings will be required to verify that savings are sustained over the incentive benefit period of four years. Under Section 12I of the Act (Industrial Policy Projects), projects that have already received incentives or grants under other types of schemes will be excluded. Such projects need to be ring-fenced and taken out of the equation when calculating and reporting savings for the tax claim.

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Section 12I provides for an additional investment allowance on manufacturing assets (new or used), applied to a project that qualifies as an Industrial Policy Project (IPP). The project must be approved by the Minister of Trade and Industry. Only projects larger than South African rand (ZAR) 200 million qualify for this allowance. The incentive in relation to a qualifying project comprises:

• 75 percent of the cost of a new and unused manufacturing asset used in an IPP within an Industrial Development Zone (IDZ); or

• 35 percent of the cost of a new and unused manufacturing asset that is used in an IPP

• If the qualifying project constitutes a Preferred Project (as defined), the incentive comprises: o 100 percent of the cost of a new and unused manufacturing asset

used in an IPP within an IDZ; or o 55 percent of the cost of a new and unused manufacturing asset

used in an IPP. The incentive (i.e. tax deduction) is limited to:

• ZAR900 million for greenfield projects with preferred status

• ZAR550 million for greenfield projects with qualifying status

• ZAR550 million for brownfield projects with preferred status

• ZAR350 million for brownfield projects with qualifying status. Energy efficiency savings allowance Section 12L provides as a deduction, in determining the taxable income of a taxpayer, an amount in respect of energy efficiency savings by the taxpayer with regard to that year of assessment. The deduction will be calculated at 45 cents per kilowatt hour (or equivalent) of energy efficiency savings. The energy efficiency savings have to be measured and confirmed by an institution, board

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or body as prescribed by regulation. No deduction is allowed if the taxpayer receives a concurrent government benefit in respect of energy efficiency savings. National Treasury has indicated that “some of the revenues generated through the carbon tax will be recycled to fund the energy efficiency savings tax incentive.” Production of renewable energy and fuels allowance Section 12B provides for an accelerated capital allowance for machinery, plant implements, utensils or articles, owned by the taxpayer, which are brought into use for the first time by the taxpayer for purpose of its trade. This section applies where the assets are used for purposes such as the generation of electricity from wind, sunlight, gravitational water forces or biomass. The allowance is calculated as 50 percent of the cost of construction of the assets for the taxpayer in the first year, 30 percent in the second year, and 20 percent in the third year. The allowance also applies to all improvements (other than repairs) and supporting structures that would form part of the machinery, plant, implement utensil or article. Research and development allowance Aside from the general 100 percent deduction, this allowance (Section 11D) provides for an additional 50 percent for all expenditures incurred in respect of eligible R&D activities. The additional 50 percent uplift will only apply to R&D approved by the Department of Science and Technology. R&D in respect to green and energy-saving industries has been identified as a new area of focus. Environmental incentives Environmental treatment and recycling or waste disposal asset allowance

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Section 37B provides for an allowance with regard to the cost incurred in acquiring a new and unused environmental treatment and recycling asset or environmental waste disposal asset used in the context of manufacturing. The allowance in respect of an environmental treatment and recycling asset is 40 percent of the cost of the asset in the first year and 20 percent per annum for the next three years. The cost of waste disposal assets can be written off on a straight line basis over 20 years (5 percent per year). Government grants/subsidies

Grants Potential Grant

Description Rates/Basis Source

Manufacturing Competitive Enhancement Programme (MCEP)

The MCEP is a cost-sharing incentive available to existing manufacturers for expanding or upgrading facilities. The grant is based on Unilever’s Manufacturing Value Added (MVA) which is calculated on sales less costs of production. The MCEP is further broken into several components, including the Capital Investment and Green

The maximum grant available is limited to 7 to 10 percent of MVA. Within this limit a benefit of 30 to 40 percent of the expenditure may be granted, capped at ZAR50 million.

Department of Trade and Industry (DTI)

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Technology and Resource Improvement components.

MCEP The Capital Investment component is utilised to support upgrading and expansion of equipment that will lead to the creation of new jobs or the retention of existing jobs.

The main qualifying criteria is that jobs should be maintained for two years and the company must be a level 4 B-BEEE contributor or must have plans in place to achieve this score in two years.

Applications need to be submitted at least 60 days prior to the commencement of the commercial use of the assets.

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Incentives

Potential Grant

Description Rates/Basis Source

Manufacturing Investment Programme (MIP)

The MIP is a tax-free grant available to manufacturing entities which is calculated based on the size of the project.

The grant is 15 percent of qualifying costs of the project.

DTI

MIP The MIP is available to existing manufacturers who plan to increase their production facilities. The grant is payable over a 2 year period.

A scoring system is in place to establish if the project will qualify for this grant. Points are allocated based

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on the sector, the B-BEEE score and the number of additional jobs created.

Applications need to be submitted at least three months prior to planned commencement date of production.

KPMG ITA: Sections 11D, 12B, 12I, 12K, 12L and 37B VAT Act: Section 11

COMPANIES

2297. Mining and prospecting This article deals with the taxation of mining and prospecting companies that are tax resident in South Africa and their non-tax resident shareholders. What is certain is that they are subject to taxes. Uncertain and even unpredictable are (1) the type of taxes and (2) the amount of tax that these companies would be subject to and liable for.

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The first uncertainty mainly originates from the “State Intervention in the Mining Sector” or so-called SIMS report that the ANC issued and the recommendations contained therein regarding the proposed fiscal changes to the taxation regime for prospecting and mining companies. The most notable recommendation being to introduce a mineral resource rent tax, similar to what Australia introduced a few years ago which received significant opposition and criticism. However, this article touches on the second uncertainty. The second uncertainty stems from the difference in interpretation by taxpayers and the South African Revenue Service (SARS) of the existing and complex tax laws applicable to mining companies and prospecting companies. This is fuelled by SARS being under pressure to collect revenues in an industry where companies’ profits have shrunk significantly (due to rising costs and the decline in commodity prices) and in most instances they are making losses. This has had a direct impact on, inter alia, the amount of income tax and mineral royalty collections from these companies. As a result, in the integrated tax audits that SARS conducts on mining and prospecting companies, some of the areas of tax that SARS focuses on are the following: Mining operations versus manufacturing operations Where mining companies in the past treated their mineral processing or beneficiation operations as “mining operations” for income tax purposes in order to take advantage of the very beneficial 100% accelerated capital expenditure allowance (the capex allowance), they now face challenges to treat these operations rather as manufacturing as opposed to mining operations, resulting in only a claim for the manufacturing allowances or wear-and-tear allowances which firstly is limited in its application to the type of qualifying expenditure (compared to the capex allowance) and is spread over a number of

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years (compared to a 100% deduction for the capex allowance). This could result in a cash tax outflow much sooner than planned. This difference in interpretation arises essentially from the unclear definition of “mining” or “mining operations” contained in the Income Tax Act, No. 58 of 1962 (the Act) and the lack of a definition of the word “mineral” contained in such definition. This is further fuelled by provisions of the Mineral and Petroleum Resources Royalty Act, No. 28 of 2008, and its interpretation and application in particular to the so-called “unrefined mineral resources” contained in Schedule 2 to such Act. These actions, arguably, are contrary and counter-active to the Government’s call on mining companies to beneficiate the minerals locally.

The tax treatment of prospecting expenditure There appears to be a difference in interpretation under which section of the Act prospecting expenditure should be claimed, which impacts directly on the overall income tax position and financial viability of the project and therefore of the company. The application of the “ring-fencing” provisions As mentioned above, a mining company is entitled to claim 100% of its qualifying capital expenditure (capex) as a deduction against its taxable income, subject to two limitations or the so-called “outer” and “inner” ring-fencing provisions, i.e. such capex can only be claimed against “income derived from mining operations” or so-called mining income and secondly where a company operates two or more mines, the capex deduction per mine is limited to the mining income derived from that mine. Therefore, where a mining company operates two or more mining operations the question is whether the different mining operations are “separate and distinct” and as such are not “one mine” but separate mines. In addition, there is uncertainty (although case law provides some but not clear enough guidance) on when income constitutes mining income or non-mining income. The conclusion of the analysis on these issues

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has a direct bearing on the application of the ring-fencing provisions and the overall income tax position and financial soundness of the mining company. Mineral royalties Although the Mineral and Petroleum Resources Royalty Act is a mere 12 or so pages, the interpretation and application of these provisions, especially to the so-called unrefined mineral resources, is very complex and creates uncertainty in the interpretation thereof to the various mineral resources. Evidence of this is in the recent change to the tax legislation which would result in coal export mining companies having to pay the mineral royalty on its export sales price for beneficiated/washed export quality coal as opposed to market related price for unwashed (typically Eskom quality) coal. Again this action, arguably, is contrary and counter-active to the Government’s call on mining companies to beneficiate minerals locally.

Diesel rebates Mining companies face challenges by SARS on the entitlement and application of diesel rebates (which is administered through the Value-Added Tax (VAT) system) applicable to their mining operations, which could have a significant impact on the amount of VAT refund or liability of the company. Mining housing There is significant pressure on mining companies to provide ownership of housing to mine workers and their families. However, there appears to be a mismatch on the income tax (for the mining company and/or the company providing the housing), the employees’ tax (PAYE) and the VAT treatment in this regard. The tax costs arising in such instance has a direct bearing on the overall cost and viability of providing mining housing to employees. Social and labour plan costs

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In order to obtain and keep a mining right, mining companies must have an approved social and labour plan that involves the spending of money by the company on the activities specified in such plans. There is uncertainty on the tax treatment (from an income tax, donations tax and VAT perspective) of this expenditure in the hands of the mining companies. Again the tax cost arising in this regard adds to the overall cost of mining. Merger and acquisition transactions It is notable that companies or rather their shareholders are revisiting their mining and prospecting portfolios and are either selling a mining operation or prospecting operation, that is non-core or otherwise not viable in the portfolio (i.e. an asset sale) to a third party; or selling shares and loan claims in a company holding the mining or prospecting asset. Where an asset sale is envisaged, apart from the very complex tax consequences arising on such sale, the parties may be required to obtain a so-called “effective valuation” from the Department of Mineral Resources the purpose of which is to determine the value and the apportionment of the purchase price between the mining property (typically mining rights, prospecting rights, land etc.), for which no capex allowance is available, and the mining assets on which the purchaser can claim the 100% capex allowance. The interpretation and application of this section is complex and since the introduction of Capital Gains Tax (CGT) it is debatable whether this section has served its purpose and is still required. Where the shares in the company are being acquired (as opposed to an asset deal) the cost of the funding of the acquisition is important, especially where interest-bearing debt funding is used. The interest deductibility rules in this regard are very complex and at this stage require approval from SARS before any interest is deductible. Where the transaction involves a share exchange, there are numerous and complex tax rules to be considered, which could trip up both the seller and purchaser, which if, unaware of these rules, could get a nasty and hefty tax bill. Non-tax resident shareholders selling their shares (whether

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directly or indirectly through intermediary companies) in South African mining companies or prospecting companies may be subject to South African CGT and if so, the purchaser is obliged to withhold 7.5% of the purchase price as an advance payment of such CGT and pay it over to SARS. In this regard, it is uncertain whether mining rights or prospecting rights constitute immovable property, which would have a direct impact on the conclusion of the analysis of the CGT liability or not of such non-resident shareholder. Conclusion Since 1 October 2012, when the new Tax Administration Act, No. 28 of 2011 (TAA) came into effect, SARS is imposing hefty understatement penalties (up to 200%) on any adjustments made to a taxpayer's tax position (whether it results in actual tax being payable or not) following audits conducted by SARS on mining and prospecting companies. In certain instances, these penalties are imposed on tax years prior to 1 October 2012, which arguably is not fair and just administrative action and/or unconstitutional. From a foreign direct investment perspective certainty and predictability are two key factors for investors when deciding on whether and the quantum of the investment they would introduce into a country. It was therefore very refreshing when the Minister of Finance announced the establishment of the Davis Commission to investigate our tax system including the taxation of mining companies. Hopefully Judge Davis will take the above-mentioned and other taxation issues into consideration when the time comes to address the taxation of mining and prospecting companies to make this industry attractive again for foreign investors. Until such time, mining and prospecting companies and their shareholders should take advice from their mining tax advisors when faced by challenges by SARS or making investment decisions, where the types of taxes and the

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quantum thereof, due to, inter alia, the complexity thereof, no doubt plays a significant role. ENSAfrica ITA: Sections 1 definition “mining operations”, 15, 36, 37 and 35A Mineral and Petroleum Resources Royalty Act, No. 28 of 2008 TAA: Sections 222 and 223 CUSTOMS AND EXCISE

2298. Search and seizure provisions unconstitutional On 8 April 2013 in Gaertner v Minister of Finance [2013] 75 SATC 184, the Western Cape High Court held that sections 4(4)(a)(i)-(ii), 4(4)(b), 4(5) and 4(6) of the Customs and Excise Act, No. 91 of 1964 (the Customs and Excise Act) are inconsistent with the Constitution, and declared them invalid. The declaration of constitutional invalidity has now been confirmed by the Constitutional Court in a unanimous judgment handed down on 14 November 2013. However, the Constitutional Court suspended the declaration of invalidity for six months to enable Parliament to remedy the unconstitutionality. The decision of the Constitutional Court is significant, not only in relation to the specific issue of the constitutionality of search and seizure in the context of the Customs and Excise Act, but for the court’s general observations on the nature of and limitations to the right of privacy, in the business and in the domestic sphere. These dicta will carry great weight if the constitutionality of the search and seizure provisions of the Tax Administration Act, No. 28 of 2011 (the TAA) comes under scrutiny.

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The facts of the case In this particular case, the first and second applicants (Gaertner and Klemp) were directors of the third applicant, Orion Cold Storage (OCS), which was an importer and distributor of bulk frozen foodstuffs and held licences for storage warehouses. Officials of the South African Revenue Service had conducted a search at OCS’s premises and at Gaertner’s home in terms of section 4 of the Act, which does not require SARS officials to obtain a prior warrant. The judgment recounts disturbing conduct on the part of those officials – they gained access to the premises on the false pretence that they were merely conducting a bond inspection, and they “warned if not threatened” Gaertner that obstructing a search was a criminal offence and that they would, if necessary, call the police for assistance. The SARS officials did not have a search warrant, and they told Gaertner that a warrant was not needed for a search in terms of section 4 of the Customs and Excise Act. After searching the company’s business premises they proceeded to Gaertner’s home to continue the warrantless search there. The SARS officials refused to give Gaertner reasons for the search and would not tell him what they were looking for. In the process of the search they went through personal belongings and gained access to the home computers, including those of Gaertner’s children. The issues before the court

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In the hearing in the Constitutional Court, all the parties were agreed that section 4 of the Customs and Excise Act is inconsistent with the Constitution and should be declared invalid, as it infringes the right to privacy. However, the parties disagreed on the extent of the invalidity and on how the reading-in by the court should be formulated. The judgment records that – ‘After some initial half-hearted tenders, SARS finally tendered the return of all seized goods and the applicants’ costs on an attorney and client scale.’ The constitutional right to privacy Citing prior judicial decisions, the court affirmed (at para [35] of the judgment) that – ‘The right to privacy extends beyond the inner sanctum of the home. Even though businesses do have a right to privacy, they have a lower expectation of privacy as to the disclosure of relevant information to the authorities as well as the public [and] regulated businesses possess a more attenuated right to privacy, more so if the business is public, closely regulated and potentially hazardous to the public.’ The court pointed out that sections 4(4)(a)(i)-(ii), 4(4)(b), 4(5) and 4(6) of the Customs and Excise Act authorise warrantless searches at any time and at any premises whatever, that this clearly extends to private homes, and that the only qualification on the exercise of the searching power is that an officer may enter any premises for the purposes of this Act. The court said that the wording of these provisions –

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‘is so broad that it brings within its sweep not only the places of business and homes of people who are players in the customs and excise industry, but also the homes of their clients, associates, service providers, and employees and their relatives. Quite conceivably, the premises – business or homes – of any person who, somehow, may be linked to a player in the customs and excise industry may be the subject of a search in terms of the impugned sections.’ The court went on to say that – ‘The language of the section says nothing about the need for the searches – regardless of type – to be motivated by a suspicion, let alone a reasonable one. This is true of business premises and people’s homes. The provisions are broad as to the manner of conducting the searches. Searches may be conducted in private dwellings at any time, and officials may not only break in at the dwellings but, once inside, they may even break up floors. And they do not need a warrant to do all this. That this power – unbounded as to time, scope of the search and type of premises – is extremely intrusive is manifest.’ The court concluded (at para [43]) that sections 4(4)(a)(i)-(ii), 4(4)(b), 4(5) and 4(6) of the Customs and Excise Act do indeed limit the right to privacy. Justification for the limitation on the right to privacy As to whether the limitations on the right to privacy inherent in the statutory provisions could be justified in terms of section 36 of the Constitution, the court quoted from its decision in Magajane v Chairperson, North West Gambling Board [2006] ZACC 8 in which it was said that – ‘The limitation analysis in terms of section 36 involves a proportionality review. A court has to consider an applicant’s expectation of privacy and the breadth of

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the legislation, among other considerations. The expectation of privacy will be more attenuated the more the business is public, closely regulated and potentially hazardous to the public.’ Quoting from its own previous decision in Mistry v Interim Medical and Dental Council of South Africa [1998] ZACC 1; 1998 (4) SA 1127 (CC), the court said (at para [48]) that – ‘The existence of safeguards to regulate the way in which state officials may enter the private domains of ordinary citizens is one of the features that distinguish a constitutional democracy from a police state. ... . [The right to privacy] accordingly requires us to repudiate the past practices that were repugnant to the new constitutional values, while at the same time re-affirming and building on those that were consistent with these values.’ The court went on to say (at paras [54] and [55]) that – ‘The primary function of [excise duties and levies] is to ensure a constant stream of revenue for the state, with a secondary function of discouraging consumption of certain products that are harmful to health or the environment. The revenue generated from these duties and levies amounts to approximately ten per cent of the total revenue received by SARS. This means customs and excise controls serve an important public purpose. The Act is essentially a fiscal piece of legislation. The tight regulation of customs and excise is calculated to reduce practices that are deleterious to the purpose of the customs and excise regime. The impugned provisions ensure effective monitoring and prevent – as far as possible – evasion of payment of what is due in terms of the Customs and Excise Act. SARS tells us that despite the industry regulation that is in place, the country still loses billions of rand. Thus there is a need for regular inspections.'

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The court differentiated business premises and private homes, and noted (at para [63]) that – ‘The customs and excise industry is closely controlled and regulated. Given that fact, participants in the customs and excise industry must be taken to expect regular inspections. Consequently, the right to privacy in respect of business premises in this context is greatly attenuated. On the other hand, in respect of private homes the right remains as strong as one can imagine.’ As regards the impugned provisions of the Customs and Excise Act, the court again remarked on the nature and scope of powers that could be exercised without a warrant, and said (at para [67] - [68]) that there must be a rational connection between the purpose of the law and the limitations on constitutional rights imposed by the legislation, and that – ‘It is difficult to see how the achievement of the basic purposes of the Customs and Excise Act requires that inspectors be allowed to enter private homes and inspect documents and possessions at will. ... Exceptions to the warrant requirement should not become the rule. A warrant is not a mere formality. It is a mechanism employed to balance an individual’s right to privacy with the public interest in compliance with and enforcement of regulatory provisions.' The court said (at para [73]) that – ‘there is no cogent reason for not providing for warrants in respect of searches of people’s homes, with exceptions similar to those provided for in section 22 of the Criminal Procedure Act. There is no readily discernible reason – in conducting searches – for not having bounds as to time, place and scope.’

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The court concluded (at para [74]) that the impugned provisions of the Customs and Excise Act cannot be justified, but said that it would be problematic to draw a distinction between routine and non-routine searches and between types of premises. The court said (at para [86]) that – ‘Privacy is most often seen as a fundamental personality right deserving of protection as part of human dignity. This Court in Mistry held that, to the extent that a statute authorises warrantless entry into private homes and the rifling through private possessions, the statute breaches the right to privacy. To this end, it is necessary that the right to privacy with regard to the homes of individuals and their private possessions is protected. In this context the expectation of privacy is higher and, at the very least, entry and searches conducted there have to be authorised by warrants.’ The order of the court In the result, the Constitutional Court confirmed the Western Cape High Court’s declaration of constitutional invalidity in relation to 4(4)(a)(i)-(ii), 4(4)(b), 4(5) and 4(6) of the Customs and Excise Act, but held that this would not be retrospective. The order was to be suspended for six months to afford the legislature an opportunity to cure the invalidity. During the period of invalidity, section 4(4) of the Customs and Excise Act would be deemed to read in the manner laid down by the court. In essence, what would be read into the Customs and Excise Act as an interim measure would be the requirement of a warrant where SARS officials wish to search private residences for the purposes of that Act.

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(Editorial comment: Section 16 of the Tax Administration Laws Amendment Act No. 39 of 2013 gives effect to the comments of the court.) PwC Constitution of the Republic of South Africa: Section 21 and 36 Criminal Procedure Act: Section 22 Customs and Excise Act No. 91: Section 4 TAA: Sections 59 to 66 DEDUCTIONS 2299. Empowerment costs Generally, the Income Tax Act, No. 58 of 1962 (the Act) contains various provisions relating to deductibility of specific expenditure and certain of these have been identified as possibilities for the deduction of expenditure relating to indirect Black Economic Empowerment (BEE) measures, such as section 12H learnership allowances, section 12I additional investment and training allowances, section18A donations to public benefit organisations and various capital allowance provisions. If one of the specific deduction provisions does not apply, the general deduction formula contained in section 11(a) read together with section 23(g), must be applied. It must therefore be determined whether any such empowerment expenditure was incurred in the production of income and that it is not of a capital nature. It was confirmed in the case of CIR v Pick 'n Pay Wholesalers (Pty) Ltd [1987], 49 SATC 132, that expenditure incurred for general philanthropic purposes, would most likely not be regarded as being incurred in the course of carrying on a trade and would therefore not be deductible under section 11(a) read with section 23(g). In the matter of Warner Lambert SA (Pty) Ltd v Commissioner for SARS [2003], 65 SATC 346, the court dealt with the deductibility of social

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responsibility expenditure and found that the relevant expenditure incurred was deductible. The company that had incurred the expenditure was a subsidiary of a US company and adhered to the Sullivan Code, which is very similar to the current empowerment principles in South Africa. As mentioned previously, SARS has issued two rulings dealing with the deductibility of similar expenditure. Binding Class Ruling 2 (BCR 2) dealt with expenditure in respect of corporate social responsibility, indicating that such expenditure would be deductible (this expenditure related to bursary payments). Binding Private Ruling 113 (BPR 113) likewise indicated that expenditure associated with Broad Based BEE, would be deductible. Recently, BCR 2 has created some concern amongst taxpayers, given that its period of validity, dated 28 August 2009 to 27 August 2013, has expired and many taxpayers sought to rely on the ruling in deducting similar expenditure. In light of the above, it must be borne in mind that the application of BCR 2 was specifically limited to a class of taxpayers and could not be seen to be generally applicable to every taxpayer. SARS has no obligation to apply a class or private ruling to any other particular set of facts in the same way. We therefore suggest that the taxpayer always apply the provisions of the Act, namely either specific deduction provisions or the general deduction formula contained in section 11(a), read with section 23(g), to their individual set of facts and does not rely blindly on rulings in determining the deductibility of empowerment or similar expenditure. This evaluation should have been completed both during the application of BCR 2, as well as after its expiry and as such, the expiry of the ruling is not a cause for great concern. SARS can only be bound by the provisions of general rulings and when it comes to empowerment expenditure, it is always best not to count one's deductibility chickens before they hatch.

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Cliffe Dekker Hofmeyr ITA: Sections 11(a), 12H, 12I, 18A and 23(g) BCR: 2 BPR: 113 EXEMPTIONS 2300. Employee share Schemes As a general rule, subject to certain exceptions, local dividends received and accrued to a South African tax resident are exempt from normal tax in terms of section 10(1)(k) of the Income Tax Act, No. 58 of 1962 (the Act). One such exception applies to employee share schemes by virtue of the application of section 10(1)(k)(i)(dd). Section 10(1)(k)(i)(dd) of the Act Section 10(1)(k)(i)(dd), which was introduced from 1 January 2011, prescribes that a dividend will not be exempt from normal tax if such dividend is received or accrued in respect of a restricted equity instrument (as defined in section 8C) unless: the restricted equity instrument constitutes an ‘equity share’ for purposes of the Act, other than an equity share that would have constituted a ‘hybrid equity instrument’ as defined in section 8E(1) but for the 3-year period requirement; or the dividend constitutes an equity instrument; or the restricted equity instrument constitutes an interest in a trust and, where that trust holds shares, all of those shares constitute equity shares, other than equity shares that would have constituted hybrid equity instruments as defined in section 8E(1) but for the 3-year period requirement.

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Accordingly, dividends in respect of restricted equity instruments (for purposes of section 8C) will be taxed as normal income in the hands of the recipient, unless it falls within one of the abovementioned exclusions. The tests to be applied in each instance are as follows: First Test: the employee must hold an ‘equity instrument’ An ‘equity instrument’ is widely defined in section 8C to mean a share in a company, including: an option to acquire such a share or part of a share; any financial instrument that is convertible to a share; and any contractual right or obligation, the value of which is determined directly or indirectly with reference to a share. Second Test: the equity instrument must be acquired by virtue of employment The equity instrument must be acquired by virtue of the employee’s employment. This means that there must be a direct or immediate link between the employment of the taxpayer and the acquisition of that equity instrument. The fact that there is a relationship between the employment of the taxpayer and the acquisition of the equity instrument will not be sufficient, as the employment (and services rendered to the employer) must be the direct cause for acquisition of the equity instrument. In the absence of such direct, immediate and primary cause, the test would not be fulfilled. Third Test: the equity instrument must be restricted An equity instrument becomes unrestricted when it ‘vests’ in a taxpayer for purposes of section 8C of the Act. An unrestricted equity instrument is deemed to vest on the date that it is acquired by the taxpayer, whilst a restricted equity instrument is deemed to vest in a taxpayer when all the restrictions in respect of such equity instrument cease to have effect, or immediately before the taxpayer disposes of such equity instrument, whichever is the earlier.

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Fourth Test: the three exceptions In order to escape a taxable dividend on a restricted equity instrument, at least one of the following three subtests must be fulfilled: Subtest 1: In terms of this test, the restricted equity instrument must constitute an ‘equity share’, other than an equity share that would have constituted a hybrid equity instrument as defined in section 8E(1) but for the 3-year period requirement. The term ‘equity share’ is defined in the Act as a share in a company, excluding any share that, neither as respects dividends nor as respects returns of capital carries any right to participate beyond a specified amount in a distribution. The use of the words “neither as respects dividends nor as respects returns of capital” indicates that both the right to dividends and the right to the capital must be restricted before a share ceases to be an equity share. Therefore, if a shareholder’s right to dividends in respect of a share is restricted but that shareholder's right to the capital is unrestricted, the share will still constitute an equity share (and vice versa, i.e. if the capital is restricted but there is an unlimited right to dividends). On the other hand, if the right to receive both dividends and capital is restricted, the share will not be an ‘equity share’. The equity share must further not constitute a hybrid equity instrument but for the 3-year period requirement. In this regard, the equity share will constitute a hybrid equity instrument if: that share does not rank pari passu as regards its participation in dividends or foreign dividends with all other ordinary shares in the capital of the relevant company or, where the ordinary shares in such company are divided into two or more classes, with the shares of at least one of such classes; or any dividend or foreign dividend payable on such share is to be calculated directly or indirectly with reference to any specified rate of interest or the time value or money; and

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any of the following three requirements are met: the issuer of that share is obliged to redeem that share in whole or in part; that share may at the option of the holder be redeemed in whole or in part; or at any time on the date of issue of that share, the existence of the company issuing that share is to be terminated or is likely to be terminated upon a reasonable consideration of all the facts at the time. Subtest 2: In terms of this test the dividend must constitute an equity instrument as defined in the first test. Subtest 3: In terms of this test, the restricted equity instrument must constitute an interest in a trust, and where that trust holds shares, all of those shares must constitute equity shares, other than equity shares that would have constituted hybrid equity instruments as defined in section 8E(1) but for the 3-year period requirement. In this regard, the same test as in subtest 1 above will apply. The application of section 10(1)(k)(i)(dd) can be illustrated as follows: A trust acquires shares in an operating company. The trust then grants vested rights to the dividends received on these shares to the beneficiaries of the trust, who are all employees of an operating company, by virtue of their employment with the operating company. The vested rights of the employees constitute equity instruments for purposes of section 8C (contractual rights, the value of which is determined with reference to the shares). If the vested rights are unrestricted, the dividends will be exempt, and if the vested rights are restricted, the dividends will only be exempt if the requirements of subtest 3 above are met. The shares held by the trust also constitute equity instruments as a result of section 8C(5)(b). The taxation of the dividends on these shares will also depend on whether the shares are restricted or unrestricted. Assuming that the shares are

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restricted equity instruments, the only way to escape taxation would be if the shares are equity shares but for the 3-year period as set out in subtest 1 above. The draft Taxation Laws Amendment Bill (TLAB) issued in July 2013 proposed to delete section 10(1)(k)(i)(dd) from the Act in its entirety in order to remove the distinction between dividends received from restricted or unrestricted employee shares. It furthermore proposed that the recipient of a dividend from an equity instrument would be taxed on the dividend as ordinary income, unless the equity instrument had vested, i.e. it applied to restricted equity instruments. The draft TLAB, however, did not state which section it proposed to replace section 10(1)(k)(i)(dd) with, as the only further section it referred to under this topic was section 11(t), as referred to in more detail below. Interestingly, the final Taxation Laws Amendment Act, 2013 (TLAA) did not delete section 10(1)(k)(i)(dd) but, instead, left section 10(1)(k)(i)(dd) unchanged and introduced a new section 10(1)(k)(i)(ii). Section 10(1)(k)(i)(ii) According to the Explanatory Memorandum it has become apparent that the anti-avoidance rules in respect of the conversion of salary to dividends are far too narrow as they only target dividends from non-equity shares. The Explanatory Memorandum furthermore states that many employee share schemes hold pure equity shares where the sole intent of the scheme is to generate dividends for employees as compensation for past and future services rendered to an employer, without the employees acquiring ownership of the shares. The dividends received are considered by SARS to be “disguised salaries” for employees, or remuneration for services rendered in another form even though these dividends arise from equity shares.

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To address the concerns raised by SARS, it became necessary to include a specific dividend exemption under section 10 of the Act, as an inclusion under para (c) of the “gross income” definition remains futile because tax exempt dividends are excluded from income in any tax calculation. In terms of section 10(1)(k)(i)(ii), with effect from 1 March 2014, a dividend shall not be exempt from tax if such dividend is received by or accrued to a person in respect of services rendered or to be rendered or in respect of or by virtue of employment or the holding of any office, other than (i) a dividend received or accrued in respect of a restricted equity instrument as defined in section 8C held by that person or (ii) in respect of a share held by that person. An analysis of section 10(1)(k)(i)(ii) reflects the following: As a first test, the dividend must be received or accrued in respect of services rendered or by virtue of employment. It is accepted that there is no difference between the meaning of the words “in respect of” or “by virtue of”, and the distinction is rather superfluous as both require a direct or causal relationship between the employment with the company and the declaring of the dividend. Based on the Explanatory Memorandum, this requirement suggests that the dividend must be compensation for services rendered and, therefore, a disguised salary. Put differently, where dividends are received and there is no motive to disguise such dividends as remuneration, for example as a result of the shareholding only, the requirement will not be met. What is peculiar are the examples given in the Explanatory Memorandum, as they appear to have a broad stroke and suggest that any dividend received through an employment scheme will be by virtue of employment and with no regard to the motive for the declaring of the dividend. The second test is that the dividend must not be received in respect of a restricted equity instrument, i.e. the dividend will only be taxed if it is received in respect of an unrestricted equity instrument. This requirement is quite strange, as according to the Explanatory Memorandum the dividend should not be taxed in the hands of employees where, upon vesting for section 8C purposes

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(i.e. when the equity instrument becomes unrestricted) the equity instrument will be taxed under section 8C. Accordingly, what the Explanatory Memorandum envisages is that if a restricted equity instrument will result in section 8C gains being taxed, a person should not be taxed on the dividend prior to such gains arising. The result of the introduction of section 10(1)(k)(i)(ii) is that no tax will be paid on dividends arising from restricted equity instruments. What is not clear is that if an employee is taxed under section 8C by virtue of the vesting of a restricted equity instrument, such instrument will in any event become an unrestricted equity instrument, with the result that the employee will pay tax on any further dividends paid on such instrument (unless it constitutes a share – see below). This requirement therefore only makes sense if one considers the first test, i.e. that dividends must be received as a disguised salary. The TLAA further states that the measure will not apply to dividends paid in respect of a share held by the employee, i.e. direct shareholders who receive dividends in terms of employee share schemes will not be affected. It is common knowledge that all dividends are paid in respect of shares. If a taxpayer holds the share directly, the taxpayer will be exempt, which means that section 10(1)(k)(i)(ii) will only apply in an indirect environment, such as employee share trusts. This means that even if the dividend is a disguised salary, if the share is held directly it will be exempt, which seems to suggest that there is no issue with receiving a disguised salary if the taxpayer holds the share directly. Dividends tax Dividends payable to natural persons are subject to Dividends Tax (DT) at the rate of 15%. Where dividends are included in the income of a taxpayer by virtue of section 10(1)(k)(i) of the Act, double taxation on the dividends may occur. The solution suggested by the Explanatory Memorandum is that, if dividends are received and distributed in the same tax year by an employee share trust and subject to income tax in the hands of the employee-beneficiary, DT does not

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have to be withheld, and the trust can make a declaration to the relevant Central Securities Depository Participant (listed shares) or the distributing company (unlisted shares) not to withhold DT. Where DT has been withheld by the trust and included in the employee’s income, the trust may make the abovementioned declaration in order to receive the refund of the amount withheld and to distribute the full dividend to the employee. Proposed dividend deductions The draft TLAB proposed that the company declaring the taxable dividend would be entitled to an income tax deduction equal to the amount of the inclusion. In this regard, a new section 11(t) deduction was proposed. The TLAB published in October 2013 removed this proposed deduction in its entirety on the basis that it should discourage companies from “disguising salaries” to employees as dividends. ENSAfrica ITA: Sections 1, gross income para (c), 8C, 8E, 10(1)(k) and 11(t), EMPLOYEES’ TAX 2301. Employer provided low cost housing Introduction As part of Government’s anti-poverty objectives, Government is seeking to provide low-income South Africans with low cost housing and more specifically, ownership of residential property. In this regard, Government appears to be supportive of employers who provide low cost housing to low-income employees with the aim of enabling these employees with the opportunity to acquire ownership of the housing. This is specifically the case in industries where companies operate in remote areas and/or require employees to live away from their ordinary place of residence, like the mining industry. It is common that employers which operate in these industries provide affordable

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low cost accommodation to their employees. To make it affordable for low-income employees to acquire ownership of residential property it is often necessary to transfer the property to low-income employees below market value. In recent years, Government has granted certain tax incentives to employers that provide accommodation to their employees, to the extent that they transfer ownership of the accommodation at below market value prices to such low-income employees. However, the tax implications arising for the employees often do not coincide with the incentives provided to the employers. Due to increased pressure from employees and workers unions on employers regarding remuneration, employers are unlikely to implement any transaction which would negatively impact employees from an earnings perspective. Thus, the current tax implications for the employees have arguably prohibited many employers from implementing tax effective affordable housing plans. As this is counterproductive to Government’s objective, the tax treatment of below market value transfers to employees has now been addressed to an extent, which is explained more fully below. Changes to the current tax regime Previously, the below market value transfer of residential property to an employee may result in a fringe benefit to the employee and accordingly, taxable in the hands of the employee. With effect from 1 March 2014, no tax will be payable on the below market value transfer if- • The employee earned less than R250 000 remuneration (which includes

salary, bonus, fringe benefits, overtime etc.) in the preceding year of assessment in which the acquisition takes place. A special rule applies where the employee was not in the employment for the full year of assessment, which effectively is a gross up of the salary;

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• The market value of the property does not exceed R450 000. This is by way of an amendment of paragraph 5 of the Seventh Schedule to the Income Tax Act, No. 58 of 1962 (the Act) by the addition of subparagraph 3A and the new definition of “remuneration proxy” in section 1.

The above changes are definitely a step in the right direction, but not yet a leap for mankind. Missing steps Low-income earning employees generally would require loans to fund the acquisition of residential property. In this regard, employers would stand in and provide the necessary loans with no or low interest payable. However, loans provided by employers to employees at a rate below the official rate of interest are also taxable as a fringe benefit. This tax treatment remains unchanged. As discussed above, Government has adopted certain tax incentives to employers in light of its objective stated above. For example, favourable tax treatment exists for employers that provide interest-free loans to employees where the employee acquired residential housing from the employer in certain circumstances. However, the interest-free loans to employees may result in tax payable by the employee who received the interest free-loan from his employer. This unfavourable tax consequence is merely one of the few adverse tax consequences arising in relation to these employer provided housing schemes. Conclusion Government is providing incentive measures in respect of below market value transfers of residential property from an employer to its employees. However, the transactions that flow commonly from the transfer of residential property, for example the advance of low interest bearing loans, continue to attract employees’ tax and other adverse tax consequences. Therefore, unless all of the

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tax consequences are addressed in the relevant tax legislation, the unchanged tax regime will hinder any positive outcome which Government was hoping to achieve with the changes to the tax legislation discussed above. Therefore, although the legislative change discussed above is a step in the right direction, further legislative changes are required. In the interim, it is advisable to consult with your tax advisor when embarking on providing housing to employees or transferring ownership of housing below market value to employees to ensure that it does not result in an unforeseen tax liability, whether for the employer or the employee. ENSAfrica ITA: Seventh schedule SARS AND NEWS 2302. Interpretation notes, media releases and other documents Readers are reminded that the latest developments at SARS can be accessed on their website http://www.sars.gov.za. Editor: Mr P Nel Editorial Panel: Mr KG Karro (Chairman), Dr BJ Croome, Mr MA Khan, Prof KI Mitchell, Prof L Olivier, Prof JJ Roeleveld, Prof PG Surtees, Mr Z Mabhoza, Ms MC Foster The Integritax Newsletter is published as a service to members and associates of The South African Institute of Chartered Accountants (SAICA) and includes items selected from the newsletters of firms in public practice and commerce

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and industry, as well as other contributors. The information contained herein is for general guidance only and should not be used as a basis for action without further research or specialist advice. The views of the authors are not necessarily the views of SAICA. All rights reserved. No part of this Newsletter covered by copyright may be reproduced or copied in any form or by any means (including graphic, electronic or mechanical, photocopying, recording, recorded, taping or retrieval information systems) without written permission of the copyright holders.

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