South Africa's decision to tax its citizens on a global basis is going to have profound consequences for those South Africans who are sending their money offshore to avoid the consequences of a weak Rand.

Since 1 March this year, South Africa has been taxing its residents wherever they are in the world. The mechanics of taxation based on residency have been well publicised, but the implications of the new regime for private banking clients are of greater interest. This global tax applies to all South Africans, including those who have been making use of their offshore investment allowances. The return they garner on the money they place offshore is now being reduced as a result of their South African marginal tax rate.

Catch 22 for investors

Local private bankers are worried that HNW investors face a dilemma over the effect that the new tax is going to have on the assets they acquire offshore over and above their offshore investment allowance. If they fail to declare the income they derive from these assets, they might face criminal prosecution for tax evasion. If they declare their income on previously undisclosed assets, they could face criminal charges for contravening the exchange controls.

On top of this ethical morass, investors are typically faced with the administrative burden of obtaining the information they need from various offshore jurisdictions which is required for local disclosure. The placement or investment of offshore investment allowances in a trust or a company may have different consequences.

The use of trusts as investment vehicles

If the client places his money in an offshore trust, it appears that the income that is distributed to beneficiaries, or the income in the trust to which the beneficiaries have a vested right, will be taxed. Should no distributions be made, and depending on the way in which the trust was capitalised, the South African Revenue Service could deem the income generated in the trust as income in the hands of the settlor. Any distributions made by the trust to a discretionary beneficiary will retain the nature they had when they were earned. In other words, interest earned and distributed will always retain its revenue nature and therefore will be subject to tax in the recipient's hands. This, however, is still untested theory.

Offshore trusts used to be an ideal vehicle by which the South African investor could earn tax-free income abroad; this income will now be taxed at some point. The offshore trustees will have to keep separate capital and income accounts. Records of the trust will have to show the amounts that were distributed and taxable and the amounts that were retained and taxable. This will undoubtedly add to the trustee costs, placing an additional burden on the already hard-hit South African taxpayer.

On the other side of the equation, the capitalisation of the trust (using interest-free loans, for example) could be taxed via the transfer pricing rules in s31 Income Tax Act. An interest rate may therefore be imputed for tax purposes. Donations to the trust will obviously attract a 25 per cent donations tax. The South African taxpayer, however, will only be taxed on one side of the balance sheet, thereby avoiding double taxation.

Using an offshore company as an investment vehicle

The company will meet the definitions of the controlled foreign equity provisions if South African residents individually or jointly, directly or indirectly, hold more than half of the participation rights or are entitled to exercise more than half of the votes or control of a corporate entity. If the company conforms to this definition, the income it has generated will be imputed to its shareholders in the proportion of their shareholding, whether this income is distributed or not. Reporting requirements to the SARS for these companies have become far more onerous.

The implications for capital gains tax

The major changes in the tax code imply a much greater level of care in deciding what vehicles are used to house offshore funds, exactly what investments are to be made and what income tax consequences will flow from these decisions. In the absence of clear-cut guidelines and the clarity that flows from practice notes and precedents from the tax industry, uncertainty is likely to prevail.

Mark Booysen is a specialist consultant at Ansbacher Private Bank. Ansbacher is a division of First Rand, one of South Africa’s ‘Big Four’ financial institutions. This article is not intended as a substitute for comprehensive professional advice.