Tax Implications of Investing in South Africa: an overview of the Construction permanent establishment

By Dr Hendri Herbst and Jané Visagie

Investing in South Africa can offer attractive opportunities for foreign businesses, but also entails various tax implications and challenges. One of the key issues that foreign investors need to consider is whether their activities in South Africa will create a permanent establishment (‘PE’) and expose them to a corporate income tax liability in South Africa. This article provides an overview of the income tax rules and principles applicable to the construction industry, which is one of the main sectors that may give rise to a PE in South Africa. Whilst not specifically discussed herein, a PE may also give rise to other tax implications (such as value added tax and employee taxes) and regulatory requirements (such as reportable arrangements and external company registrations), which may be applicable and should be considered in evaluating a possible PE risk in South Africa.

South Africa applies a residence basis of taxation, with non-residents only being subject to income tax on South African-sourced income, unless relief is provided under an applicable double tax treaty (‘DTA’).

The corporate income tax rate in South Africa is 27%, which is applied uniformly to both domestic companies and branches of foreign companies. South Africa does not impose a separate branch tax rate. Dividends withholding tax of 20% is levied on dividends paid by South African companies, subject to exemptions and applicable DTA terms. Notably, branches are not classified as ‘companies’ under the Income Tax Act, No. 58 of 1962 (‘ITA’), and thus, dividends withholding tax does not apply to amounts paid by a branch to its foreign head office.

Section 1 of the ITA defines the term PE with reference to article 5 of the OECD Model Tax Convention on Income and Capital (‘OECD Model DTA’). The applicable DTA delineates the scope of activities that an enterprise of one contracting state must conduct in another contracting state before the source state can tax the profits generated from such activities. The underlying principle is that a resident of a contracting state should not be taxed in the source state unless they establish significant ‘economic allegiance’ with the source state.

Article 5 of the OECD Model DTA defines a PE as a fixed place of business where the enterprise’s business is wholly or partly carried on, including management places, branches, offices, factories, workshops, mines, and construction sites lasting over 12 months. Excluded activities that do not create a PE include facilities used solely for storage, display, or delivery of goods, processing by another enterprise, and preparatory or auxiliary activities.

According to the OECD Model DTA, a building site, a construction, installation or assembly project constitutes a PE only if it lasts more than 12 months. While this time period can differ depending on the DTA in question, the 12 month threshold applies to the majority of South Africa’s DTA‘s.

Based on the OECD commentary, the phrase “a building site or construction or assembly project” should not be interpreted restrictively and the aforesaid also includes associated activities or activities of a similar nature. The OECD commentary further provides that a project should be regarded as a single unit, even if it is based on several contracts, provided that it forms a coherent whole commercially and geographically. It follows that a site exists from the date on which the contractor begins his work, including any preparatory work (but excluding time spent on negotiations), in the country where the project is to be established.

If a general contractor which has undertaken the performance of a comprehensive project subcontracts all or parts of such a project to subcontractors, the period spent by a subcontractor working on the building site must be considered as being time spent by the general contractor on the project for purposes of determining whether a PE exists for the general contractor.

A site typically continues to exist until the work is completed or permanently abandoned. The period during which testing is performed by the contractor or subcontractor should therefore generally be included in the period during which the site exists. The 12 month test applies to each individual site or project. In this determination, temporary interruptions do not result in the disregarding of time on site.

Considering the wording of the OECD Model DTA and the OECD Commentary, the intention is that once the 12 month threshold is met, the PE is deemed to exist retrospectively from the date of commencement of the project and not only from the date that the threshold is met.

Article 7 of the OECD Model DTA states that profits of an enterprise are taxable only in the residence state unless business is conducted in the source state through a PE. Profits attributable to the PE may then be taxed in the source state. A functional and factual analysis identifies PE activities and the arm’s length principle applies to determine remuneration for dealings between the PE and the enterprise. Deductions are allowed for expenses incurred for the PE’s purposes, including executive and administrative expenses, in line with the source state’s tax laws.

In light of the principles outlined above, it may be deceptively easy for a construction PE to arise in South Africa. Contractors and subcontractors involved in cross-border construction projects should therefore carefully monitor the duration and nature of their activities in South Africa and seek professional advice to avoid any unintended tax consequences.