Funding African subsidiaries – thinking outside the proverbial box
Lend in Haste, Repent at Leisure
Like birds putting worms in the open beaks of their young, global groups are faced with the requirement to finance their subsidiaries (“subs”). As discussed in our recent article (click here to read) funding subs in Africa is complex and full of tax pitfalls.
The choice is made between debt and equity. In simple terms, the tax effect of each are as follows:
- Interest incurred by the foreign sub on the debt advanced is deductible against that sub’s profits;
- The interest is taxed in the country where the lender (Finance Co) is based; while
- Dividends paid by the sub company, as compensation to the parent for its equity investment, are not deductible against profits. The dividends are treated as exempt from tax when received by the parent.
There has historically been a preference by Group’s to finance through debt. This is not only for tax reasons but rather because it is generally thought that a loan is more flexible. Thus easier to pull back than a capital injection. But such financing can also, in theory result in tax benefits. Where the debt is advanced from a low tax jurisdiction to a high tax jurisdiction such that a tax deduction is granted for the interest at a high effective tax rate with the interest taxed at a low effective tax rate. Therefore, in theory, the tax benefit for the group is the difference between the two countries’ tax rates.
That’s how it worked in the old days. But in practice woe betide the CFO who thinks this is an easy tax win, when funding African subs. In practice there are a myriad of obstacles including:
- Withholding tax (“WHT”) on the interest payment which often cannot be reclaimed by the lender;
- Tests to the deductibility of the interest by the borrower;
- Low sub profits and restricted loss carry-forward rules which negate the benefit of a deduction for the borrower;
- Painful transfer pricing documentation to justify the quantum and terms of the loan;
- Exchange control approval;
- Currency losses and conversion costs;
all of which mean that getting tax benefits through financing is often a pipe-dream.
We advise funding through different ways because of these pitfalls and the mind-numbing TP and exchange control compliance burden. Capital injections can be a suitable mechanism depending on the country.
Funding through leasing
Another option is leasing. Let’s say an African sub requires financing to purchase equipment required for its business. What if the equipment were leased instead of a loan to enable the sub to buy the equipment?
Finance Co could itself acquire the asset (as legal owner) and lease the asset to the foreign sub for use in its business. Generally, the tax benefits that come with debt financing can be replicated with leasing without having to deal with:
- Limits on the deduction of the lease payment by the foreign sub;
- Traditionally lease payments are allowed as a deduction by the foreign sub jurisdiction; and
- Imposition of high WHT on lease payments. Typically, but with some notable exceptions, no WHT apply on lease fees.
- Group’s can structure the asset acquisition to take place in a country which offers favourable tax allowances/incentives, which are typically not available in the foreign African country concerned, is an added benefit of leasing.
Therefore, there are more finance options available to Groups and these options are not merely limited to “debt v equity” choice. The option that is chosen should be appropriate based on the unique circumstances of your business, the tax profile of the foreign sub concerned as well as the differences in tax laws of the applicable countries.
Please contact us to discuss further or click here to arrange a call with one of our team.
How can we help?
How you structure your business is a critical question as you expand globally. The right structure will protect your assets, improve your currency position, support your business operations, facilitate future business expansion and changes, and optimise your overall tax rate. Trying to unscramble a sub-optimal structure entered into in haste or without full consideration of relevant facts is complex and expensive, so it’s important to plan upfront.
Structuring an international business is both a science and an art – this is our specialist area of expertise. Regan van Rooy is an international tax and structuring advisory firm focussing on Africa. We have offices in South Africa, Mauritius and Ireland and we can help you with any international tax or structuring query.