The Challenges of Taxing Investments in Offshore Hybrid Entities: A South African Perspective

• Jurisdiction: South Africa
• Author: Annet Wanyana Oguttu
• Citation: (2009) 21 SA Merc LJ 51
• Date: 25 May 2019
• Pages: 51-73
• Published date: 25 May 2019

The Challenges of Taxing Investments in

Offshore Hybrid Entities: A South African

Perspective

ANNET WANYANA OGUTTU*

University of South Africa

1 Introduction

Tax avoidance (by contrast with tax evasion) involves using perfectly legal

methods of arranging one’s affairs to pay less tax. This is done by utilising

loopholes in tax laws and exploiting them within legal parameters.

1

So, for

instance, taxpayers often exploit the fact that there are tax variations across

international borders and international tax systems that can be used avoid

taxes.

2

This article deals with the resulting tax avoidance when taxpayers

invest in entities that two or more countries classify differently for tax

purposes. These entities, often referred to as ‘hybrid entities’, are basically

legal relationships in which the entity is treated as a taxable entity (eg, a

corporation) in one jurisdiction and as a transparent (non-taxable) entity in

another.

3

In a treaty context, the different tax treatment of these entities may

be used to take advantage of treaty benef‌its and even to avoid taxes.

4

Hybrid

entities usually take the form of trusts or partnership structures.

5

This article

* LLB (Makerere University, Uganda), LLM with Specialisation in TaxLaw (Unisa), LLD (Unisa).

Associate Professor, Department of Mercantile Law, College of Law, University of South Africa. This

article emanates from my LLD thesis entitled Curbing Offshore Tax Avoidance: The Case of South

African Companies and Trusts (2008).

1

Organisation for Economic Co-operation and Development: Committee on Fiscal Affairs

International Tax Avoidance and Evasion: Four Related Studies (1987) at 1; David Meyerowitz

Meyerowitz on Income Tax (2008) in par 29.1;AP de Koker Silke on South African Income Tax vol 3

(2007) in par 19.1.

2

These variations include differences between countries’ tax rates, legal concepts, standards of

administration, reporting and enforcement, and governments’ attitudes towards the liberty and privacy

of taxpayers and the conf‌identiality of f‌inancial and business transactions. See United Nations: Ad Hoc

Group of Experts on International Co-operation in Tax Matters International Co-operation in Tax

Matters: Guidelines for International Co-operation against the Evasion and Avoidance of Taxes(with

Specific Reference to Taxeson Income, Profits, Capital and Capital Gains) (1984) at 18.

3

Brian J Arnold & Michael J McIntyre International TaxPrimer 2 ed (2002) at 144; Lynette Olivier

& Michael Honiball International Tax: A South African Perspective 4 ed (2008) at 464-5. Hybrid

entities can be located in a high-tax jurisdiction or in a tax haven. But the term ‘hybrid entity’ should not

be confused with the term ‘hybrid instrument’, which refers to a situation in which a f‌inancial

instrument may be treated as debt instrument in one country but as a preferred share in another.

4

See Arnold & McIntyre op cit note 3 at 144.

5

See the various examples of hybrid entities structures as expounded by Arnold & McIntyre op cit

note 3 at 144. Under French law, eg, a société en nom collectif (SNC) has separate legal personality

although the partners are jointly and severally liable for its debts. Under French tax law, however, a

SNC can elect to be taxed as a corporation. If another country treats the French SNC as a partnership,

then residents of that country with interests in the SNC would be treated as partners. Thus, if a French

SNC borrows funds for use in its business, the interest will be deductible in computing the SNC’s

income. If the owners of the SNC are residents of a country that treats the SNC as transparent, the

interest deduction will also be avoidable to those owners in their country of residence. In effect, the SNC

can be used to obtain an interest deduction in both countries, signif‌icantly reducing the after-tax cost of

51

(2009) 21 SA Merc LJ 51

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covers only partnership structures.

In South Africa, the topic of the taxation of hybrid entities has received

little attention, and there is no legislation in place dealing with the taxation of

these entities. However, a number of South African residents have been

known to invest in offshore hybrid entities whereby it is possible to avoid

South African taxes on their income.

6

This article discusses the difficulties of

taxing partnership hybrid structures and the methods of manipulating these

difficulties to avoid taxes. The challenges of taxing these entities in South

Africa are also discussed, and recommendations are provided on how the

ensuing tax avoidance can be prevented.

2 Why is it Necessary for Countries to Classify Entities for Tax

Purposes?

Whether or not a particular entity is a hybrid entity depends on the

domestic laws of the countries involved that classify the entities for tax

purposes.

7

Discussing the taxation of hybrid entities, Essers and Meussen

8

note that ‘the taxation of hybrid entities in cross-border transactions has

proved to be exceptionally complicated and is perhaps one of the most

difficult issues in the application of rules on international tax law’. The

difficulties of dealing with hybrid entities arise from the fact that different

countries may classify an entity differently in their domestic law.

9

The classif‌ication of an entity for income tax purposes is required by the

source state in which another state’s entity is doing business in order to

determine issues such as whether to tax the entity or its members, the rate of

tax and the taxable income. Classif‌ication is required by the residence state

of the participators in an entity formed in another state so as determine the

nature of the taxable income, the timing of taxation, and the possible

availability of a foreign tax credit on the distributed income.

10

In the context

of a tax treaty, the classif‌ication of an entity is important to determine whether

the entity is a resident of the other contracting state. This is necessary, for

instance, to ensure that the treaty rates of withholding tax on dividends,

interest and royalties apply.

11

Generally, states have rules for classifying entities in the body of their

general law. Thus classif‌ication problems seldom arise internally. Dealings

with other states’ entities have to be f‌itted into the internal law classif‌ications.

f‌inancing. This type of planning exemplif‌ies a double-dip f‌inancing structure through the use of a hybrid

entity.Another example of a hybrid entity is the silent partnership recognised in some jurisdictions.

6

Olivier & Honiball op cit note 3 at 464.

7

See Arnold & McIntyre op cit note 3 at 144.

8

Peter Essers & Gerard TK Meussen ‘Taxation of Partnerships/Hybrid Entities’ in: Joseph A

McCahery, Theo Raaijmakers, Erik PM Vermeulen (eds) The Governance of Close Corporations and

Partnerships: US and European Perspectives (2004) at 415.

9

Arnold & McIntyre op cit note 3 at 144.

10

John Avery Jones et al ‘Characterisation of Other States’Partnerships for Income Tax’ (2002) 56

Bulletin for International Fiscal Documentation 288.

11

Ibid.

(2009) 21 SA Merc LJ52

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