Relaxation of South African exchange control rules in ‘loop’ structures, investments

The ‘loop’ structure and investments 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.

In simple terms, a ‘loop’ structure is generally created by a South African resident, trust or company transferring authorised or unauthorised funds from the country to, 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 authorised or unauthorised funds in South Africa, thereby creating ‘a loop structure.’ An exception to this, however, applied in South African residents permitted to individually or collectively acquire up to 40 per cent equity and/or voting right, whichever is higher, in a foreign target entity, which may in turn hold investments and/or make loans into any Common Monetary Area, which consists of South Africa, Eswatini, Lesotho and Namibia.

Prior to the Exchange Control Circular

Prior to January 1, 2021, South African individuals, companies, trusts and private equity funds were prohibited from utilising funds or any other authorised foreign asset to enter into a transaction or series of transactions to, directly or indirectly through any structure or scheme of arrangement, acquire shares or any other asset or interest in the CMA.

Changes the Exchange Control Circular introduced?

The changes outlined in the circular apply with effect from January 1, 2021 and are summarised below.

Individuals, companies and private equity funds

The amendments to the Exchange Control Rules provide that individuals, companies and private equity funds with authorised 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 authorised 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 authorised foreign assets. Individuals, companies and private equity funds may utilise authorised 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 is finalised. A yearly progress report must be submitted to the Financial Surveillance Department of the South African Reserve Bank through an authorised dealer;

An authorised dealer must view an independent auditor’s report verifying that the transaction 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 unauthorised loop structures (i.e. created prior to January 1, 2021), must still be regularised with the Finsurv. These amendments apply to South African trusts, which will continue to be prohibited from establishing loop structures.

Foreign inheritance

In the event that 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 may not represent or be sourced from a South African resident’s authorised 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 section 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.

FinSurv regulation

It is important to note that existing unauthorised loop structures created prior to January 1, 2021 and unauthorised loop structures where the 40 per cent 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’s approval will still be required, as this would continue to constitute an externalisation of South African assets. This aspect is of particular relevance to the private equity industry, where “dual structures” has become the industry norm to comply with the historic loop structure prohibitions.

Tax implications

It is particularly important for investors 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 they 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 with regard to loop structures that may primarily be the potential tax pitfalls, rather than the exchange control rules which have been prohibitive in the past.

Last line

While 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 authorised foreign assets, and thereby continues to subject residents without authorised foreign assets to exchange control approval with intent on establishing a loop structure.

It is recommended that individuals, who intend to invest 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.

*Mafongoya is legal intern at The Centurion Law Group