Lifting of the Prohibition on Loops – Opportunity or Not?

On the 4th of January 2021, not only were South African residents already planning the normal “New Year New Me” resolutions, but the South African Reserve Bank (SARB) wasted no time by following up on their statements in the 2020 Medium Term Budget speech, pertaining to the abolition on the prohibition of ‘Loop Structures’.

SARB Exchange Control Circular No. 1/2021 stated as of the 1st January 2021, the Prohibition of “Loop Structures” will cease.

This action was hailed as a significant step forward for South Africa by the Minister of Finance who pointed out that it would enable i) new cross border capital flow management and ii) encourage the inward listing of investments into South Africa. SARB in turn pointed out that the objective of this amendment is to assist with cross border commercial initiatives that will have economic benefit for South Africa.

In this article we will take a brief look at what a Loop is, how legislation has evolved and the current position. It also considers what this means for South African resident individuals.

Loops and their history to date

Very simply, Regulation 10(1)c prohibited any South African i.e. individual or corporate from entering a transaction where the intention is to export the flow of capital through a foreign entity that invests back into South Africa.

Some relief from this prohibition came in 2019 where SARB started to consider applications by individuals or corporate entities to invest in an offshore entity that invested back into South Africa, subject to set limiting criteria.

As of 1st January 2021, South African companies and residents can now externalise funds by investing into foreign structures that in turn fully reinvest into South Africa.

However, there is no automatic right to enter into a Loop and all transactions require authorisation and are subject to a range of requirements and ongoing reporting to SARB’s Financial Surveillance Department (FSD).

In short, the requirements are as follows;

1. the inward investment must be done through an Authorised Dealer and that Authorised Dealer must report the transaction to the FSD of SARB;
2. the applicant to the Authorised Dealer has to demonstrate the transaction is on an arm’s length basis and the transaction must be for a fair market value or consideration;
3. point ii) above must be supported by an auditor’s report or suitable factual evidence to confirm the commercial aspects of the transaction comply with arm’s length and fair market value requirement;
4. after authorisation the applicant must provide progress reports for the FSD and a final completion report. The latter confirming; the names of the investors affiliated, full description of the assets acquired, the nature of the transaction i.e. inward foreign loans, acquisition of shares or property, the name of the targeted company in the South Africa, date of the transaction, currency and transaction reference numbers.

Other Considerations

It should be noted that all other exchange control requirements must also be met. For example, inward loans Section I. 3 must be complied with where the loop is via an inward loan. Furthermore, these changes do not legitimise any existing unauthorised loop which will need to be regularised and may lead to penalties.

For private individuals’ resident in South Africa, foreign inheritance can remain abroad but be invested into South Africa via a foreign entity but this requires approval and an application must be sent to the FSD. Furthermore, the assets may not be placed at the disposal of other South African residents whilst the loop is in place.

Risk and Mitigants

The biggest risk to South Africa is that the externalisation of assets to a foreign territory results in tax arbitrage or profit shifting that erodes the South African tax base.

However, anyone considering the use of loops to reduce tax should take caution given certain changes to tax reliefs pertaining to foreign dividends and capital gains stemming from loops and provide for new apportionment tax rule. In addition, well-developed anti-avoidance and controlled foreign company legislation needs consideration as this may have a significant bearing on the tax treatment, and one should not ignore South Africa’s well-established jurisprudence on the application and interpretation of its tax laws.

Conclusion

Any relaxation of exchange control must be a positive outcome as it supports the movement of capital for investment and opens South Africa to more foreign direct or indirect investment. It will also enable domestic companies to internationalise their enterprise in ways that they were unable to previously provided for, where the purpose is commercial.

For private clients with foreign pension funds, it will enable such pensions the ability to purchase shares in South African companies which was restricted to inward listed investments. Hence the opportunity to invest in South African private equity or other listed stock ,where the pension was funded by outward funds, is now an option.

However, such considerations should be tempered with the fact that pension fund investment should focus on capital preservation and should adopt diversification as a key tool to reduce concentration and market risk which included geographic, market and currency exposure .

Lastly, one should not forget that financial transactions inevitably have tax consequences and these need to be carefully considered as part of any planning that uses a Loop. Financial advisers and their clients are therefore best placed to get specific tax and exchange control advice before embarking on a loop.