Author: Pieter van der Zwan (NWU)
Pieter van der Zwan revisits the economic reasons for the introduction of section 6quin.
Section 6quin was introduced into the Income Tax Act by the 2011 Taxation Laws Amendment Act as a measure to enable entities to provide services into Africa in a manner that such services were commercially viable. With the section having been in effect for more than 3 years now, it was indicated in the 2015 Budget Review that the concession contained in section 6quin would be withdrawn due to the significant compliance burden that it places on SARS and taxpayers as well as the fact that it is being exploited by some taxpayers.
This article provides a review of the reasons for the introduction of section 6quin, the effect of the proposed withdrawal thereof. It also suggests an alternative that may address the void that would be left if the section is withdrawn due to alleged exploitation thereof.
Reason for introduction of section 6quin
Section 6quat allows South African taxpayers to claim a rebate for foreign tax paid against normal tax payable in South Africa. In order to be entitled to the rebate, the income in respect of which the foreign tax was imposed must however have accrued or been received from a source outside of South Africa. This requirement is premised on the fact that the source country would have the first right to tax profits arising in its state, while the resident country (in the case of foreign sourced income, South Africa) has a secondary right to tax the profit. In addition, section 6quat only allows a rebate where the foreign tax is proved to be payable to the foreign government. As the rebate essentially reduces the South African tax base, this requirement ensures that the relief from double tax is only afforded to residents for valid foreign tax obligations. This means that the foreign tax must be payable in terms of the domestic tax law of the other country after application of the double tax treaty (if any), which may limit the right to impose the tax under the country’s domestic law.
In addition to the rebate, section 6quat also allows for a deduction for foreign taxes. Like the rebate, the deduction is only allowed in respect of taxes that are proved to be payable to foreign governments. The deduction applies where the rebate is not available – normally when the source of the income is not outside of South Africa. The deduction is however much less favourable and effective in reducing the effect of double tax on income as it reduces the taxpayer’s taxable income, as opposed to tax payable on such taxable income.
In principle, double tax should not arise when income is earned from South African sourced services rendered by South African residents to customers abroad as the country of residence of the taxpayer and source of the income are the same. Therefore section 6quat does not have to address such transactions. Most double tax agreements would not allocate a taxing right to the country where the foreign customer is located if the actual source of the income is in South Africa. The tax legislation of many African countries however contain rules that treat or deem the source of the income to be in that country based on the fact that the payer is a tax resident of the country. The income “sourced” in that country due to the deeming provision is then subject to tax there, often to be withheld at the time of payment.
Given the South African taxpayer’s lack of presence in such country, no permanent establishment is likely to exist, which in turn means that the foreign country should in most cases not have the right to tax such income if a treaty has been concluded. Due to the absence of a right to levy tax, this tax cannot be said to be payable to the foreign government. In practice it is however extremely difficult, if not impossible, to recover this tax withheld, based on the deemed source, at the time of payment. As the actual source of the income is in South Africa and the foreign tax cannot be proved to be payable, no section 6quat rebate is available. Similarly, as the tax cannot be proved to be payable, the deduction under section 6quat is also not available. This leaves the South African resident service provider in a position where it has to bear the burden of both the South African as well as the customer’s country tax.
Services that would typically become problematic when trying to apply section 6quat are those where the bulk of the work is done from South Africa while the final product is closely connected to the customers operations abroad. In many instances, the reason for performing the work from South Africa would be that expertise need to be centralised at a location to work on the project for purposes of knowledge sharing or prevention of duplication of functions. South Africa would be that centralised location. In other instances, the reason could just be that it is more cost effective to work from South Africa where the employees normally reside than to pay recurring travel and accomodation costs to perform the same work abroad.
This double tax effect of the African withholding tax together with the normal South African income tax left South African service providers in a position where the commercial viability of providing such services to African customers was threatened due to the high tax burden, which significantly reduced margins earned from the services. The National Treasury indicated in the Explanatory Memorandum that accompanied the 2011 amendments that: “While the South African position is theoretically correct, the practical implication of this position is adverse to South Africa’s objective of becoming a regional financial centre. As long as this theoretically correct position is maintained, the only viable solution for regional operations is to shift their management location to a low-taxed or no taxed location so as to avoid double taxation”. This statement recognises the importance of being able to apply South African based expertise to contribute to, but also to share in the growth of, African economies in the form of fees extracted from these economies.
Effect of section 6quin and implications of the proposed withdrawal
Section 6quin provides a concession that alleviates some of the tax pressure caused by the withholding tax imposed in the country where the customer is situated. The section allows a rebate for foreign tax imposed in respect of South African sourced service income earned for services rendered within South Africa. It is important to note that the nature of services to which the section apply is not limited, even though the Explanatory Memorandum specifically referred to a concession in respect of management fees. The availability of the rebate depends on whether South Africa has concluded a double tax agreement with the other country and the manner in which the tax is paid. This rebate is limited on an income-stream by income-stream basis to South African tax on the profits from such services. Even though this concession cannot provide relief from the fact that withholding taxes are imposed on income on a gross basis without any deduction, the adverse impact of such taxes is reduced by the fact that a further tax burden is not added to it.
An example of services that would typically benefit from the concession in section 6quin are consulting services related to a customer’s business or operations abroad that are rendered at least partially on a remote basis from South Africa or where the routine or behind the scenes work is performed in South Africa. These services include engineering services, architectural and design services, system and process development as well as in some instances management and advisory services. As the work is physically being performed in South Africa, the dominant source of the income would be South Africa in terms of case law such as CIR v Epstein. This may still be the case notwithstanding the fact that the services are perhaps only performed in South Africa purely as a matter of convenience rather than anything else (as illustrated in the cases of ITC 134 and CIR v Nell).
Given the wide scope of the section 6quin, it would however arguably also allow rebates for foreign taxes withheld on payments by foreign customers in respect of services that do not necessarily directly relate to operations or business in the country of the customer, such as manufacturing or procurement activities that are outsourced to be performed in South Africa. These type of services may be closely connected to South African operations and infrastructure. It was not indicated in the 2015 Budget Review what the nature of the exploitation of the section is, but it is submitted that the scenario described may be a situation where the section applies to transactions outside its initially intended scope.
Should section 6quin be withdrawn, it is submitted that South African service providers will again be under similar pressure as before its introduction. The tendency by African tax authorities to require significant taxes to be withheld on payments made to foreign services providers has not necessarily changed since 2012. This may force South African service provider in the long-run to set up their operating bases outside of South Africa, either in the customer country itself (and in this manner ensure it is taxed on profits only) or alternatively in a low-tax country as suggested by the National Treasury, in order to be able to continue to do business and share in the growth of African economies. If the base for providing the services is moved, there is no guarantee that the funds generated will necessarily be repatriated into the South African economy. It is submitted that such a shift of activities together with the funds generated from these activities out of South Africa is not ideal and should not be allowed to take place at the expense of the opportunity to collect tax on this income in the short-term while the activities are still conducted from South Africa.
An alternative model to consider
It is submitted that as a starting point, the South African Government and the National Treasury need to identify the types of service activities that are of strategic importance and at risk of being shifted out of the country in the long-run if no assistance is provided. These may be activities where the nexus of the service is not so closely related to South Africa that it is critical that the service must be performed from South Africa. Put differently, the services are conveniently performed from South Africa but it is not critical to the outcome that South Africa is the base for performing such service. The services are “mobile” in the sense that it can be performed from South Africa or any other different location, whichever is more economically viable. The utilisation of South Africa as a base to render such mobile services from would be strategically important as these type of services attract skilled persons to the country and ensure that the funds generated by the services flow into the South African economy. For purposes of the remainder of this article, these services are referred to as strategically important mobile services. Such mobile services can be contrasted to services that make use of the South African infrastructure, for example, transport or manufacturing, and cannot be performed elsewhere. This exercise of identifying which type of service fees should be protected from double tax may already have been done, at least partially, when the decision was taken to introduce section 6quin into the Income Tax Act.
An alternative model, of which the scope and application may be easier to control, to assist persons that provide strategically important mobile is based on and derived from the current provisions of the South Africa/Botswana double tax treaty relating to technical fees. Article 20(5) of this treaty deems technical fees to arise in the state where the payer is a resident. The term ‘technical fees’ is defined in the treaty to refer to administrative, technical, managerial or consultancy services. Importantly, this concession of the source of income to the payer’s state of residence is limited only the technical services as defined. It is submitted in many instances, the real connection of these types of services to South Africa, other than the fact that the service provider is currently conveniently located in South Africa, is likely to be limited. This deemed source rule in the treaty results in these types of services being performed in South Africa for clients in Botswana to qualify for the rebate in section 6quat as the income now becomes foreign sourced. This reduces or eliminates the burden of double taxation.
It is submitted that by identifying strategically important mobile services, carefully defining the source of these identified services to be outside of South Africa in a manner that is narrow enough to avoid exploitation and thereby ensuring that it is possible to reduce the effect of double taxation using the section 6quat rebate, it may be possible to provide relief similar to that currently provided in section 6quin for these identified services. The advantages of the suggested approach would be that, firstly, the scope of the concession can be well-defined to limit the concession to strategically important mobile services and, secondly, that there will only be a single rebate provision to administer as opposed to the burdensome 60-day FTW01 declaration system followed under section 6quin.
This approach may however not resolve the matter of foreign tax that must be proved to be payable in order to qualify for the section 6quat rebate as many of South Africa’s treaties do not make provision for specific type of business income, such as technical fees. As a result, foreign tax imposed in respect of business profits or income where the South African entity does not have a permanent establishment in the customer’s country will still be imposed contrary to the treaty provisions. A further exception to define the taxes in respect of such strategically important mobile service fees for which the section 6quat rebate is available is likely to be required.
This article revisited the economic reasons for the introduction of section 6quin into the Income Tax Act. It is submitted that the reasons why section 6quin was introduced in 2012 still exist and may in the long-run force providers of services to relocate certain activities to a different base if the aggregate tax burden between South Africa and the source country becomes, and remains, unbearable. This would be particular threat where the connection of the service to South Africa as a base from which to render the service from is not critical. A suggestion to resolve some of the concerns of alleged exploitation of section 6quin, as advanced as the reason for the proposed withdrawal by the National Treasury in the 2015 Budget Review, is made. This suggestion however also highlights some of the challenges that are likely to arise in drafting such an alternative. In conclusion, the discussion in this article shows the importance of identifying certain strategically important activities for which South Africa needs to be an attractive base to render such services from. As the overall economic benefit, besides collecting tax on the income, of such activities for South Africa should outweigh the tax revenue generated by it in the short-run, a more narrowly defined tax concession could contribute in making it possible for these activities to remain based in South Africa for the benefit of the greater South African economy in the long-run.
This article first appeared on the July/August 2015 edition on Tax Talk.