The long-anticipated relaxation of the South African Exchange Control Rules relating to "loop" structures and investment was released on the 4th of January 2021 by the South African Reserve Bank under Exchange Control Circular No. 1/2021.
The "loop" structure and investment restriction were lifted to promote inward investments into South Africa, subject to the normal criteria applying to inward investments and reporting to the Financial Surveillance Department (FinSurv).
What is a “loop” structure?
In simple terms, a "loop" structure is generally created by a South African resident individual, trust, or company transferring authorized or unauthorized funds from South Africa too, for example, set up a foreign trust or foreign company. The foreign trust or company would then directly or indirectly (via another offshore entity) invest the authorized or unauthorized funds in South Africa, thereby creating a" loop structure".
An exception to this however applied in that South African residents were permitted to individually or collectively acquire up to 40% equity and/or voting rights, whichever is the higher, in a foreign target entity, which may, in turn, hold investments and/or make loans into any Common Monetary Area (CMA) which consists of South Africa, Eswatini, Lesotho, Namibia, and South Africa.
What was the South African Reserve Bank's position before the Exchange Control Circular?
Before 1 January 2021, South African individuals, companies, trusts, and private equity funds were prohibited from utilizing funds or any other authorized foreign assets to enter into a transaction or a series of transactions, directly or indirectly through any structure or scheme of the arrangement, acquire shares or any other assets or interests in the CMA.
What changes has the Exchange Control Circular introduced?
The changes outlined in the Circular apply with effect from 1 January 2021 and are summarized below.
Individuals, companies, and private equity funds.
The amendments to the Exchange Control Rules provide that individuals, companies, and private equity funds with authorized foreign assets may invest in South Africa through offshore structures, subject to reporting of the transactions through an Authorised Dealer to FinSurv.
The wording of this seems to suggest that the restrictions in terms of "loop" structures have only been lifted to the extent that the relevant exchange control residents already have authorized foreign assets. A South African resident would not be able to a create "loop" structure without prior exchange control approval where it does not have authorized foreign assets. Individuals, companies, and private equity funds may utilize authorized foreign assets to invest in South African assets through a loop structure, subject to the following requirements:
- The investment must be reported to an Authorised Dealer for instance a local bank, as and when the transaction(s) is finalized. An annual progress report must be submitted to the Financial Surveillance Department of the South African Reserve Bank (Finsurv) through an Authorised Dealer;
- An Authorised Dealer must view an independent auditor’s report verifying that the transaction(s) is concluded on an arm’s length basis and at a fair and market-related price;
- Upon completion of the transaction, the Authorised Dealer must submit a report to the Finsurv which should, among others, include the name(s) of the South African affiliated foreign investor(s), a description of the assets to be acquired, the name of the South African target investment company (if applicable), the date of the acquisition and the foreign currency amount introduced;
All inward loans from South African affiliated foreign investors must still comply with the current exchange control rules applying to inward foreign loans and existing unauthorized loop structures (i.e. created before 1 January 2021), must still be regularized with the Finsurv. These amendments to do apply to South African trusts, trusts will continue to be prohibited from establishing "loop" structures.
If a resident has inherited foreign assets held by the deceased offshore in compliance with exchange control regulations, the resident may apply to Finsurv for approval to retain the assets offshore.
Until recently, such approval would be subject to the condition that the assets may not be used to invest in a loop structure. The prohibition on the investment in loop structures has now been removed.
Inward foreign loans
Inward foreign loans received from foreign lenders will no longer be subject to the restriction that:
- The loan funds may not represent or be sourced from a South African resident’s authorized foreign assets; and
- There may not be any direct/indirect South African interest in the foreign lender.
Thus all clients who are either currently invested in loop structures or who have been unable to make investments as a result of the loop structure restrictions should carefully consider the impact of the proposed relaxations on their current or future investments.
Currency and Exchanges Manual
The changes to the exchange control rules do not affect sections B.2(F)(ii) and B.2(F)(iii) of the Currency and Exchanges Manual for Authorised Dealers which have not been deleted or amended.
These changes are also not industry-specific, as is the case with B.2(F)(ii) of the Currency and Exchanges Manual for Authorised Dealers, which provides that unlisted South African technology, media, telecommunications, exploration, and other research and development companies may establish an offshore company to raise foreign funding for their operations, subject to certain conditions.
Companies established in terms of this dispensation have been permitted to hold investments and/or make loans into South Africa in terms B.2(F)(iii) of the Currency and Exchanges Manual for Authorised Dealers.
It is important to note that existing unauthorized "loop" structures created before 1 January 2021 and unauthorized "loop" structures where the 40% shareholding threshold was exceeded will not be automatically regularised as a result of the changes to the exchange control rules.
These structures must still be regularised with the FinSurv. Additionally, where assets are contributed by a South African corporate to an offshore structure FinSurv approval will still be required as this would continue to constitute an externalization of South African assets.
This aspect is of particular relevance to the private equity industry where "dual structures" have become the industry norm to comply with the historic "loop" structure prohibitions.
Investors need to seek professional legal advice regarding the impact of the proposed tax changes on existing loop structures. This is because the proposed changes are intended to address potential tax leakage arising from the relaxation of loop structures. Several amendments have been proposed to existing tax legislation (in some instances punitive) to limit any tax leakage resulting from the relaxation of the rules to "loop" structures.
It is important to consider these changes once promulgated as it may have negative tax consequences on South African tax residents holding into existing "loop" structures or who consider implementing "loop" structures.
There are potential tax challenges that may arise in the future concerning "loop" structures that may primarily be the potential tax pitfalls rather than the exchange control rules which have been prohibitive in the past.
Whilst the removal of the prohibition of "loop structures" is a progressive welcomed development and a step in the right direction, the relaxation of "loop" structure prohibitions has possibly fallen short of what was anticipated. This is because the changes are limited to South African exchange control residents who already have authorized foreign assets and thereby continues to subject residents without authorized foreign assets to exchange control approval when intent on establishing a "loop" structure.
It is recommended that individuals who are intending on investing in an offshore company or structure with a loop structure component, should seek professional legal advice beforehand to understand the tax and exchange control considerations that will apply to their investment.
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