International taxes: Government weighs its options

The Minister of Finance remains under pressure to raise revenues from an already overtaxed population.

In the area of corporate taxation, government has expressed its support for international efforts to curb base erosion and profit shifting (BEPS) and changes to the international tax rules to address the tax challenges arising from the shift of a bricks and mortar economy to a digital economy. We predict that government’s support for these international tax measures may lead to the ratification of the multilateral instrument (see below) in 2022, and that government will not take unilateral steps to impose new digital services taxes. We further predict that proposals to limit the deduction of cross-border interest-bearing debt by multinational groups will be stayed in 2022 pending a possible reduction in the corporate income tax rate from 28% to 27% from 2023 at the earliest.

The BEPS project has various strands to it, three of which are highlighted herein:

(i) profits generated by multinational entities should be taxed in the jurisdiction where the profits emerge;

(ii) curbs should be placed on the deduction of debt to fund investments and working capital; and

(iii) the international tax rules, including bilateral tax treaties, should be updated to provide for the taxation of profits derived in the digital economy.

The first strand noted above speaks to transfer pricing and the underlying philosophy that related parties should transact with each other on an ‘arm’s length’ basis (that is, as if they were independent of each other) to ensure that each party is compensated adequately. The temptation where related parties transact with each other is to shift profitability to the jurisdiction with the lower tax rate in order to reduce the overall tax burden to the group. South Africa has had transfer pricing rules in its income tax legislation since the 1990s to counter profit shifting through transfer pricing and has supported international efforts to strengthen the transfer pricing rules. It has also, as recently as last year, tried to strengthen its transfer pricing rules by broadening the definition of related parties (connected persons). The proposed changes were met with resistance and have been put on hold for the time being. However, we can expect further work to see how the transfer pricing rules can be strengthened in the year ahead.

The second strand referred to above has already received legislative attention in South Africa: a specific provision in the Income Tax Act seeks to limit corporate income tax deductions claimed on interest incurred by parties in a controlling relationship. Similar rules are found in several jurisdictions globally and are supported by the Organisation for Economic Co-operation and Development (OECD). South Africa, last year, proposed to extend these rules by further tightening the deductibility of interest incurred by multinationals. However, various submissions were made regarding technical difficulties with the proposed amendments and the redesign of the rules. Government has therefore delayed the implementation of the proposed changes for the time being. These rules will now take effect when the Minister of Finance announces a reduction in the corporate income tax rate in the annual Budget Speech. In last year’s Budget Speech, it was proposed to reduce the corporate income tax rate from 28% to 27%; however, for various reasons, that proposal has been delayed and we do not expect an announcement to this effect in the 2022 Budget Speech. Consequently, the proposals to further restrict the deductibility of interest as discussed above will be delayed, we predict, to not earlier than 2023.

As for the third strand referred to above, the G20/OECD developed a multilateral instrument to amend bilateral tax treaties without the need for governments to amend each of their treaties. The multilateral instrument introduces minimum standards to the application of a tax treaty and proposes changes to several treaty articles to make them more fit for purpose to a modern economy. However, a country only becomes bound to the multilateral instrument once it ratifies it. Whilst South Africa has expressed support for the multilateral instrument, it has not yet ratified it. We predict that South Africa will ratify the instrument in 2022.

A further aspect of the third strand referred to above is the OECD initiative to create a new taxing right for countries in respect of profits earned in their markets by very large multinationals which do not have a taxable presence in their market; and to require a minimum corporate income tax rate of 15% per country. This initiative, known as the Pillar 1 and Pillar 2 rules, holds that in a digital economy a company could be generating significant revenues from a market where it has no presence, and that it is only fair that that market country should be entitled to some taxes from the company’s profits. It further seeks to discourage a race to the bottom of corporate income tax rates by imposing a minimum level of 15% per country. South Africa already has a 28% corporate income tax rate. Consequently, it does not have to make any changes to its corporate tax laws to align itself with the Pillar 1 and Pillar 2 rules. We therefore do not expect any specific action from government in this regard, but if this project stalls (it is meant to become effective in 2023), government may decide to proceed with imposing a digital services tax.