Claiming Foreign Tax Credits

Back in the day when I was still running my tax practice full-time, I was called upon by a client to assist with the tax and accounting treatment of taxes withheld by a foreign country from income earned in that country—in this particular case, Botswana.

The client’s query centred on the following two issues:

• Claiming Botswana withholding taxes against South African taxable income; and
• What happens with the Botswana withholding taxes when the South African company has an assessed tax loss.

The advice provided to the client was based on the provisions of the South African Income Tax Act No 58 of 1962 (‘the Act’), as well as those contained in the Double Taxation Agreement entered into between the Republic of South Africa and the Republic of Botswana on 12 May 2004 (‘the DTA’).

While the tax treatment in this particular instance relates specifically to the tax relationship between South Africa and Botswana, similar principles apply when it comes to taxes withheld by other countries. In such cases, it is critical that the appropriate Double Tax Treaty (if one exists) is consulted.

General principles

South Africa’s tax system is based on residence, which means that a South African-domiciled taxpayer (individual or corporate) will pay tax in South Africa on their world-wide income.

However, many countries around the world levy some form of taxation on income earned in the country concerned. This tax can take the form of an income tax, value-added tax, general sales tax, withholding tax, or any other form of tax enshrined in that country’s taxation legislation.

In the case of Botswana, any payments made to foreign countries for goods imported or services rendered will be subject to the deduction of a withholding tax of 10% of the payment due.

However, in terms of accounting principles as well as South African tax legislation, the gross amount needs to be accounted for when determining income for both accounting and tax purposes.

For example, if the invoice amount is R100, the withholding tax will be R10 and the amount physically received will amount to R90. The full R100 will be recognised as income, and the withholding tax would be recognised as an expense.

From a tax perspective, the full R100 forms part of gross income (Section 1 of the Act, ‘gross income’ definition).

However, when it comes to determining the taxable income in South Africa, the R10 paid to the Botswana tax authorities will not be allowable as a deduction in determining taxable income, since the Act specifically prohibits the deduction of tax paid.

The dilemma is this: Having already paid tax on the full amount in Botswana, will this amount be subject to taxation in South Africa as well? In other words, will the amount be taxed twice?

Article 20 of the DTA refers to the payment of ‘technical fees’. The management fees paid from Botswana to South Africa would be considered to be ‘technical fees’ for the purposes of this Article.

In terms thereof, the “Contracting State” (in this case, Botswana) may subject the payment to taxation, provided that such taxation does not exceed 10% of the gross amount paid. It is this Article that gives rise to the 10% withholding tax levied by Botswana.

However, Article 22 of the DTA provides for the elimination of double taxation on such amounts, stating under Paragraph (b) that

“[i]n South Africa, subject to the provisions of the law of South Africa regarding the deduction from tax payable in South Africa of tax payable in any country other than South Africa in respect of income taxable in Botswana, in accordance with the provisions of this Convention, shall be deducted from the taxes due according to South African fiscal law.  Such deduction shall not, however, exceed an amount which bears to the total South African tax payable the same ratio as the income concerned bears to the total income”.

This rather long-winded paragraph gives effect to the principle that such payments, having been taxed in Botswana, will not be subject to further taxation in South Africa.

The relief from double taxation is engineered by the South African tax authorities allowing the Botswana withholding tax as a credit against the eventual South African tax liability.

Section 6quat of the Act contains a general principle that any tax paid in a foreign country would be claimable against South African tax due, subject to the following conditions:

1. The foreign taxes payable must not be capable of recovery by either the taxpayer or any other person after they have become due. For example, Malta provides for the refund of taxes paid by a Maltese subsidiary to its offshore parent. In such a case, there would be no credit claimable against the South African tax liability.
2. The income on which the foreign country levies the tax need not necessarily be derived in that country, but may for example be derived from a branch in a third country.
3. The aggregate of foreign taxes may not exceed the amount of South African tax which is proportionate to the foreign amount’s inclusion in taxable income, relative to the total taxable income of the taxpayer. In other words, if the withholding tax paid in Botswana was, for example, 35%, relief would only be given on an amount equivalent to 27% of the income in question, being the South African corporate tax rate.
4. The conversion of the tax paid in foreign currency must take place at the average exchange rate for the year in which the tax was paid.

If, for example, income of R100 is received from Botswana, and there is taxable income in South Africa amounting to R200 (excluding the Botswana income), the tax position in South Africa would be as follows:

Tax situation where there is an assessed loss

When a South African company has an assessed loss, such loss is carried forward to the following year. The loss remains available for set-off against future profits provided that the company continues to trade.

If a company makes an assessed loss, the taxable income for the year amounts to nil. Therefore, no tax is payable on such a loss, and any provisional tax paid would be refunded to the taxpayer.

However, what happens when the taxpayer has an assessed loss, but has paid withholding tax on the foreign portion of such income? Consider the following scenario:

The tax loss in this example would be carried over to future years, and any provisional tax paid in South Africa would be refunded. However, the tax paid in Botswana is not refundable by the South African tax authorities, since the inclusion of such income does not give rise to South African taxable income.

Provisos (i) and (ii) to Section 6quat(1B) of the Act provides for the carrying-over to future years of any such foreign credit disallowed in terms of this rule, and treated as foreign tax due on income from any country if the foreign tax credits for that year have not been fully absorbed against the attributable South African tax.

If the foreign tax credit is not fully absorbed, it can be carried forward again, but there is a seven-year limitation on this carry-forward, i.e. any unutilised portion remaining after seven years will be forfeited as a tax credit.

To summarise

1. Botswana withholding tax can be set off against any South African tax liability arising in the same tax year.
2. If the withholding tax is recoverable from the Botswana tax authorities, it cannot be used as a credit against the South African tax liability.
3. The set-off is limited to the equivalent rate of tax in South Africa, had the income in question been from a South African source.
4. In the case of an assessed loss, the foreign tax is not refundable by the South African tax authorities, but can be carried over to future tax years.
5. If the tax credit is not fully utilised in the next year, the unutilised portion can be carried over into the following year. There is however a seven-year limitation on such carryovers.
6. Any unutilised portion of the tax credit carried over will be forfeited after seven years.
7. The South African assessed loss can be carried over indefinitely, subject to the limitation provisions introduced with effect from 1 April 2022 whereby only 80% of taxable income or R1 million (whichever is higher) can be set off against an assessed loss in a particular tax year.

WRITTEN BY STEVEN JONES

Steven Jones is a registered SARS tax practitioner.

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