Sibanda & Zantwijk

As a step towards releasing our Income Tax Act from reliance on our Exchange Control Regulations, and ensuring increased revenues from the use of foreign registered intellectual property (IP), new section 23I has been inserted into our Income Tax Act and the “connected persons” definitions in our transfer pricing provision (section 31) was recently amended. (See Treasury's call for submissions)

 

These amendments reflect the growing importance of IP (patents, trademarks, designs and copyright) in the value of business operations and the management of its tax liabilities. Historically, expatriation of IP to a foreign registered entity (typically in a tax haven) required Exchange Control approval, and this continues to be the case. Where assignments were approved, few negative SA tax consequences followed – capital gains tax triggered by the disposal is at least 50% of the income tax rate and IP CGT base costs are in many instances inflated . But, once legally transferred to an entity in a tax haven, the IP could be licensed back to the SA assignor. The royalty payments being tax deductible in the SA licensee’s hands and subject to tax at a reduced rate in the foreign licensor’s hands – a flow of royalties (often circular) that generates a significant tax arbitrage that could reduce the SA licensee’s effective SA tax rate by up to 40% (if “the 25% Rule” (i.e. royalties = 25% to 33% of licensee’s profits before interest and tax) is applied) … in perpetuity.

 

A few years ago, the South African Reserve Bank (SARB) clamped down on expatriated IP, but various mechanisms that achieve the same goal – directing royalty payments to a lower taxed vehicle - continue to exist, albeit in a synthetic form. In other words, instead of expatriating the IP and directing the royalties to an entity in a tax haven, the domestic royalties can be converted into an instrument that is not subject to tax in South Africa. For example, local royalty receipts could be: securitized and paid as “interest” to the foreign bond holders; evidenced by “promissory notes” that are then transferred into the untaxed policy holders fund of an insurance company; converted into “variable payments” in terms of a credit default swap that is purchased by a foreign entity.

 

The problem is that should our Exchange Control Regulations be relaxed, what is now being done indirectly on a small scale can easily be adopted by companies directly on a large scale, giving many SA companies a cheap ticket to an effective 5 year tax holiday (i.e. the present value of the tax saving over the licence period would equate to the company not paying any tax whatsoever for a period of 5 years).

 

Tax authorities were concerned about the potential tax losses in this regard and introduced various amendments via the Revenue Laws Amendment Bill 2007. These amendments include a section on the prohibition of deductions in respect of certain IP (s23I) and a change to the “connected person” definition in the “transfer pricing” section (s31). These amendments will only become effective as from 1 January 2009 to provide a sufficient period for proper consideration by Treasury of comments submitted. The new section 23I pertains to Tainted IP, which is defined as IP that was: at any time the property of the licensee or a resident; or developed by the licensee or a resident connected to the licensee by a 20% shareholding.

Where Tainted IP is licensed to residents, the licensees may only claim tax deductions for payment of royalties to the extent that the royalty receipts by the licensor do not “constitute income”. In other words, where the royalty receipts by the licensor are exempt from tax in South Africa, the licensee will be denied related tax deductions. Basically, the tax arbitrage previously generated by expatriating IP or redirecting royalty income (either directly or indirectly) into tax exempt entities will be removed. As from 1 January 2009, the tax on South African royalty income will generally mirror deductions relating to royalty expenditure.

 

If a review of foreign patents is anything to go by, more than 400 patent licences may be denied royalty deductions. But, the largest impact is expected to be felt in the area of trademarks, where free lunches evolved into veritable feasts, with excessive royalties being paid over many years in respect of many trademarks - whereas royalties payable in respect of patents and designs are limited to specific product ranges and to the remaining life of the patent (20 years) / design (10 or 15 years), trademark royalties can be levied on the entire product and service range of a company for as long as the business continues to operate.

 

Tailored anti-avoidance mechanisms have also been introduced to prevent licensees circumventing the section by merely interposing third parties that convert royalty streams into derivative payments, such as credit default swaps, that generate SA deductions that match the SA royalty income. This is a sign that our legislature is waking up to the use of derivatives to re-characterise and divert income streams to low tax jurisdictions.

 

For example OpCo has a trademark. Trader buys it for R100m and licences it back to OpCo for royalties totaling R200m over 8 years (assuming present value of R100m). Trader then sells the bare dominium (i.e. ownership rights less rights of use) in the trademark to a subsidiary of OpCo and sells the royalty promissory notes to a bank for R100m (i.e. the present value). The bank in turn removes this R100m “loan” from its books by selling a credit default swap (CDS) to its Mauritian cell captive. The terms of the CDS are as follows: MauritianCC pays R100m upfront and receives the royalties (totaling R200m) as they are payable. Both the Trader and the Bank are in a tax neutral position, OpCo claims R200m as royalty deductions in terms of the Act and the MauritianCC never pays SA tax. There is thus a R200m synthetic arbitrage on the royalty payments and the royalties may be returned as tax exempt foreign dividends to the bank without triggering our controlled foreign company (CFC) tax provisions.

 

Furthermore, the proposed section will have the effect of generally denying deductions to “traders” of IP - traders will in future not be entitled to claim deductions for the acquisition of “IP trading stock” where the corresponding receipt in the hands of the seller is capital in nature. This will impact the manner in which existing IP sale and leaseback transactions are structured.

 

Finally, the definition of a connected person in terms of our transfer pricing provision has been broadened within the context of IP licences. As from 1 January 2009, the section will regard all entities to an international licence that are linked to a SA company by a 20% shareholding as connected, irrespective of the presence of a majority shareholder. This means that a broader class of licences (both existing and future) will have to ensure that the royalties payable are market-related. The amendment will affect many existing 49%:51% foreign joint ventures (JVs) where the SA company extends royalty-free licences to the JV, retaining the profits in the JV and returning them as tax exempt foreign dividends. As from 2009, the JV will be regarded as a connected person in relation to the SA company and a market-related royalty payment will be deemed to be received by the SA company and subject to SA tax.

 

(See the updated article on s23I published in Finweek on 19 March 2009)

 

Anthony van Zantwijk

Sibanda & Zantwijk

March 2008

 

(An abridged version of this article was published in Finweek 13 March 2008)