Challenges in Taxing Derivative Financial Instruments: International Views and South Africa’s Approach

• Jurisdiction: South Africa
• Published date: 25 May 2019
• Pages: 385-415
• Date: 25 May 2019
• Author: Annet Wanyana Oguttu

Challenges in Taxing Derivative Financial

Instruments: International Views and South

Africa’s Approach

ANNET WANYANA OGUTTU*

University of South Africa

1 Introduction

Before an investment is made, taxpayers often consider the appropriate

funding method since there are tax consequences that f‌low from the method

selected.

1

International investments are often f‌inanced by f‌inancial instru-

ments, which are contractual rights and obligations to transfer a specif‌ic

amount of money at a specif‌ic point in time.

2

Traditionally there are two main

f‌inancial instruments that have been used to f‌inance investments: debt and

equity.

3

However, over the years, the f‌inancial industry developed hybrid

f‌inancial instruments, which possess characteristics of both debt and equity.

4

As tax authorities internationally were trying to cope with the taxation of

hybrid f‌inancial instruments, over the last two decades, the f‌inancial markets

developed yet another category of f‌inancial instruments referred to as

derivatives.

The taxation of derivatives has proved challenging because f‌inancial

engineers often keep a step ahead of tax authorities by constantly devising

new derivatives that often include some kind of tax incentive.

5

For most

developing countries with less sophisticated f‌inancial markets, the taxation of

derivatives may not be a priority, for any revenue losses due to ineffective tax

rules may have minimal economic signif‌icance.

6

Although South Africa is not

categorised as a developed country, its economy displays aspects of both a

developed and an undeveloped economy. Its developed aspect explains why

South Africa is recognised as ‘the economic powerhouse of Africa’.

7

It has a

sizable economy, a relatively developed f‌inancial structure, and overall

* LLB (Makerere) LLM with Specialisation in Tax Law (Unisa) H Dip International Tax Law (UJ)

LLD (Unisa). Professor, Department of Mercantile Law, School of Law, University of South Africa.

1

Lynette Oliver & Michael Honiball International Tax: A South African Perspective 5 ed (2011) at

216.

2

Roy Rohatgi Basic International Taxation (2002) at 561.

3

For details see HS Cilliers & ML Benade et al Corporate Law 3 ed (2000) ch 14.

4

Oliver & Honiball op cit note 1 at 239.

5

Antti A Laukkanen Taxation of Investment Derivatives (2007) at 12; Anthony G Cornyn ‘Financial

Derivatives: Regulatory Quagmire or Opportunity for Reengineering?’ in: Robert A Klein & Jess

Lederman (eds) Derivatives Risk and Responsibility: The Complete Guide to Effective Derivatives

Management and Decision Making (1996) at 595–6.

6

Victor Thuronyi ‘Taxationof New Financial Instruments’, a paper presented to the Ad Hoc Group

of Experts on International Cooperation in TaxMatters Tenth Meeting, Geneva, 10–14 September 2001.

7

Explanatory Memorandum on the Taxation Laws Amendment Bill of 2010 in par 5.4 in part II.

385

(2012) 24 SA Merc LJ 385

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strength in f‌inancial services.

8

‘The f‌inancial services sector is at the heart of

South Africa’s economy’,

9

and over the past decade, there has been a rapid

increase in the use of derivatives by South African taxpayers.

10

The National

Treasury has noted that ‘South Africans invest about R5 trillion of their R6.04

trillion aggregate savings – about 80 percent – into Johannesburg Stock

Exchange listed equities and bonds and their derivative products’.

11

Although

South Africa has legislation that deals with the regulation of f‌inancial

services,

12

like other developed countries, South Africa’s income tax system

has struggled to keep pace with the complex and sophisticated developments

in the derivative industry.

13

The country’s ordinary tax principles are

inadequate to deal with the taxation of derivatives, and at present there is little

legislation that specif‌ically deals with the taxation derivatives.

14

In the 2012

Budget tax proposals, the National Treasury indicated that its tax policy

research projects for 2012–2013 include research on the taxation of

derivatives.

15

This article discusses the challenges of taxing derivatives internationally

and specif‌ically in South Africa. It begins by explaining what derivatives are

with examples, how they are traded and the problems they pose for global

f‌inancial systems. Then it focuses on the challenges of taxing derivatives

internationally. The recommendations of the Organisation for Economic

Cooperation and Development (OECD) in this regard are then pointed out and

a brief overview is given of how countries such as the United States of

America (US) and the United Kingdom (UK) have attempted to deal with the

problem. In this light, an analysis is made of South Africa’s legislation that

deals with the taxation of derivatives, and recommendations are made where

this legislation is found wanting.

8

MM Katz (chairman) Fifth Interim Report of the Commission of Inquiry into certain Aspects of the

Tax Structureof South Africa (1997) in par 2.2.5.

9

National Treasury ‘ASafer Financial Sector To Serve South Africa Better’ (23 February 2011) at 1,

available at http://www.oecd.org/dataoecd/21/13/48464023.pdf (visited on 2April 2012).

10

S Hutton ‘The Taxation of Derivatives in SouthAfrica’ (1998) 47 The Taxpayer 164.

11

National Treasury ‘Reviewing the Regulation of Financial Markets in South Africa: Policy

Document Explaining the Financial Markets Bill, 2011’ (August 2011) at 4, available at

http://www.fsb.co.za/finmarks/FinancialMarketsBill/FMBPolicyDocument.pdf (visited on 2April 2012).

12

Such legislation includes the Collective Investments Schemes Control Act 45 of 22; the Financial

Advisory and Intermediary Services Act 37 of 2002; and the Securities Services Act 36 of 2004. The

National Treasury is now working on a comprehensive review of the Securities ServicesAct, in terms of

the Financial Markets Bill, 2011.

13

South African Institute of Chartered Accountants (SAICA) ‘Consultative Document on the Tax

Treatment of Financial Arrangements by the Tax Advisory Committee’ (1994) at 1; SAICA‘Report of

the Tax Treatment of Futures and Options by the South African Institute of Chartered Accountants’

(1994) at 2.

14

Hutton op cit note 10 at 164.

15

South African Revenue Service (SARS) ‘Tax Proposals Budget 2011’ at 23, available at

http://www.treasury.gov.za/documents/national%20budget/2011/guides/Budget%20Tax%20Proposals%

202011.pdf (visited on 2April 2012).

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