In August I returned to East London for the 40th reunion of my class at Clarendon Girls’ High School. There is something wonderfully strange about seeing people again after four decades. Careers have been built, businesses started, families raised, countries crossed and lives have taken turns none of us could possibly have predicted when we walked out of those school gates.
And yet, within minutes, forty years seem to disappear.
Perhaps less surprisingly, when you have spent your career in tax, it doesn’t take very long before someone asks you a tax question. One of my old school friends mentioned that she was in the process of selling a business she owns in another African country. “What tax am I going to pay when I sell it?”
It sounds like a straightforward question. It isn’t.
Because when someone tells me they are “selling a business”, one of my first questions is: what exactly are you selling?
Are you selling shares in a company? Is the company selling its underlying assets and then distributing the proceeds to you as a dividend? Do you trade in your personal name or through a partnership?
These may look like different routes to the same commercial destination. From a South African tax perspective, however, they can produce very different outcomes.
The participation exemption
Where a South African tax resident disposes of a sufficiently substantial shareholding in a foreign company, one of the first provisions to consider is the foreign participation exemption contained in the Income Tax Act.
Broadly, where the requirements are satisfied, a capital gain arising from the disposal of shares in a foreign company is not taxable. For a South African resident selling shares in a foreign business, this can be an extremely valuable exemption.
But that wasn’t necessarily what was happening here.
As we talked through the proposed transaction, it became apparent that “selling the business” could mean several different things – and the distinction was important.
If my friend sold her shares in the foreign company, the foreign participation exemption could potentially apply to the capital gain on those shares. Subject to the requirements being met, that could produce a very favourable South African tax result.
But what if the company itself sold the underlying business or its assets?
In that case, the participation exemption on the disposal of foreign shares would not apply, because my friend would not be disposing of her shares. The company would be selling its business assets.
The next question would then be how the sale proceeds ultimately reached her.
If the proceeds were distributed to her as a foreign dividend, another participation exemption could come into play. Section 10B(2)(a) of the Income Tax Act broadly exempts a foreign dividend from South African normal tax where the South African resident holds at least 10% of both the equity shares and voting rights in the foreign company.
So there was potentially another tax-free route to consider – not because she had sold her shares, but because the proceeds might ultimately reach her as an exempt foreign dividend.
There was, however, a third possibility.
If she owned the business or qualifying business assets personally, or through a partnership, and was herself disposing of those assets, neither of the participation exemptions necessarily provided the answer.
And that brought us to another CGT concession that receives far less attention: the small business disposal exclusion which deserves more attention.
Generally, where the requirements are met, an individual who is at least 55 years old, or who disposes of the business because of ill-health, infirmity or death, may disregard R2.7 million of the capital gains arising from the disposal of qualifying small business assets.
For the 2027 year of assessment, the market value of the gross assets must not exceed R15 million. This was recently increased from R10 million, while the amount of qualifying capital gains that may be disregarded increased from R1.8 million to R2.7 million.
Importantly, the R2.7 million is a lifetime cumulative amount. It can potentially apply across more than one qualifying business and more than one disposal during the taxpayer’s lifetime.
There are, of course, further requirements.
Among other things, the relevant assets or business interest generally need to have been held for at least five years, and the individual must have been substantially involved in operating the business during that five-year period.
This is relief aimed at active businesses, rather than simply portfolios of passive investments or rental property. It may apply to a sole proprietor business, a partnership and/or shares in a company or close corporation.
And there is another important point: the relief is not limited to South African businesses. It may also apply to a qualifying foreign business.
When two countries enter the conversation
Once a business operates across borders, however, South African tax is only part of the picture. There may also be tax consequences in the country in which the business operates, which means the applicable double taxation agreement (DTA) needs to be considered carefully.
In this particular case, the DTA indicated that South Africa had the sole taxing right over the capital gain. In theory, relatively straightforward.
In practice, not quite. The country in which the business operates intended to withhold tax at 15% on the disposal.
That creates a practical difficulty. The taxpayer may have to submit a return or refund claim in that country to recover tax which, under the DTA, should not have been imposed. At the same time, claiming that foreign tax as a credit against the South African tax liability may itself be problematic precisely because the foreign country did not have the taxing right under the treaty.
The result could be an uncomfortable cash-flow position: paying the tax due in South Africa while separately pursuing recovery of the 15% withheld offshore.
And this is exactly why tax planning should happen before the transaction rather than once the agreements have been signed and the proceeds are on their way.
Tax planning isn’t tax avoidance
There is sometimes an unfortunate assumption that “tax planning” means finding ways not to pay tax.
It doesn’t.
Good tax planning means understanding the provisions, exemptions and reliefs legitimately available to you and structuring a commercial transaction with full knowledge of its tax consequences.
The difference between selling shares, selling assets or receiving proceeds as a dividend is not semantics. It can materially change the tax outcome.
For business owners approaching retirement or considering an exit, the small business disposal exclusion is particularly worth investigating. A R2.7 million CGT exclusion is hardly insignificant, but neither is it automatic. The nature of the business, its value, how long it has been held, the owner’s involvement and the structure of the disposal all matter.
And if the business is offshore, the DTA and the tax rules in the other jurisdiction need to be considered before the deal is concluded.
Forty years later
I rather loved the fact that this particular conversation happened at our 40th school reunion.
When we left Clarendon as young women, none of us could have known where the next forty years would take us.
Some built businesses. Some travelled the world. We became professionals, entrepreneurs, mothers and grandmothers. We experienced successes and setbacks and accumulated forty years’ worth of stories to bring back to East London.
Somewhere along the way, the conversations changed from school, sport and what we were going to do with our lives to business sales, retirement and – inevitably in my case – capital gains tax.
The friendships remain much the same. The tax questions have become considerably more complicated.
And perhaps there is a useful lesson in that too: after spending years building a business, don’t wait until you are selling it to find out what the tax consequences will be.
