Out with the old

The present Estate Tax Treaty between the United States and South Africa was signed by Jan Smuts on 10 April 1942. It was updated by Supplementary Protocols in 1950 and 1952, but has not been updated since. It remains in force between the two countries, governing the way in which the estates of South African individuals, which include US assets, and the estates US individuals, which include South African assets, are taxed in South Africa and the United States.

The existing treaty confers significant benefits on both South African residents and United States residents and citizens to the benefit of those individuals and their respective countries alike. However the treaty is in an outdated format. It does not have the precision of later treaties, it does not achieve some of the significant international policy objectives of both countries, and it contains provisions that present a significant impediment to international investment between the two countries. Accordingly in the interests of both the fisc and the citizens of both countries it should be updated.

South African investments in the US

From the point of view of the residents of South Africa and the United States, perhaps the most obvious difficulty with the present format is the way in which it constrains investment in the other country. Let us take the example of a South African resident, not a US citizen, who uses his or her exchange control allowance to invest internationally. He or she may choose to invest in the United States directly or, following an international model that is widely available, may choose to invest through collective investment vehicles in the legal form of partnerships which are fiscally transparent. Whichever method is used, the individual will be regarded for tax purposes as owning shares in and loans to United States companies.

Under the Estate Tax Treaty, the right to taxation of assets in the international states is addressed by means of a concept of ‘deemed situs’, with all assets in such estates being allocated either to South Africa or to the United States. The shares in the US company will be deemed situated in the United States for estate tax purposes, while the loans will be deemed situated in South Africa. Accordingly on death, the South African resident will have a US estate potentially subject to US taxation in respect of the appropriate proportion of the US shares held by the resident through the intermediate collective investment partnership. There will be no such liability in respect of the debt instruments, which are deemed as situated in South Africa, although these assets will be included in the South African estate. Full deductions will be allowed in the US against the US estate, ignoring the South African estate, and this may limit actual liability to taxation in the US, but not eliminate the hassle of complying with the treaty provisions. If US tax is imposed in respect of certain property, then in South Africa, credit will be allowed against South African tax to the extent that such tax is attributable to the same property.

By way of contrast, if this investment had been made under a treaty in the style of a more modern treaty, for example, a treaty similar to the US/French Double Tax Treaty, a new concept of ‘fiscal domicile’ would exist, introduced by the treaty. The South African resident would be deemed fiscally domiciled in South Africa. Under Article 8 of this treaty, intangible movable property, which includes shares and debts, is taxable only in the estate where the individual is fiscally domiciled. Accordingly there would be no US estate tax, and considerable fiscal complication would have been avoided to the advantage of both countries and their respective taxpayers.

US investments in South Africa

Let us consider the opposing example, where a US domiciled and resident citizen makes an inward investment into South Africa. Inward investment is to be encouraged from a South African perspective. From a US perspective, taxation policy requires US individuals to invest directly in the ultimate business entities in South Africa (either directly or through the medium of the collective investment partnerships referred to above), since adverse tax consequences attach to investments made by US persons through intermediate holding companies that are not fiscally transparent.

From a US perspective, the situs rules in the existing Estate Tax Treaty would be used to determine the situs of the assets. Pursuant to these rules, South Africa would have taxing rights in respect of the shares in SA companies held by the US citizen, but not in respect of the debt instruments held by the citizen. Under South African law, estate duty is imposed on shares in South African companies and debts enforceable in South Africa held by persons not ordinarily resident in South Africa at the date of death, so there would be South African estate duty imposed. Accordingly there will be an estate in South Africa, against which full allowances can be set. The US citizen will get credit for the South African tax payable. Again, there are significant compliance costs associated with this arrangement, which outweigh the minor differences in allocation of the tax proceeds, and which significantly impede inward investment in South Africa by US residents and citizens.

Again, by way of contrast, if a treaty in the style of the US/French Double Tax Treaty had been applicable, the US citizen would have been deemed fiscally domiciled in the United States. The situs rules would have prevented any imposition of tax in South Africa on the South African shares and debts held. Accordingly there would have been considerable simplification in the administration of the estate of the US citizen, again to the advantage of the US taxpayers and in a manner which would encourage inward investment by US investors.

US citizens resident in South Africa

The position of US citizens who are resident in South Africa is worthy of special consideration. They comprise a special class of individual since, as a matter of US internal policy, they remain subject to US taxing rights, no matter how close their other connections to South Africa may be.

From a South African perspective, under the existing treaty, such citizens are treated no differently from any other person ordinarily resident in South Africa. The South African estate would be subject to normal taxation, while the US estate would be subject to taxation based upon the situs rules set out in the treaty. A US citizen is more likely to have US assets and liabilities, perhaps acquired prior to moving to South Africa or indeed a US business. South Africa would treat US debts as South African situs, and US shares as US situs. From a US perspective, the entire estate of the US citizen would also be subject to US estate tax, with full credit being allowed under Article V of the existing treaty for the South African tax payable.

Under the provisions of a treaty along the lines of the more modern French treaty, the provisions of the treaty would allocate fiscal domicile in respect of the US citizen to South Africa. This would avoid the awkward allocation of US debts to South African situs and US shares to US situs. It would also make US shares fully taxable in South Africa, which South Africa would regard as a natural consequence of full ordinary residence in South Africa. This would not prevent US international policy in respect of its citizens from being fully applicable. Accordingly the restriction in treaty benefits applicable to US citizens would cause the US citizen’s estate to be fully subject to US estate tax but, just as under the existing treaty, the US citizen’s estate will receive full credit for the South African tax payable.

However the following provisions, included in the French/US double tax treaty, would confer significant additional benefits on the US citizens, which could be of significant benefit to South Africa and are not available under the existing SA/US treaty.

• A provision enabling the estate of a US citizen to claim the benefit of the charitable exemption, in making gifts to South African charities, and not just US charities.
• The provisions relating to community of property and the marital deduction.

Both these concessions would be of significant benefit to persons resident in South Africa and are missing if the treaty is not renegotiated.

US fiscal policy

In addition, of course, the new style double tax treaty contains significant provisions intended to protect the position of and enforce US international fiscal policy. Examples are the extension of the taxing powers of the United States to the former citizens or long-term residents whose loss of such status had as its principal purposes the avoidance of tax, for a period of ten years after such loss. Such provisions are not particularly in the interests of South African citizens or residents, but equally such provisions have been part of the domestic law of the United States for some time, and they are aimed at persons who have accepted a relationship with the United States presumably knowing that such provisions may become applicable, and so they should not be an insurmountable stumbling block for South Africa.

Conclusion

Both South Africa and the United States should devote some resources to addressing the estate tax treaty even if this particular aspect of their relationship may appear obscure. Not only will there be significant benefits to both countries arising from increased efficiencies in the administration of the estates of individuals having assets in both countries, but this itself may result in more international investment in both directions, to the advantage of both countries.

This article first appeared in Without Prejudice in December 2008.

In addition, of course, the new style double tax treaty contains significant provisions intended to protect the position of and enforce US international fiscal policy. Examples are the extension of the taxing powers of the United States to the former citizens or long-term residents whose loss of such status had as its principal purposes the avoidance of tax, for a period of ten years after such loss. Such provisions are not particularly in the interests of South African citizens or residents, but equally such provisions have been part of the domestic law of the United States for some time, and they are aimed at persons who have accepted a relationship with the United States presumably knowing that such provisions may become applicable, and so they should not be an insurmountable stumbling block for South Africa.