Cessation of tax residency: tax triggers for retirement fund interests

Over the last year or so we have seen legislative changes to the taxation of retirement fund interests for individuals who cease to be tax resident of South Africa. With the publication of the draft Taxation Laws Amendment Bill (TLAB) on 28 July 2021, National Treasury and SARS propose further changes to this tax regime which in many tax professionals’ views are unreasonable, procedurally unfair and simply unconstitutional.

In 2020, changes were proposed to the definitions of ‘pension preservation fund’, ‘provident preservation fund’ and ‘retirement annuity fund’ in section 1 of the Income Act Tax No. 58 of 1962 (the Act) to remove the reference to emigration as recognised by the South African Reserve Bank for exchange control purposes in order that lump sum benefits could only be paid from such funds where a member ceased to be tax resident and remained nonresident for an uninterrupted period of three years or longer on or after 1 March 2021. Historically, individuals who emigrated from South African for exchange control purposes could access their retirement fund interest in pension preservation, provident preservation and retirement annuity funds before actual retirement date and remit such funds offshore; now, with effect from 1 March 2021, a member who ceases to be tax resident will only be able to withdraw his or her interest in such funds before retirement date when that member has been a non-resident for a minimum of three consecutive years.

This was in line with the removal of the concept of emigration for exchange control purposes, while shifting the focus to tax emigration.

Section 9(2)(i) of the Act deems amount to be from a South African source, and hence subject to South African tax, where a lump sum or pension or annuity is paid by a retirement fund in respect of services rendered and where such services were rendered in South Africa. However, in terms of the provisions of certain tax treaties, such lump sums, pensions or annuities are not always subject to tax where an individual ceases to be tax resident.

A tax treaty is an agreement between two governments essentially to avoid double taxation and prevent fiscal evasion with respect to taxes on income, and in terms of our Constitution, any international agreement becomes law in South Africa once enacted into law by national legislation.

Most tax treaties are based on the OECD Model Tax Convention. Article 18 of this convention provides that payments from retirement funds are taxable only in the country that the individual is tax resident, giving no consideration to the source or location of the services rendered in respect of which such payments are made. Therefore, where an individual becomes resident of a country with which South Africa has concluded a double tax treaty, in general he or she will not be subject to South African tax on payments from retirement funds, only being taxed in the country in which he or she is tax resident. This results in a loss to the South African fiscus.

Accordingly, a South African tax resident will be taxed on withdrawals from his or her retirement fund whether as a pre-retirement withdrawal, on retirement or death but if the individual ceases to be tax resident before he or she retires or dies the interest in a retirement fund may not be subject to tax as South Africa may forfeit its taxing rights in terms of the application of a tax treaty.

This surely is unfair and inequitable treatment towards taxpayers who choose to remain South African tax resident.

This inequity is compounded by the fact that these emigrants enjoyed years of tax savings by claiming a tax deduction on contributions made to pension and retirement annuity funds, and recently with the change in tax treatment of provident funds, contributions to such funds as well. So, it appears that allowing individuals to benefit from tax savings at a likely marginal tax rate of 45% with no tax payable on receipt of the payouts is inequitable.

Perhaps these factors prompted National Treasury and SARS to attempt to ensure tax equity in respect of the taxation of retirement funds, irrespective of an individual’s tax residency status.

The proposed changes which, if enacted, will see the insertion in the Act of a new section 9HC, will subject to South African tax an individual’s interest in retirement funds when he or she ceases to be tax resident, at the tax rates applicable to either a withdrawal benefit or a retirement benefit. A two pronged approach is proposed to cater for where an individual ceases to be tax resident and either withdraws his or her interest in the South African retirement fund prior to retirement or death or retains his or her investment in a South African retirement fund and only withdraws his or her interest in the retirement fund on death or retirement from employment. It is proposed that:

  • The individual will be deemed to have withdrawn from the retirement fund on the day before he or she ceases to be tax resident as envisaged in the Act.
  • The interest in the retirement fund will be subject to tax rates applicable to lump sum benefits. However, the tax payment (including associated interest on the tax as calculated) will be deferred until an amount is receivable from the retirement fund.
  • When the individual receives a payment in respect of the withdrawal from the retirement fund, tax will be calculated based on the prevailing withdrawal tax tables while on receipt of a payment in respect of retirement from the retirement fund, tax will be calculated based on the prevailing retirement fund lump sum tax tables or in the form of an annuity.
  • A tax credit will be provided for the deemed tax as calculated when the individual ceased to be tax resident.

In essence, the proposals have the effect that an individual is deemed to have disposed of his or her interest in the retirement fund on the day immediately before ceasing to be tax resident. However, the tax liability is deferred until an amount is actually received from the retirement fund, while interest is deemed to be incurred from such day until the tax is settled in full.

Some of the concerns raised and anomalies identified by various tax professionals include that:

  • Tax is levied on the individual on the day before he or she ceases to be tax resident. However, the individual may be prohibited from accessing or withdrawing such funds for three years, so will only be liable to pay the tax after the three-year period. In the meantime, interest accumulates on the outstanding tax. When the individual eventually does exit from the retirement fund, tax is calculated on his or her total retirement interest at such date, utilising the prevailing tax rates. This tax be reduced by the tax calculated on the deemed withdrawal and the interest accumulated.
  • It is established law that in order to charge interest on late payments the debt must in fact be due. Sections 189 and 187(3) of the Tax Administration Act, No. 28 of 2011 confirm the imposition of interest on a debt that is due. It may be questioned whether it is reasonable or even constitutional to levy interest on a tax debt which is not yet due.
  • Certain tax treaties give the taxing right on retirement funds to the country of residence which will, in terms of the proposed changes, subject the retirement fund interest to double taxation, namely in South Africa upon tax emigration and in the country of residence upon subsequent withdrawal of amounts from the retirement fund. The proposals appear to be at odds with the spirit and overall purpose of tax treaties, namely the avoidance of double taxation.
  • Furthermore, the proposals do not cater for instances of failed emigration or where an individual who ceased to be tax resident again becomes resident of South Africa, whether in terms of our residence tests or in terms the provisions of a tax treaty.
  • In terms of the rules for pension, pension preservation funds and retirement annuity funds, one third of the value may be commuted for cash while an annuity must be purchased with the remaining two-thirds. The proposed deemed tax debt deferral is levied on the full fund value. However, the resultant cash flows on exit from the retirement fund equates to only one-third of the value.
  • For National Treasury and SARS to give effect to the proposed amendments, changes would need to be made to the Pension Funds Act. If the intended effective date of these proposals is 1 March 2022 this does not leave much time for engagement with the relevant industry stakeholders.

One wonders how these proposals can be considered reasonable and fair or even within the rights afforded to taxpayers in terms the Promotion of Administrative Justice Act, No. 3 of 2000 (PAJA), to which National Treasury and SARS are bound. PAJA requires procedurally fair administrative actions and seeks to protect among other parties, the public, from unlawful, unreasonable and procedurally unfair administrative decisions.

The continued focus by government on retirement funds causes uncertainty and concern in the financial markets and may even fuel the perception that our retirement funds may no longer be as attractive as investment vehicles, whether for the standalone investor or for purposes of compulsory occupational retirement savings for an employee. The proposed changes act as a further deterrent to these future investors who may choose alternative investment vehicles, notwithstanding the current beneficial tax treatment of contributions to retirement funds. These tax benefits are a tax deduction for contributions up to 27.5% of taxable income, limited to a maximum of R350 000 per tax year.

It is for these reasons that the tax and retirement fund industry has been vocal in calling for the withdrawal of the proposals, until at the very least government has engaged with the relevant stakeholders.

The timing of these proposals is somewhat perplexing. Many South African tax residents have already ceased tax residency and it seems that National Treasury and SARS are now scrambling to enact legislation dealing with the above situation.

As a tax-paying patriotic South African I am all for the collection of taxes rightly due and payable by emigrants for the enjoyment and privilege of having worked and lived in our beautiful country, similar to the taxes I will one day pay on retirement, or at the very least the recoupment of the tax deductions afforded to those emigrants. But there is a right way and not such a right way…upholding our Constitution and adhering to international agreements is the right way, rushing this piece of legislation is not.

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