Should SA scrap corporate tax?

For the last five years, South Africa has raised around 20% of its tax revenue from corporate taxes. In the 2014-2015 tax year, these taxes totalled just under R185 billion.

The marginal rate for companies, other than small and micro enterprises, is set at 28% of taxable income. In reality, however, what companies actually pay is extremely variable.

“Company tax to most economists is a highly unsatisfactory system because companies do not pay the same tax, even within the same jurisdiction,” says Prof. Brian Kantor, chief economist at Investec. “It all turns on your definition of income, and what the tax authorities will allow in terms of deductions.”

For instance, in South Africa the more debt a company carries the less tax it will pay because any payments towards interest on loans are tax deductible. Since some sectors of the economy are less risky than others, companies that operate within these sectors are more capable of adding debt and naturally pay less tax.

Companies operating in certain areas are also given tax incentives. In South Africa, businesses get concessions for investing in blighted urban areas for example, or for operating from certain economic development zones.

“All of that makes corporate tax very much negotiated, rather than equal,” Kantor argues. “The company tax rate can, and does, vary because companies in effect manage their own tax with connivance from the government in the form of allowances and incentives.”

At the same time, shareholders in companies are also not treated equally.

“A private individual in South Africa will pay dividends withholding tax, and will pay tax at the marginal rate on all interest and rental income,” Kantor explains. “But pension funds are not subject to those taxes.”

All income in a retirement funding vehicle attracts no tax, so anyone who holds shares in a company through a pension fund, provident fund or retirement annuity is not being taxed at the same rate as someone who holds those shares in a private portfolio. This creates further inequalities in the way that the proceeds and benefits from business activity are taxed.

Kantor believes that this is a situation in need of reform.

“It’s not an original or unique idea, but the argument is that all of these distortions can be avoided if the companies themselves pay no tax, but all of the owners of companies are treated as partners with limited liability rather than shareholders,” he says. “You treat all the income received from the company, be it dividends or interest or rent, as ordinary income in the hands of the owners. This way you avoid the companies acting as a barrier to flows towards the owners and the company then could also act as the withholder of tax on behalf of the receiver as with PAYE.”

Real estate investment trusts (Reits) already have this character. Tax is payable only on the cash distributed to shareholders.

Having made some calculations, Kantor believes that if the state did this and taxed all income received by business owners in the same way, including those represented by pension funds, the amount of tax collected would be similar. However, there would be significant advantages.

“If we initiated a reform of this kind, we would be way ahead of the international competition in attracting head office business,” he says. “South African companies all over the world would be remitting profits to this country.”

This would stimulate economic growth, which benefits the country and ultimately leads to higher tax revenues.

In addition, while eliminating company tax would mean that there is no more place for any tax incentives from government, welfare to companies would become more transparent.

“There would be nothing to stop the government from giving companies cash to do certain things they think is useful,” Kantor argues. “But the cost of that will be an on-the-line budget item. If you are offering corporate welfare, you have to show what you’re spending. Tax incentives are largely hidden since it’s taxes saved rather than government expenditure.”

You also remove the significant problem of transfer pricing and companies moving profits to tax havens. Foreign-owned companies that add significantly to GDP in South Africa would no longer look to transfer operating profits to foreign tax havens.

“When you tax these foreign companies you have a real problem because the income being generated can be transferred to low tax havens,” Kantor says. “The tax authorities have to ask whether the charges made by head office are fair to South Africa. Is the company disguising or hiding its profits? Maybe it is and maybe it isn’t. There is huge room for disagreement and lack of consistency. That’s the problem with company tax – it’s a question of what expenses are allowed or negotiated.”

Fundamentally, Kantor believes that removing company tax and taxing all shareholders as partners with limited liability would be a far more rational system.

“If you go back in history, the reason governments came to tax companies on behalf of their owners was because it is so convenient to do so,” he says. “Companies are very effective agencies for collecting taxes, but ultimately it’s their owners – their shareholders – who are really paying.

“I’m arguing that South African companies could still do the collections, but in a much more rational, less distorting way,” Kantor concludes. “The taxes actually paid by different owners on the income realised for them would be much more equal as those earning the same income from whatever source would be liable for the same rate of taxation. Companies would then focus on realising economic income rather than income after taxes to satisfy their shareholders, and the economy would be much better directed.”

-Brought to you by Moneyweb