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TAXES: Withholding behaviour

We all pay tax. Sometimes we pay it over to SARS ourselves. But, at least as far as individuals are concerned, it is usually withheld by someone else, who then pays it over.

The most ubiquitous form of tax is probably VAT. Even the humblest among us pays VAT. In fact, it’s almost impossible to spend any money at all without paying VAT, unless you only buy basic foodstuffs and banking services.

Take the story (probably an urban legend) that I’ve heard more than once at dinner parties. It tells of the resident beggar who, up on his luck at the traffic lights (variously reported to have been outside Eastgate, or at Sandton City) is seen at some chichi coffee shop treating himself to a cappuccino. Some versions of this tale include the alleged indigent also tucking in to a tramezzini – after all, a person has to eat.

Your honest reaction? Moral outrage? Disbelief? Now, having got that out of your system, consider the significance of the tale from the tax theorist’s point of view. You might note with interest that, when the alleged beggar pays for his meal, he joins the ranks of South African taxpayers. Whether he consumes a cuppuccino, tramezzini or both,14% VAT is levied and added to the bill. The coffee shop owner hangs on to this tax and ultimately pays it over to SARS. Well, unless he’s a cowboy. Or his input tax exceeds his output tax… But I digress.

This feature of the VAT system – that Person A bears the cost while Person B pays it over to the authorities – is the reason why it is called an indirect tax. The beggar is taxed indirectly, via the coffee shop owner.

Yet even a direct tax, such as income tax, is often borne by Person A (for example, me) and paid over to SARS by Person B (for example, Deloitte). This is generally called “pay as you earn” or “PAYE“.

Why does this happen? Why can’t I pay my own tax? Why must it be withheld from what I earn?

Well, speaking theoretically, I may be an unreliable person. I may abscond from Deloitte and disappear off the face of the earth without paying my tax. And Deloitte may not be able to tell SARS where I’ve gone.
So, rather than Take a Chance on Me (to quote Abba), the PAYE system places the onus on Deloitte to ensure that my share of tax is paid. If it isn’t, then Deloitte is liable.

This makes things much easier for SARS.

But it’s not only individuals that may have income tax withheld from payments to them. In some cases, companies or trusts are treated as individuals in that they are also subjected to PAYE. These companies and trusts are called personal service providers, and are considered to be thinly disguised versions of people like you and me.

Of more global significance is the phenomenon of withholding taxes. These are taxes levied by one country (for example, SA) on specific types of payment (for example, royalties) by the residents of that company to a recipient situated in another country (say, Bermuda). The SA resident is obliged to withhold tax from the royalty payment to the Bermuda recipient and pay the tax over to SARS. Withholding taxes are usually significantly lower than corporate income tax rates. For example, the royalty withholding tax in SA is 12%, as opposed to the corporate tax rate of 28%.

SA currently only levies withholding tax on royalties. However, this will change when secondary tax on companies (STC) is finally replaced by the new dividends tax, since this will be a conventional dividend withholding tax.

Apart from royalties and dividends, the other type of payment that is often subjected to withholding taxes (though not by SA) is interest. For this reason most double tax agreements deal with withholding taxes in relation to these three types of payment. A country’s right to impose withholding tax is often overridden, or limited, by the terms of a double tax agreement (DTA).

Why would a country (Country X) feel the need to withhold tax on these types of payment to a foreign recipient (YCo)? And why would international tax practice let Country X do so? The point is that it is generally acknowledged that, to a certain extent, YCo is generating income in Country X. It might be doing so by lending money there, exploiting its intellectual property there or by investing in a company situated there. Therefore, it is acknowledged that at least a portion of the income derived by YCo is derived (or sourced) in Country X. It follows that it is not unreasonable for Country X to impose some form of tax on these types of payment.

A phenomenon in Africa is that many countries impose withholding tax not only on the usual types of payment but also on management fees (or technical fees). This practice conflicts with what is usually done in the first world and is also not consistent with the logic outlined in the previous paragraph. More specifically, management services would usually be rendered from a foreign country from where the resultant fees are therefore sourced. Therefore, the usual reason for justifying the imposition of a withholding tax doesn’t apply.

So why do it? The reason is probably more practical than theoretical. The reality is that many African countries do not have transfer pricing rules, or the effective administrative capability to enforce those rules. Therefore, excessive management charges by greedy multi-nationals could potentially go unpunished. A pragmatic solution is to subject outbound management charges to a withholding tax, so that the tax base of the African country is to some extent protected.

The problem is that the withholding taxes apply whether the management fees are excessive or not. In the SA context, there is the further problem that the tax relief provided here for foreign withholding tax is more limited if the income is SA-sourced. This presents a very real problem for SA based multi-nationals rendering management services to African subsidiaries.

At this point, your poor head may be spinning as you reflect that this brief discussion has ranged from cappucino quaffing beggars to royalty charging multi-nationals, to companies doing business in Africa. What do they have in common? Well, like all of us, they pay tax. Another shared attribute is that, for very different reasons, the tax they pay is sometimes not paid by them directly but is held back and actually paid over to SARS (or the SARS equivalent in another country) by a third party.

Billy Joubert, BA LLB, H Dip Tax, H Dip International Tax, an Admitted Attorney of the High Court of South Africa is Tax Director Head: Transfer Pricing at Deloitte.