Prohibition no more: Loop structure rules amended and related considerations
Prohibition no more: Loop structure rules amended and related considerations
In our Tax & Exchange Control Alert of 17 August 2018, we discussed how South Africa’s exchange control rules prohibit the creation of so-called loop structures, with certain exceptions. A loop structure entails the formation by a South African resident of an offshore structure which, by reinvestment into the Republic, acquires shares, loan accounts or some other interest in a South African resident company or a South African asset. Fast forward to January 2021 and it is now official that the loop structure prohibition is no more, after the release of Exchange Control Circular 1/2021 (Circular) by the South African Reserve Bank (SARB) on 4 January 2021.
At a glance
- The South African Reserve Bank (SARB) has lifted the prohibition on loop structures to encourage inward investments into South Africa and support the country's growth as an investment and financial hub for Africa.
- South African individuals, companies, and private equity funds can now invest in South Africa through offshore structures without the previous limitation of holding only up to a 40% interest collectively with other South African residents.
- While the change allows for greater investment flexibility, certain exchange control rules and reporting requirements still remain in place, and tax consequences need to be considered, including the application of controlled foreign company rules and the tax treatment of dividends and share sales in offshore loop structures. Professional advice is recommended for those considering such investments.
What is the reason for the change?
In terms of the Circular;
“in order to support South Africa’s growth as an investment and financial hub for Africa, it is advised that the full ‘loop structure’ restriction has been lifted to encourage inward investments into South Africa”.
What exactly does the change entail?
The Circular, amongst other things, amends sections B.2(B)(i), B.2(C)(i)(f), B.2(C)(ii)(e) and B.2(G) of the Currency and Exchanges Manual for Authorised Dealers (AD Manual). These sections deal with the loop structure prohibition applicable to South African individuals, companies and private equity funds. Whereas these persons were previously only allowed to hold up to a 40% interest, collectively with other South African residents, in an offshore entity, this limitation will no longer apply. Pursuant to the amendment, the rules that now apply to each category of persons are the following:
- Resident individuals, companies and private equity funds with authorised foreign assets may invest in South Africa, provided that where South African assets are acquired through an offshore structure (loop structure), the investment is reported to an Authorised Dealer as and when the transaction(s) is finalised. An annual progress report must also be submitted to the SARB’s Financial Surveillance Department (FinSurv) via an Authorised Dealer. The aforementioned party also has to view an independent auditor’s written confirmation or suitable documentary evidence verifying that such transaction(s) is concluded on an arm’s length basis, for a fair and market-related price.
- Upon completion of the abovementioned transaction, the Authorised Dealer must submit a report to FinSurv which should include, amongst other things:
- the name(s) of the South African affiliated foreign investor(s);
- a description of the assets to be acquired (including inward foreign loans, the acquisition of shares and the acquisition of property);
- the name of the South African target investment company, if applicable; and
- the date of the acquisition as well as the actual foreign currency amount introduced including a transaction reference number.
- All inward loans from South African affiliated foreign investors must comply with the directives issued in section I.3(B) of the AD Manual.
- Existing unauthorised loop structures (i.e. created prior to 1 January 2021) and/or unauthorised loop structures where the 40% shareholding threshold has been exceeded (created prior to 1 January 2021), must still be regularised with FinSurv.
What is not affected by this change?
Despite the above, it should be noted that there are some exchange control rules that still remain in place and that need to be complied with where an investment is made into an offshore structure, including:
- In the case of individuals, the remaining rules regarding the foreign investment allowance, limited to R10 million per year still apply.
- In the case of South African companies, the remaining rules regarding the foreign investment allowance for investments below and above R1 billion per year, as contained in section B.2(C) of the AD Manual still apply. This means that in practical terms, where a company wishes to make use of this allowance to invest offshore, it will still require prior approval from an authorised dealer or FinSurv, depending on the nature and terms of the investment. Furthermore, one should appreciate that as things stand, the investment into an offshore structure that invests into South Africa will now potentially create an additional reporting requirement. This is because any approved investment made under the foreign investment allowance is subject to a requirement that an annual report must be submitted. It is not yet clear whether the annual reporting requirement applicable to the loop structure (as set out in sections B.2(C)(i)(f) and B.2(C)(ii)(e) of the AD Manual) can be combined with the existing annual reporting requirement applicable to offshore investments.
- In the case of private equity funds, the remaining rules regarding investing offshore will still apply, including the requirement that private equity funds that are members of the South African Venture Capital Association, mandated to invest outside the CMA, may only do so with FinSurv’s prior approval.
The other important consideration is that the Income Tax Act 58 of 1962 (Act) has been amended and as a result, there will now be specific tax consequences applicable to loop structures. We will not delve into the amendments, as they only became final this week with the publication of the Taxation Laws Amendment 23 of 2020. However, some of the issues that may have to be considered from a tax perspective are the following:
- The potential application of the controlled foreign company rules in section 9D of the Act;
- The tax treatment of dividends paid to a South African shareholder in an offshore loop structure; and
- The provisions of paragraph 64B of the Eighth Schedule to the Act, dealing with the participation exemption where shares are sold by a South African shareholder in an offshore structure.
Any person who considers investing into an offshore company or structure with a loop structure component, would be well advised to obtain professional advice beforehand so as to understand the tax and exchange control considerations that will apply to their investment.
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