Uncertainty regarding foreign tax relief for SA resident businesses providing technical services from South Africa to clients outside SA
SA resident companies providing technical services (SA Co) to clients outside of SA (Client Co) are required to include the following in their SA taxable income:
- profits from services carried out in SA (which would be ‘SA source profits’) (e.g. preparation of technical designs and specifications); and
- profits from sources carried on outside of SA, (which would be ‘non-SA source profits’) (e.g. on site construction oversight).
The foreign resident client (Client Co), due to its in-country tax legislation, very often deducts withholding tax on payments made to non-residents not only in respect of work carried on in-country, but also in respect of work carried out in SA.
The general rule is that SA Co is entitled to claim tax credit relief (i.e. a reduction of SA tax payable) in respect of this withholding tax to the extent of SA tax payable arising from this profit (income less expenses), but only to the extent that the income is not from a SA source (S6quat (1A) Income Tax Act).
In respect of SA source income, tax relief for foreign withholding taxes is restricted to tax deduction relief (i.e. a deduction of the withholding tax against that underlying income) in terms of S6quat(1C). The deduction is limited to the taxable income arising from that SA source income (S6quat (1C). Tax credit relief which was previously available in terms of Section 6quin in respect of SA source income was terminated with effect from years of assessment commencing on or after 1 January 2016.
This article focuses on technical services provided by SA Co in South Africa, i.e. SA source income, and in particular SA tax deduction relief in respect of the incorrect deduction of withholding tax by Client Co (either through incorrect interpretation or through unwillingness to honour the terms of the DTA) and in contradiction to the DTA.
The abovementioned tax deduction relief in respect of SA source income is subject to the proviso that no relief may be claimed by SA Co for foreign withholding taxes where SA Co has a right to recover the withholding tax, other than in terms of a mutual agreement procedure (MAP) in a double tax treaty (DTA).
Firstly, what does SARS mean by the phrase “right of recovery”?
In SARS Interpretation Note 18 at para 8.2, they indicate that “the term ‘right of recovery by any person’ is interpreted very broadly and includes any form of relief against a foreign tax liability”. At para 4.3.3 SARS provide an example “For example, a refund, credit, rebate, remission, or deduction, is considered to be a right of recovery. Any other form of economic benefit to which a person becomes entitled to in consequence of the payment of the relevant tax is also considered to be a ‘right of recovery by any person”.
The above references seem to indicate that SA Co needs to carry out a due diligence review of its own as to whether the withholding tax imposed by Client Co on SA source work is recoverable, which would require SA Co to determine whether Client Co is entitled to claim relief in terms of any applicable tax treaty.
This analysis should however not be carried out by SA Co, but rather by Client Co taking account of its domestic tax provisions, which may seek to restrict tax treaty relief.
Where there is a treaty with SA, relief may be available in terms of either:
- a technical services article, if present in the treaty, (which may grant taxing rights to Client Co as payer of the technical services); or
- in terms of the business profits article that limits the foreign revenue authority’s taxing rights to the extent that the income relates to a permanent establishment carried on by SA Co in Client Co country.
It is this treaty relief that foreign tax jurisdictions often ignore, resulting in Client Co withholding tax from payments made to SA Co incorrectly, for fear of the local tax authority holding them responsible for the withholding tax.
Practically speaking; does SA Co need to obtain a tax ruling from Client Co tax authorities in this regard, or is a tax opinion from a reputable local tax counsel sufficient? It appears from paragraph five (5) of Interpretation Note 18 that SARS expects SA Co to approach the Client Co Tax Authorities for confirmation in this regard. But this does not really make sense given that such approach should be undertaken by Client Co.
Secondly, what does SARS mean by a “right of recovery which forms part of a mutual agreement procedure”.
The SARS website states that “In cases where the taxation which is not in accordance with the DTA has been imposed, the taxpayer must first raise the issue with the relevant State as agreement by the other State will negate the need for a MAP , and …..if unsuccessful, the taxpayer may then approach the Competent Authority of his/her country of residence to request a MAP under the relevant DTA".
The above seems to suggest that SA Co is now back to having to request Client Co tax authorities for a ruling regarding the imposition of withholding tax on SA source income per the treaty.
To summarise then, where SA Co is tendering for contracts to provide services to non SA resident clients, they should:
- Ensure that the contract clearly separates between work carried on inside and outside of SA and that the contract allocates estimated values to each. Separate contracts may, in certain circumstances, be preferable;
- Ask Client Co to confirm with their local tax authority in writing whether withholding tax should be imposed on contract payments and if so, to what amounts as well as at what rate; failing which Client Co should at least take professional advice regarding the applicable withholding tax rate taking account of any applicable treaty relief and this should be shared with SA Co;
- Prepare a summary of after-tax contract cash-flows summarising all applicable withholding taxes as well as available tax reliefs in SA (credit or deduction). It is important to note that both the tax credit and tax deduction relief is granted in respect of profits, i.e. technical services income less attributable expenses, which may result in relief falling short of withholding taxes for low margin profits. For example, assuming a profit margin of 10% on R100 of SA source technical services and a withholding tax of 20% from gross technical service payments, in the absence of tax deduction relief, SA Co would incur negative after tax cash flow on this contract (R100 – R90 cost – R2.8 income tax – R20 withholding tax = -R12.80). The contract revenue would have to be grossed up by 38.5% to R138.5 to achieve the desired after tax cash flow of R7.2 (R10 profit x 72%). If tax deduction relief were available, this negative cash flow reduces to –R10 and the contract revenue would have to be grossed up by 25% to R125 to achieve after tax cash of R7.2; and
- Consider requesting Client Co to gross up the contract consideration for any possible tax leakage, if there is any uncertainty regarding the imposition of withholding taxes or available SA relief for their withholding taxes.
SARS should really be more willing to assist SA-based businesses looking to secure valuable foreign service contracts (which include a large SA-work component), with practical guidance regarding reasonable steps to determine available foreign tax credits. These may ultimately be the difference between winning or losing the contract, if grossing up for tax leakage renders the tender price uncompetitive.
As can be seen from the numerical example above, the absence of tax deduction relief increases the required percentage contract revenue from 25% to 38%, which may cause SA Co to lose the tender to countries with friendlier tax regimes governing relief for foreign tax.