Quick Summary. South Africa is a parliamentary democracy with three branches sharing Constitutional authority: the executive, judiciary, and parliament branches. Its blended legal system combines Roman-Dutch civil law, English common law, and customary law. Under South African law, there are three levels of governmental authority: National; Provincial; and Local government.
Beginning in 2001, South Africa moved from a source-based income tax system to a residence-based income tax system. Residents are taxed on their worldwide income. Non-residents are taxed on their South African sourced income. The same rates apply to both residents and non-residents.
The U.S.-South Africa bilateral tax treaty eliminating double taxation entered into force in 1998. The U.S. and South Africa signed a new bilateral tax treaty in June 2014 to implement the U.S. Foreign Asset Tax Compliance Act which went into force in October 2015.
South Africa is a member of the Southern Africa Customs Union (SACU) and the Southern Africa Development Community (SADC). SACU maintains a common external tariff, while SADC is a 15-member free trade agreement.
Exchange control (ExCon) regulations restrict the inflow and outflow of capital in South Africa under the Currency and Exchanges Act 9 of 1933 (Currency and Exchange Act) through the Exchange Control Regulations, which were promulgated on 1 December 1961, as amended from time to time (Exchange Control Regulations).
State-owned enterprises (SOEs) play a significant role in the South African economy. In key sectors such as electricity, transport (air, rail, freight, and pipelines), and telecommunications, SOEs play a lead role, often defined by law, although limited competition is allowed in some sectors (i.e., telecommunications and air). The government’s interest in these sectors often competes with and discourages foreign investment.
- Convention Between the United States of America and the Republic of South Africa for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains, signed at Cape Town on February 17, 1997
- Technical Explanation of the Convention between the United States and South Africa signed on February 17, 1997
Currency. South African Rand (ZAR)
Common Legal Entities. Public company (Ltd.), private company (Pty. Ltd.), close corporation, partnership, business trust, branches.
Tax Authorities. South African Revenue Service (SARS)
Tax Treaties. South Africa is party to more than 70 tax treaties. It is a signatory to the OECD’s MLI and signed a bilateral tax treaty in June 2014 to implement the U.S. Foreign Asset Tax Compliance Act, which went into force in October 2015.
Corporate Income Tax Rate. 28% generally
Individual Tax Rate. 45%
Corporate Capital Gains Tax Rate. 0% / 28% (on 80% of gains)
Individual Capital Gains Tax Rate. Taxed at ordinary income rates on 40% of gains
Residence. Based upon “ordinarily resident” of South Africa status or physical presence for more than 91 days in current year and a specified aggregate presence of more than 915 days in each of five preceding years.
Dividends. 20% (individual residents) / 20% nonresident company) / 20% (non resident individual)
Interest. 15% (nonresident)
Royalties. 15% (nonresident)
Transfer Pricing. Follow arm’s length principles. Certain multinational enterprises are subject to country-by-country (CbC) reporting.
CFC Rules. South African residents subject to tax on share of net income earned by CFC.
Hybrid Treatment. Anti-avoidance rules applicable under the Income Tax Act.
Inheritance/estate tax. No.
The principal purposes of the income tax treaty between the United States and South Africa are to reduce or eliminate double taxation of income earned by residents of either country from sources within the other country and to prevent avoidance or evasion of the income taxes of the two countries.
As in other U.S. tax treaties, these objectives principally are achieved by each country agreeing to limit, in certain specified situations, its right to tax income derived from its territory by residents of the other country. For example, the treaty contains provisions under which neither country generally will tax business income derived from sources within that country by residents of the other country unless the business activities in the taxing country are substantial enough to constitute a permanent establishment or fixed base (Articles 7 and 14 ). Similarly, the treaty contains “commercial visitor” exemptions under which residents of one country performing personal services in the other country will not be required to pay tax in the other country unless their contact with the other country exceeds specified minimums (Articles 14 , 15, and 17). The treaty provides that dividends and certain capital gains derived by a resident of either country from sources within the other country generally may be taxed by both countries; however, the rate of tax that the source country may impose on a resident of the other country on dividends generally will be limited by the proposed treaty. The treaty also provides that interest and royalties derived by a resident of either country generally will be exempt from tax in the other country.
In situations where the country of source retains the right under the treaty to tax income derived by residents of the other country, the treaty generally provides for relief from the potential double taxation through the allowance by the country of residence of a tax credit for certain foreign taxes paid to the other country.
The treaty includes the “saving clause” contained in U.S. tax treaties that allows the United States to retain the right to tax its citizens and residents as if the treaty had not come into effect. In addition, the treaty contains the standard provision that it may not be applied to deny any taxpayer any benefits the taxpayer would be entitled to under the domestic law of a country or under any other agreement between the two countries.
Residence and Application
The treaty generally applies to residents of the United States and to residents of South Africa, with modifications to such scope provided in other articles (e.g., Article 19 (Government Service), Article 24 (Non-discrimination) and Article 26 (Exchange of Information and Administrative Assistance)).
The treaty provides that it generally does not restrict any benefits accorded by internal law or by any other agreement between the United States and South Africa. Thus, the treaty applies only where it benefits taxpayers. As discussed in the Treasury Department’s Technical Explanation of the treaty (hereinafter referred to as the “Technical Explanation”), the fact that the treaty only applies to a taxpayer’s benefit does not mean that a taxpayer could inconsistently select among treaty and internal law provisions in order to minimize its overall tax burden. The Technical Explanation sets forth the following example. Assume a resident of South Africa has three separate businesses in the United States. One business is profitable, and constitutes a U.S. permanent establishment. The other two are trades or businesses that would generate effectively connected income as determined under the Internal Revenue Code (the “Code”), but that do not constitute permanent establishments as determined under the proposed treaty; one trade or business is profitable and the other generates a net loss. Under the Code, all three operations would be subject to U.S. income tax, in which case the losses from the unprofitable line of business could offset the taxable income from the other lines of business. On the other hand, only the income of the operation which gives rise to a permanent establishment would be taxable by the United States under the proposed treaty. The Technical Explanation makes clear that the taxpayer could not invoke the proposed treaty to exclude the profits of the profitable trade or business that does not constitute a permanent establishment and invoke U.S. internal law to claim the loss of the unprofitable trade or business that does not constitute a permanent establishment against the taxable income of the permanent establishment.
Like all U.S. income tax treaties, the treaty is subject to a “saving clause.” The saving clause in the treaty is drafted unilaterally to apply only to the United States. The Technical Explanation states that South Africa elected not to have the saving clause apply for purposes of its tax. Under this clause, with specific exceptions, the treaty is not to affect the U.S. taxation of its residents or its citizens. By reason of this saving clause, unless otherwise specifically provided in the treaty, the United States continues to tax its citizens who are residents of South Africa as if the treaty were not in force. “Residents” for purposes of the treaty (and, thus, for purposes of the saving clause) include corporations and other entities as well as individuals who are not treated as residents of the other country under the proposed treaty’s tie-breaker provisions governing dual residents (as defined in Article 4 (Residence)).
The treaty contains a provision under which the saving clause (and therefore the U.S. jurisdiction to tax) applies to a former U.S. citizen or long-term resident whose loss of citizenship or resident status, respectively, had as one of its principal purposes the avoidance of tax; such application is limited to the ten-year period following the loss of citizenship or resident status.
Exceptions to the saving clause are provided for the following benefits conferred by the treaty: correlative adjustments to the income of enterprises associated with other enterprises the profits of which were adjusted by South Africa (Article 9, paragraph 2); exemption from U.S. tax on social security benefits paid by South Africa, alimony and child support payments made by a resident of South Africa and cross-border contributions to a South African pension fund (Article 18, paragraphs 2, 4, 6 and 7); relief from double taxation (Article 23);nondiscrimination (Article 24); and mutual agreement procedures (Article 25).
In addition, the saving clause does not apply to the following benefits conferred by the United States with respect to an individual who neither is a citizen nor has been admitted as a permanent resident. Under this rule, the specified treaty benefits are available to a South African citizen who spends enough time in the United States to be taxed as a U.S. resident under Code section 7701(b), provided that the individual has not acquired U.S. immigrant status (i.e., is not a green-card holder). The benefits that are subject to this rule are exemptions from U.S. tax for the following items of income: compensation and pensions for government service (Article 19); certain income received by temporary visitors who are students, apprentices or business trainees (Article 20); and certain fiscal privileges of diplomatic agents and consular officers referred to in the proposed treaty (Article 27).
The treaty generally applies to the income taxes of the United States and similar taxes of South Africa. However, for purposes of the non-discrimination article, the treaty applies to taxes of all kinds imposed by the countries, including any taxes imposed by their political subdivisions or local authorities. Moreover, Article 26 (Exchange of Information and Administrative Assistance) generally is applicable to all national-level taxes, including, for example, estate and gift taxes.
In the case of the United States, the treaty applies to the Federal income taxes imposed by the Code, but excludes social security taxes. Unlike many U.S. income tax treaties in force, but like the U.S. model, the treaty applies to the accumulated earnings tax and the personal holding company tax. In addition, the treaty applies to the U.S. excise tax imposed with respect to private foundations.
In the case of South Africa, the treaty applies to the normal tax and the secondary tax on companies.
The treaty also contains a provision generally found in U.S. income tax treaties to the effect that it applies to any identical or substantially similar taxes that either country may subsequently impose.
The assignment of a country of residence is important because the benefits of the treaty generally are available only to a resident of one of the treaty countries as that term is defined in the treaty. Furthermore, double taxation often is avoided by the assignment of a single treaty country as the country of residence when, under the internal laws of the treaty countries, a person is a resident of both.
Under U.S. law, residence of an individual is important because a resident alien is taxed on worldwide income, while a nonresident alien is taxed only on certain U.S.-source income and on income that is effectively connected with a U.S. trade or business. An individual who spends substantial time in the United States in any year or over a three-year period generally is treated as a U.S. resident (Code sec. 7701(b)). A permanent resident for immigration purposes (i.e., a green-card holder) also is treated as a U.S. resident. The standards for determining residence provided in the Code do not alone determine the residence of a U.S. citizen for the purpose of any U.S. tax treaty (such as a treaty that benefits residents, rather than citizens, of the United States.) Under the Code, a company is domestic, and therefore taxable on its worldwide income, if it is organized in the United States or under the laws of the United States, a State, or the District of Columbia.
Under the treaty, the term “resident of a Contracting State” is defined separately for U.S. residents and South African residents. The definition of a U.S. resident is consistent with that contained in the U.S. model. The Technical Explanation states that the definition of a South African resident is intended to include only those persons over which South Africa exerts its broadest taxing jurisdiction.
In the case of the United States, the treaty defines the term “resident of a Contracting State” to mean any person who, under U.S. law, is liable to tax therein by reason of his or her domicile, residence, citizenship, place of incorporation, or any other criterion of a similar nature. The Technical Explanation states that the term also includes aliens who are considered U.S. residents under Code section 7701(b).The term does not include any person who is liable to tax in the U.S. in respect only of income from U.S. sources or of profits attributable to a permanent establishment in the United States. The term also includes a legal person organized under the laws of the United States, and that is generally exempt from U.S. tax and is established and maintained in the United States either (1) exclusively for a religious, charitable, educational, scientific, or other similar purpose, or (2) to provide pensions or other similar benefits to employees pursuant to a plan. The Technical Explanation states that the reference to an entity that is “generally” exempt from U.S. tax is intended to reflect the fact that under U.S. law, certain entities that generally are considered to be exempt from U.S. tax may be subject to certain excise taxes or to the income tax on unrelated business profits. The Technical Explanation also states that the term “other similar benefits” is intended to include employee benefits such as health and disability benefits.
In the case of South Africa, the treaty defines the term “resident of a Contracting State” to mean any individual who is ordinarily resident in South Africa, and any legal person which is incorporated or has its place of effective management in South Africa.
The treaty also defines “resident of a Contracting State” to include the United States or South Africa, or any of its political subdivisions or local authorities.
In the case of income, profit or gain derived through an entity that is fiscally transparent under the laws of either country, the treaty provides that the income is considered to be derived by a resident of a country to the extent that the income is treated for purposes of the tax laws of such country as the income, profit or gain of a resident. The Technical Explanation states that fiscally transparent entities include entities such as partnerships and certain estates and trusts. In the case of the United States, such entities would include partnerships, common investment trusts under section 584 of the Code, grantor trusts, and U.S. limited liability companies treated as partnerships for U.S. tax purposes. Thus, for example, if the U.S. partners’ share in the income of a U.S. limited liability company (treated as a partnership for U.S. tax purposes) is only one-half, South Africa would be required to reduce its withholding tax pursuant to the proposed treaty on only one-half of South African-source income paid to the partnership.
The Technical Explanation states that the rules in the treaty for income derived through fiscally transparent entities apply regardless of where the entity is organized (i.e., in the United States, South Africa or a third country). The Technical Explanation also states that these rules apply even if the entity is viewed differently under the tax laws of the other country. As an example the Technical Explanation states that income from South African sources received by an entity organized under the laws of South Africa, which is treated for U.S. tax purposes as a corporation and is owned by a U.S. shareholder who is a U.S. resident for U.S. tax purposes, is not considered derived by the shareholder of that corporation, even if under the tax laws of South Africa, the entity is treated as fiscally transparent. Rather, for purposes of the proposed treaty, the income is treated as derived by the South African entity.
A set of “tie-breaker” rules is provided to determine residence in the case of an individual who, under the basic residence rules, would be considered to be a resident of both countries. Such a dual resident individual is deemed to be a resident of the country in which he or she has a permanent home available. If this permanent home test is inconclusive because the individual has a permanent home in both countries, the individual’s residence is deemed to be the country with which his or her personal and economic relations are closer (i.e., the “centre of vital interests”). If the country in which the individual has his or her centre of vital interests cannot be determined, or if the individual does not have a permanent home available in either country, such individual is deemed to be a resident of the country in which he or she has an habitual abode. If the individual has an habitual abode in both countries or in neither country, the individual is deemed to be a resident of the country of which he or she is a national. If the individual is a national of both countries or neither country, the competent authorities of the countries are to settle the question of residence by mutual agreement.
In the case of a company that is resident in both countries under the basic residence rules, the treaty provides that the company is treated as a resident of the country in which it is incorporated.
In the case of a person other than an individual or a company that is resident in both countries under the basic residence rules, the treaty requires the competent authorities to determine the residence of such person by mutual agreement and the mode of application of the treaty to such person.
The treaty contains a definition of the term “permanent establishment” that generally follows the pattern of other recent U.S. income tax treaties, the U.S. model, and the OECD model.
The permanent establishment concept is one of the basic devices used in income tax treaties to limit the taxing jurisdiction of the host country and thus to mitigate double taxation. Generally, an enterprise that is a resident of one country is not taxable by the other country on its business profits unless those profits are attributable to a permanent establishment of the resident in the other country. In addition, the permanent establishment concept is used to determine whether the reduced rates of, or exemptions from, tax provided for dividends, interest, and royalties apply or whether those amounts are taxed as business profits.
In general, under the treaty, a permanent establishment is a fixed place of business through which the business of an enterprise is carried on in whole or in part. A permanent establishment includes a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry, or other place of extraction of natural resources. It also includes a warehouse, in relation to a person providing storage facilities for others, and a store or premises used as a sales outlet. The term also includes a ship, drilling rig, installation or other structure used for the exploration or exploitation of natural resources, but only if it lasts for more than 12 months. The term also includes a building site or construction, installation or assembly project, or supervisory activities in connection with such site or project, where such site, project or activities last for more than 12 months. Unlike the U.S. and OECD models, the term also includes the furnishing of services, including consultancy services, within a country by an enterprise through employees or other personnel engaged by the enterprise for such purposes, but only if such activities continue (for the same or a connected project) in that country for a period or periods aggregating more than 183 days in any 12-month period commencing or ending in the taxable year concerned. The Technical Explanation states that projects that are commercially and geographically interdependent are to be treated as a single project for purposes of the 12-month test. The 12-month period for establishing a permanent establishment in connection with a site or project is similar to the rules of the U.S. and OECD models.
The general definition of a permanent establishment is modified to provide that a fixed place of business that is used for any of a number of specified activities does not constitute a permanent establishment. These activities include the use of facilities solely for storing, displaying, or delivering goods or merchandise belonging to the enterprise and the maintenance of a stock of goods or merchandise belonging to the enterprise solely for storage, display, or delivery or solely for processing by another enterprise. These activities also include the maintenance of a fixed place of business solely for the purchase of goods or merchandise or the collection of information for the enterprise. These activities include as well the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character. The Technical Explanation states that advertising and the supply of information qualify as activities that are preparatory or auxiliary. The treaty, like the U.S. model, provides that the maintenance of a fixed place of business solely for any combination of these activities does not constitute a permanent establishment.
If a person, other than an independent agent, is acting on behalf of an enterprise and has and habitually exercises the authority in a country to conclude contracts in the name of an enterprise of the other country, the enterprise generally will be deemed to have a permanent establishment in the first country in respect of any activities that person undertakes for the enterprise. Consistent with the U.S. model and the OECD model, this rule does not apply where the contracting authority is limited to those activities described above, such as storage, display, or delivery of merchandise which are excluded from the definition of a permanent establishment.
The treaty contains the usual provision that no permanent establishment is deemed to arise based on an agent’s activities if the agent is a broker, general commission agent, or any other agent of independent status acting in the ordinary course of its business. The Technical Explanation provides that an independent agent is one that is legally and economically independent of the enterprise, and that is acting in the ordinary course of business in carrying out activities on behalf of the enterprise. Whether an agent and an enterprise are independent depends on the facts and circumstances of the particular case.
The fact that a company that is resident in one country is related to a company that is a resident of the other country or to a company that engages in business in that other country does not of itself cause either company to be a permanent establishment of the other.
Income from Immovable Property (Real Property)
Under the treaty, income derived by a resident of one country from immovable property (real property) situated in the other country may be taxed in the country where the real property is located. This rule is consistent with the rules in the U.S. and OECD models. For this purpose, income from immovable property includes income from agriculture or forestry.
The term “immovable property (real property)” has the meaning which it has under the law of the country in which the property in question is situated. The treaty specifies that the term in any case includes property accessory to immovable property; livestock and equipment used in agriculture or forestry; rights to which the provisions of general law respecting landed property apply; usufruct of immovable property; and rights to variable or fixed payments as consideration for the working of, or the right to work, mineral deposits, sources and other natural resources. Ships, boats and aircraft are not considered to be immovable property.
The treaty provides that the country in which property is situated may tax income derived from the direct use, letting, or use in any other form of such real property. The provisions allowing source country taxation also apply to income from real property of an enterprise and to income from real property used for the performance of independent personal services.
Business Profits Internal taxation rules
U.S. law distinguishes between the U.S. business income and other U.S. income of a nonresident alien or foreign corporation. A nonresident alien or foreign corporation is subject to a flat 30-percent rate (or lower treaty rate) of tax on certain U.S.-source income if that income is not effectively connected with the conduct of a trade or business within the United States. The regular individual or corporate rates apply to income (from any source) which is effectively connected with the conduct of a trade or business within the United States.
The treatment of income as effectively connected with a U.S. trade or business depends upon whether the source of the income is U.S. or foreign. In general, U.S.-source periodic income (such as interest, dividends, and rents), and U.S.-source capital gains are effectively connected with the conduct of a trade or business within the United States if the asset generating the income is used in, or held for use in, the conduct of the trade or business or if the activities of the trade or business were a material factor in the realization of the income. All other U.S.-source income of a person engaged in a trade or business in the United States is treated as effectively connected with the conduct of a trade or business in the United States (referred to as a “force of attraction” rule).
Foreign source income generally is treated as effectively connected income only if the foreign person has an office or other fixed place of business in the United States and the income is attributable to that place of business. Only three types of foreign source income are considered to be effectively connected income: rents and royalties for the use of certain intangible property derived from the active conduct of a U.S. business; certain dividends and interest either derived in the active conduct of a banking, financing or similar business in the United States or received by a corporation the principal business of which is trading in stocks or securities for its own account; and certain sales income attributable to a U.S. sales office. Special rules apply in the case of insurance companies.
Any income or gain of a foreign person for any taxable year that is attributable to a transaction in another taxable year is treated as effectively connected with the conduct of a U.S. trade or business if it would have been so treated had it been taken into account in that other taxable year (Code sec. 864(c)(6)). In addition, if any property ceases to be used or held for use in connection with the conduct of a trade or business within the United States, the determination of whether any income or gain attributable to a sale or exchange of that property occurring within ten years after the cessation of the business is effectively connected with the conduct of a trade or business within the United States is made as if the sale or exchange occurred immediately before the cessation of the business. (Code sec. 864(c)(7)).
Foreign corporations and nonresident individuals generally are subject to the South African normal tax only on income derived from sources within, or deemed to be within, South Africa. Business income derived in South Africa by a foreign corporation or nonresident individual generally is taxed in the same manner as the income of a domestic company or resident individual.
Treaty limitations on internal law
Under the treaty, profits of an enterprise of one country are taxable in the other country only to the extent that they are attributable to a permanent establishment in the other country through which the enterprise carries on business. This is one of the basic limitations on a country’s right to tax income of a resident of the other country. As described above, unlike the U.S. and OECD models, the treaty defines a permanent establishment of a country to include cases in which employees or other personnel of an enterprise provide services in that country for 183 days or more within a 12-month period in connection with the same or connected project. Thus, the rules of the treaty granting the source country the right to tax business profits are somewhat broader than the corresponding rules in the U.S. and OECD models.
The taxation of business profits under the treaty differs from U.S. rules for taxing business profits primarily by requiring more than merely being engaged in a trade or business before a country can tax business profits and by substituting an “attributable to” standard for the Code’s “effectively connected” standard. Under the Code, all that is necessary for effectively connected business profits to be taxed is that a trade or business be carried on in the United States. Under the treaty, a permanent establishment would have to be present and the business profits generally would have to be attributable to that permanent establishment.
The Technical Explanation states that it is understood that the business profits attributed to a permanent establishment include only those profits derived from that permanent establishment’s as sets or activities. This is consistent with the U.S. and OECD models and other existing U.S. treaties in this respect.
The business profits of a permanent establishment are determined on an arm’s-length basis. Thus, there are to be attributed to a permanent establishment the business profits which would be expected to have been derived by it if it were a distinct and independent entity engaged in the same or similar activities under the same or similar conditions. For example, this arm’s-length rule applies to transactions between the permanent establishment and a branch of the resident enterprise located in a third country. Amounts may be attributed to the permanent establishment whether they are from sources within or without the country in which the permanent establishment is located.
In computing taxable business profits, the treaty provides that deductions are allowed for expenses incurred for the purposes of the permanent establishment. These deductions include a reasonable allocation of executive and general administrative expenses, research and development expenses, interest, and other expenses incurred for the purposes of the enterprise as a whole (or, if not the enterprise as a whole, at least the part of the enterprise that includes the permanent establishment), whether incurred in the country in which the permanent establishment is located or elsewhere. According to the Technical Explanation, under this language, the United States is free to use its current expense allocation rules, including the rules under Treas. Reg. secs. 1.861-8 and 1.882-5.
The treaty specifies that in computing taxable business profits, no deductions are allowed for certain amounts incurred by the permanent establishment to any office of the enterprise, other than reimbursements of actual expenses. Such amounts include royalties, fees or similar payments in return for the use of patents or other rights; commissions or other charges for specific services performed or for management; or interest on moneys lent to the permanent establishment. As an example, the Technical Explanation states that a permanent establishment may not deduct a royalty deemed paid to the head office. It may, however, deduct an actual reimbursement to its head office for costs it incurred in developing an intangible generating the royalty. Similarly, the treaty specifies that in computing taxable business profits, a permanent establishment may not take into account certain amounts charged by the permanent establishment to any office of the enterprise, other than for reimbursement of actual expenses. Such amounts include royalties, fees or similar payments in return for the use of patents or other rights; commissions or other charges for specific services performed or for management; or interest on moneys lent by the permanent establishment to any office of the enterprise.
Business profits are not attributed to a permanent establishment merely by reason of the purchase of merchandise by a permanent establishment for the enterprise. Thus, where a permanent establishment purchases goods for its head office, the business profits attributed to the permanent establishment with respect to its other activities are not increased by the profit element with respect to its purchasing activities.
The amount of profits attributable to a permanent establishment must be determined by the same method each year unless there is good reason to change the method. Where business profits include items of income which are dealt with separately in other articles of the treaty, those other articles, and not the business profits article, govern the treatment of such items of income. Thus, for example, profits attributable to a U.S. ticket office of a South African airline are generally exempt from U.S. Federal income tax under the provisions of Article 8(Shipping and Air Transport).
Unlike the U.S. model, the treaty contains no definition of “business profits.” The Technical Explanation states that the term “business profits” generally is understood to mean income derived from any trade or business, including income derived by an enterprise from the performance of personal services, and income from the rental of tangible personal property. This definition is the same as that contained in the U.S. model.
The treaty incorporates the rule of Code section 864(c)(6) and provides that any income or gain attributable to a permanent establishment or a fixed base during its existence is taxable in the country where the permanent establishment or fixed base is located even though payments are deferred until after the permanent establishment or fixed base has ceased to exist. This rule applies with respect to business profits (Article 7, paragraphs 1 and 2), dividends (Article 10, paragraphs 4 and 6), interest (Article 11, paragraph 3), royalties (Article 12, paragraph 3), capital gains (Article 13, paragraph 3), independent personal services income (Article 14) and other income (Article 21, paragraph 2).
The treaty, like most other U.S. tax treaties, contains an arm’s length pricing provision. The treaty recognizes the right of each country to make an allocation of profits to an enterprise of that country in the case of transactions between related enterprises, if conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises. In such a case, a country may allocate to such an enterprise the profits which it would have accrued but for the conditions so imposed. This treatment is consistent with the U.S. model.
For purposes of the treaty, an enterprise of one country is related to an enterprise of the other country if one of the enterprises participates directly or indirectly in the management, control, or capital of the other enterprise. Enterprises also are related if the same persons participate directly or indirectly in the management, control, or capital of such enterprises.
Like the U.S. and OECD models, the treaty does not include the paragraph contained in many other U.S. tax treaties which provides that the rights of the treaty countries to apply internal law provisions relating to adjustments between related parties are fully preserved. Nevertheless, the Technical Explanation states that it is understood that the respective countries will apply their internal intercompany pricing rules (e.g., Code section 482, in the case of the United States). The Technical Explanation also states that the U.S. “commensurate with income” standard for determining appropriate transfer prices for intangibles is consistent with the arm’s-length standard.
When a redetermination of tax liability has been properly made by one country, the other country will make an appropriate adjustment to the amount of tax charged in that country on the redetermined income, if it agrees with the adjustment. In making that adjustment, due regard is to be given to other provisions of the treaty, and the competent authorities of the two countries will consult with each other if necessary. For example, under the mutual agreement article (Article 25), a correlative adjustment cannot necessarily be denied on the ground that the time period set by internal law for claiming a refund has expired. To avoid double taxation, the proposed treaty’s saving clause retaining full U.S. taxing jurisdiction with respect to its citizens and residents (discussed above in connection with Article 1 (General Scope)) does not apply in the case of such adjustments.
Limitation on Benefits
The treaty contains a provision generally intended to limit indirect use of the treaty by persons who are not entitled to its benefits by reason of residence in the United States or South Africa. The treaty is intended to limit double taxation caused by the interaction of the tax systems of the United States and South Africa as they apply to residents of the two countries. At times, however, residents of third countries attempt to use a treaty. This use is known as “treaty shopping,” which refers to the situation where a person who is not a resident of either country seeks certain benefits under the income tax treaty between the two countries. Under certain circumstances, and without appropriate safeguards, the nonresident may be able to secure these benefits indirectly by establishing a corporation (or other entity) in one of the countries, which entity, as a resident of that country, is entitled to the benefits of the treaty. Additionally, it may be possible for a third-country resident to reduce the income base of a treaty country resident by having the latter pay out interest, royalties, or other deductible amounts under favorable conditions either through relaxed tax provisions in the distributing country or by passing the funds through other treaty countries (essentially, continuing to treaty shop), until the funds can be repatriated under favorable terms.
Summary of treaty provisions
The anti-treaty shopping article provides that a resident of a country is entitled to all treaty benefits in the other country only to the extent provided in this article. Under this provision certain persons are identified as qualifying as residents of a country. Alternatively, certain items of income of a treaty resident may qualify for treaty benefits if the resident satisfies one of several other tests of the treaty.This provision of the treaty is in some ways comparable to the U.S. Treasury regulation under the branch tax definition of a qualified resident. However, the treaty provides opportunities for treaty benefit eligibility which are not provided for under the regulation.
The treaty entitles a resident of either country to qualify for all the benefits accorded by the treaty if such resident is defined in one of the following categories:
(1) An individual;
(2) One of the treaty countries, a political subdivision or local authority thereof;
(3) A company that satisfies an ownership test and a base erosion test;
(4) A trust that satisfies an ownership test and a base erosion test;
(5) A company that satisfies a public company test;
(6) A company that is owned by certain public companies
(7) A not-for-profit, tax-exempt organization; or
(8) A tax-exempt pension fund
Such persons will be referred to as “qualified residents.” Alternatively, a resident that does not fit into any of the above categories may claim treaty benefits with respect to certain items of income under the active business test. Moreover, a treaty country resident is entitled to treaty benefits if the resident is otherwise approved by the source country’s competent authority, in the exercise of the latter’s discretion. Special rules apply to income derived by a resident of South Africa in certain “triangular” cases described below.
Ownership and base erosion tests—companies
Similar to many U.S. treaties that have a limitation on benefits article, the treaty contains an ownership test and a base erosion payment test, both of which must be met if a company is to qualify for treaty benefits under this rule. The rules under the treaty are similar, but not identical, to those contained in the U.S. model.
To meet the ownership test, it is necessary that at least 50 percent of each class of shares or other beneficial interests in the company is owned, directly or indirectly, on at least half the days during the taxable year by: individual residents of South Africa or the United States; the countries themselves, political subdivisions or local authorities of the countries; certain publicly traded companies and companies owned by certain publicly traded companies (as described in the discussion of the public company tests below); or certain tax-exempt organizations including charitable organizations and pension funds (as described in the discussion of tax-exempt entities below). The treaty provides that in the case of indirect ownership, each person in the chain of ownership must be entitled to the benefits of the proposed treaty as one of the qualified residents referred to above.
Base erosion test
The base erosion test is met only if less than 50 percent of the gross income of the company for the year is paid or accrued, directly or indirectly, to persons who are not residents of either country, in the form of payments that are deductible for income tax purposes in the company’s country of residence. Under the treaty, payments by the company to a resident of either country, or payments that are attributable to a permanent establishment in either country, are not considered base eroding payments for these purposes. This test is intended to prevent a corporation, for example, from distributing most of its income in the form of deductible payments such as interest, royalties, service fees, or other amounts to persons not entitled to benefits under the treaty.
Ownership and base erosion tests-trusts
The treaty provides a separate ownership test and base erosion test for trusts. These rules are similar to the ownership and base tests for companies described above; however, the treaty provides more stringent ownership rules in the case of trusts. This is unlike the U.S. model, which generally applies the same ownership and base erosion tests to companies and trusts.
Under the treaty, the ownership test is met if at least 80 percent of the aggregate beneficial interests in the trust is owned, directly or indirectly, on at least 274 days during the taxable year by: individual residents of South Africa or the United States; the countries themselves, political subdivisions or local authorities of the countries; certain publicly traded companies and companies owned by certain publicly traded companies (as described in the discussion of the public company tests below); certain tax-exempt organizations including charitable organizations and pension funds (as described in the discussion of tax-exempt entities below); or companies satisfying the ownership and base erosion tests. The at-least-80 percent ownership threshold for trusts is more stringent than the at-least-50 percent ownership threshold for companies, described above. The treaty provides that in the case of indirect ownership, each person in the chain of ownership must be entitled to the benefits of the treaty as one of the qualified residents referred to above.
Base erosion test
The base erosion test under the treaty is the same as the base erosion test for companies described above. This test requires that less than 50 percent of the trust’s gross income be paid or accrued, directly or indirectly, to nonresidents of either country (unless the income is attributable to a permanent establishment located in either country), in the form of payments that are deductible for tax purposes in the trust’s country of residence. The Technical Explanation states that trust distributions would be considered deductible payments to the extent that they are deductible from the tax base.
Public company tests
Like many other U.S. income tax treaties that have a limitation on benefits article, the treaty contains a rule under which a company is entitled to treaty benefits if sufficient shares in the company are traded actively enough on a suitable stock exchange. This rule is similar to the branch profits tax rules in the Code under which a company is entitled to treaty protection from the branch tax if it meets such a test or if it is the wholly-owned subsidiary of certain publicly traded corporations resident in a treaty country. The rules under the treaty are similar to those contained in the U.S. model.
Publicly traded companies
A company that is a resident of South Africa or the United States is entitled to treaty benefits if all the shares in the class or classes of its shares representing more than 50 percent of the voting power and value of the company are regularly traded on a recognized stock exchange. Thus, such a company is entitled to the benefits of the treaty regardless of where its actual owners reside or the amount or destination of payments it makes. The Technical Explanation states that the requirement that “all the shares” in the principal class of shares be regularly traded makes clear that all shares in the principal class (or classes) of shares of the company must be regularly traded, as opposed to only a portion of such shares. This treatment is consistent with the U.S. model.
Although the term “regularly traded” is not defined in the treaty, the Technical Explanation states that the term will be defined by reference to the domestic laws of the country in which treaty benefits are sought. The Technical Explanation states that in the case of the United States, this term is understood to have the meaning it has under Treasury regulations relating to the branch profits tax provisions of section 884 of the Code.
Subsidiaries of publicly traded companies
A company that is a resident of South Africa or the United States is entitled to treaty benefits if at least 50 percent of each class of shares in the company is owned, directly or indirectly, by companies that satisfy the public company tests described above. The treaty provides that in the case of indirect ownership, each intermediate owner in the chain must be a person entitled to the benefits of the proposed treaty (as one of the qualified residents referred to above) under this article.
An entity also is entitled to benefits under the treaty if it is a legal person organized under the laws of a country and is generally exempt from tax in that country under laws relating to charitable and other similar organizations. The Technical Explanation clarifies that such organizations include entities organized and operated exclusively to fulfill religious, educational, scientific and other charitable purposes. Like the U.S. model, there is no requirement that specified percentages of the beneficiaries of these organizations be residents of one of the countries.
An entity also is entitled to the benefits under the treaty if it is a legal person organized under the laws of a country, is generally exempt from tax in that country, and is established and maintained in that country to provide pensions or other similar benefits to employees pursuant to a plan, provided that more than 50 percent of the beneficiaries, members or participants are individuals resident in either country. This rule is similar to a rule contained in the U.S. model.
Active business test
Under the active business test, treaty benefits in the source country are available under the treaty to an entity that is a resident of the United States or South Africa if (1) it is engaged directly in the active conduct of a trade or business in its country of residence, (2) the income derived from the source country is derived in connection with, or is incidental to, that trade or business, and (3) the trade or business is substantial in relation to the activity of the resident (and any related parties) in the source country. These rules are generally similar to the rules in the U.S. model.
The treaty provides that the business of making or managing investments is not considered to be an active trade or business for purposes of these rules, unless the activity is a banking, insurance or securities activity conducted by a bank, insurance company or registered securities dealer, respectively. The Technical Explanation states that a headquarters operation will not be considered to be engaged in an active trade or business for purposes of these rules.
Income derived in connection with, or incidental to, a trade or business
The treaty specifies that an item of income is derived in connection with a trade or business if the income-producing activity in the source country is a line of business which forms a part of, or is complementary to, the trade or business conducted in the residence country. This rule is similar to the rule in the U.S. model. The Technical Explanation states that it is intended that a business activity generally will be considered to “form a part of” a business activity conducted in the other country if the two activities involve the design, manufacture or sale of the same products or type of products, or the provision of similar services. The Technical Explanation further states that in order for activities to be “complementary,” the activities need not relate to the same types of products or services, but they should be part of the same overall industry and be related in the sense that success or failure of one activity will tend to result in the success or failure of the other activity. The Technical Explanation provides several examples illustrating these principles.
The treaty specifies that income is incidental to a trade or business if it facilitates the conduct of a trade or business in the other country. This rule is the same as the rule in the U.S. model.
The treaty provides that whether a trade or business of a resident is substantial is determined based on all the facts and circumstances. According to the Technical Explanation, the factors to be considered include the relative scale of the activities conducted in the two countries, and the relative contributions made to the conduct of the trade or business in both countries. However, the treaty includes a safe harbor under which the trade or business of the resident is considered to be substantial if certain attributes of the residence-country business exceed a threshold fraction of the corresponding attributes of the trade or business located in the source country that produces the source-country income. Under this safe harbor, the attributes are assets, gross income, and payroll expense. To satisfy the safe harbor, the level of each such attribute in the active conduct of the trade or business by the resident (and any related parties) in the residence country, and the level of each such attribute in the trade or business producing the income in the source country, is measured for the prior year or for the prior three years. For each separate attribute, the ratio of the residence country level to the source country level is computed.
In general, the safe harbor is satisfied if, for the prior year or for the average of the three prior years, the average of the three ratios exceeds 10 percent, and each ratio separately is at least 7.5 percent. These rules are similar, but not identical, to those contained in the U.S. model. The Technical Explanation states that if a resident owns less than 100 percent of an activity in either country, the resident will only include its proportionate interest in such activity for purpose of computing the safe harbor percentages.
Grant of treaty benefits by the competent authority
Finally, the treaty provides a “safety-valve” for a treaty country resident that has not established that it meets one of the other more objective tests, but for which the allowance of treaty benefits would not give rise to abuse or otherwise be contrary to the purposes of the proposed treaty. Under this provision, such a person may be granted treaty benefits if the competent authority of the source country so determines.
The Technical Explanation provides that the competent authority of a country will base its determination on whether the establishment, acquisition, or maintenance of the person seeking benefits under the treaty, or the conduct of such person’s operations, has or had as one of its principal purposes the obtaining of benefits under the proposed treaty. Thus, persons that establish operations in either the United States or South Africa with the principal purposes of obtaining benefits under the treaty ordinarily will be denied such benefits.
Under present laws and treaties that apply to South African residents, it is possible for profits of a permanent establishment maintained by a South African resident in a third country to be subject to a very low aggregate rate of South African and third-country income tax. The treaty, in turn, eliminates the U.S. tax on several specified types of income of a South African resident. In a case where the U.S. income is earned by a third-country permanent establishment of a South African resident (the so-called “triangular case”) the treaty has the potential of helping South African residents to avoid all (or substantially all) taxation, rather than merely avoiding double taxation. The treaty is drafted unilaterally to apply only to income of a South African resident, because it has no application with respect to the United States the United States does not exempt profits of a U.S. person attributable to a foreign permanent establishment.
The treaty includes a special rule designed to prevent the treaty from reducing or eliminating U.S. tax on income of a South African resident in a case where no other substantial tax is imposed on that income. Under the special rule, the United States is permitted to tax interest and royalties paid to the third-country permanent establishment at the rate of 15 percent. In addition, under the special rule, the United States is permitted to tax other types of income without regard to the proposed treaty.
In order for the special rule to apply, four conditions must be satisfied. First, a South African enterprise must derive income from the United States. Second, such income must be attributable to a permanent establishment that the South African enterprise has in a third country. Third, the South African enterprise must be exempt from South African tax on the profits attributable to the third-country permanent establishment. Fourth, the combined South African and third-country taxation of the item of U.S.-source income earned by the South African enterprise and the third-country permanent establishment must be less than 50 percent of the South African tax that would be imposed if the income were earned by the same enterprise in South Africa and were not attributable to the permanent establishment.
The special rule does not apply to interest derived in connection with, or incidental to, the active conduct of a trade or business carried on by the permanent establishment in the third country (other than the business of making or managing investments unless these activities are banking or insurance activities carried on by a bank or insurance company, respectively). The special also does not apply to royalties received as compensation for the use of, or the right to use, intangible property produced or developed by the third-country permanent establishment. In addition, the special rules does not apply to income derived by a South African enterprise if the United States taxes the profits of that enterprise according to the subpart F controlled foreign corporation provisions of the Code (as it may be amended from time to time without changing the general principles thereof).