Passive Holding Companies

In a previous article, I discussed the change from secondary tax on companies (STC) to a shareholder level tax on dividends. The recently released Revenue Laws Amendment Bill, 2008 continues the conversion process. One ancillary aspect, which was previously announced in the Budget Speech, is the introduction of the concept of “passive holding companies”.

The possibility has been identified that individuals may choose to earn passive income, such as interest and dividends, in a company rather than in their own hands, for tax reasons. The 28% company income tax rate, as opposed to the 40% maximum marginal income tax rate for individuals, has been identified as offering an arbitrage opportunity.

The proposed solution is the introduction of the concept of passive holding companies. These are intended to eliminate the abovementioned arbitrage opportunity, by levying a charge on certain passive income. The charge will be 40% (instead of 28%) on passive ordinary revenue and 10% on dividends. Debt, equity, derivatives and annuities will fall within the passive holding companies regime, but royalties will not.

The charge will be offset against future dividends declared by the passive holding company. The income that has been subject to the additional charges will be deemed to be distributed first.

A company will constitute a passive holding company in one of two sets of circumstances. The first is where a company is formed or availed of for the sole or main purpose of deferring, reducing or otherwise avoiding income tax or dividend tax, by accumulating ordinary revenue or dividends instead of having those amounts accumulated directly by natural persons. The second is where the tax benefit of accumulating dividends in a company, rather directly than by individuals, outweighs the other commercial benefits of utilising a company for such purpose.

The proposed classification approach is acknowledged as being different from many similar regimes internationally. A common approach is to use objective criteria involving numbers of shareholders or connected person relationships between shareholders. The proposed approach is a subjective one, which may create some uncertainty as to whether a particular company is to be treated as a passive holding company.

There are certain exclusions from the passive holding companies regime. Some of the exclusions are for certain types of entities, such as listed companies. Others arise as a result of a company’s activities, such as having more active than passive income or distributing its passive income.