By Joon Chong, Partner in the Tax Practice at Webber Wentzel

Section 1 of the Income Tax Act (ITA) defines a "dividend" to be any amount transferred by a resident company for the benefit of any person in respect of any share in that company whether by way of a distribution or consideration for a share repurchase but does not exclude a reduction of contributed tax capital of the company.

The section 31 transfer pricing rules in the ITA require transactions between resident and non-resident connected parties (affected transactions) to be carried out on an arm's length basis. To the extent that this is not done, section 31(2) requires a taxpayer to calculate its taxable income to account for any adjustments necessary, as if any affected transaction has been entered into on an arm's length basis. This is the primary adjustment to taxable income.

Section 31(3) requires a taxpayer to make a further secondary adjustment as follows. If there is a difference in:

• the taxable income calculated to account for any arm's length adjustment; and
• the taxable income calculated which did not account for such adjustments,

the difference in taxable income would be considered to be a distribution in specie (i.e. in a form other than cash) of the resident company on the last day six months after the end of the financial year.

The Budget Review 2018 (Budget) notes that there is potential overlap between the treatment of dividend in section 1 and the treatment of dividend under the transfer pricing rules in section 31. To remove the anomaly, the Budget proposes to amend section 31 to provide that the deemed distribution in this section be treated as a dividend in specie, unless the amount already constitutes a dividend as defined in section 1.

The scope of the proposed amendment to section 31 described in the Budget is not clear. We are uncertain from the wording used in the Budget whether there would only be an amendment to section 31 to provide for the deeming distribution (as there is already a deeming distribution) or would there also be a corresponding amendment to the definition of "dividend" in section 1 as well. It is also unclear how a "distribution in specie" would not fall into the definition of "dividend" in section 1, hence the necessity of the proposed amendment to provide for two types of distributions - a deemed distribution in specie unless the distribution is already a dividend.

We note, however, the interesting views expressed by SARS in the Comprehensive Guide to Dividends Tax (Issue 2) (Guide) that a resident company will not qualify for the exemption for dividends withholding tax (DWT) or treaty relief for the deemed dividend distribution in specie in terms of section 31(3).

SARS expresses the view in the Guide that the beneficial owner of the dividend must submit the declaration and written undertaking in order to qualify for the DWT exemption or treaty relief. The term "beneficial owner" is defined as the person entitled to the benefit of the dividend attaching to a share. SARS is of the view that the recipient of the section 31(3) deemed distribution in specie is not entitled to the benefit of the dividend because the recipient derives no benefit. The deemed dividend in specie is an amount calculated for tax purposes only and is the difference from two taxable income calculations. The actual economic benefit received by the recipient of the affected transaction is different to the deemed dividend in specie as section 31 does not re-characterise the actual benefit to be a dividend. The deemed dividend in specie arises over and above the underlying transaction.

As there is no beneficial owner of the section 31(3) deemed dividend in specie, it is not possible for any treaty relief to apply regardless of the definition of "dividend" or requirement of holding specific capital or voting rights in applicable treaties.

However, the Guide continues, even if there is a benefit received by the recipient, the benefit would not be considered to attach to a share. There is no direct link between the benefit and the share. The benefit attaches to the affected transaction "that gave rise to" the application of section 31(2) and 31(3).

The Guide does not refer to any international jurisprudence or OECD instrument in support of the views expressed.

It remains to be seen in the 2018 draft bills (anticipated in July 2018) whether the proposed amendment to section 31 is intended to support the views expressed in the Guide, and if it is, how. We hope that there would be commentary and examples in the explanatory memorandum to clarify the overlap and the purpose of the proposed amendment.