The Constitutional Court has agreed to hear an application by a subsidiary of Coronation Fund Managers for leave to appeal the asset manager’s dispute with the South African Revenue Service (Sars).
The outcome of the case could have far-reaching tax implications for South African companies with offshore operations.
On 1 September, the Constitutional Court issued a directive that it will hear the company’s application for leave to appeal and hear arguments on the merits of the matter. The matter will be set down for hearing by the Constitutional Court in due course, Coronation Fund Managers said in a SENS announcement on 5 September.
In February, the Supreme Court of Appeal (SCA) upheld an appeal by the Sars and ordered the company’s subsidiary, Coronation Investment Management SA (Pty) Ltd (CIMSA), to pay additional taxes in respect of profits earned by its international operations, together with interest and costs.
Coronation originally planned to set aside between R800 million and R900m to cover the disputed tax liability. It subsequently reduced the total obligation payable to Sars to R716m, which includes all its tax assessments from 2012 to 31 March 2023.
In 2022, Sars took CIMSA to the SCA, arguing against a previous decision of the Tax Court that the net income of Coronation Global Fund Managers (Ireland) Limited (CGFM) was not subject to tax in South Africa for the 2012 tax year.
The Ireland-based subsidiary is 100% held by CIMSA, an entity tax resident in South Africa. CGFM is therefore a “controlled foreign company” (CFC) under South Africa’s tax laws.
Sars believes the profits earned by CGFM should be included in CIMSA’s taxable income. CIMSA believes the income of Coronation Ireland is excluded under the “foreign business establishment” (FBE) exemption.
CIMSA would prefer the profits to be taxed in Ireland because that country has lower tax rates than South Africa.
CFC tax regime
The CFC rules, which are contained in section 9D of the Income Tax Act, are complex anti-avoidance rules aimed at taxing South African residents on the net income of a CFC. The purpose of this provision is to strike a balance between protecting the South African tax base and enabling South African multinationals to compete offshore.
The CFC rules contain exclusions and exemptions for certain types of income. For instance, if the CFC is in a high-tax jurisdiction, the CFC’s net income will not be imputed in the hands of the South African tax resident.
Furthermore, amounts that are attributable to an FBE of a CFC, as defined in section 9D, are excluded from the net income of the CFC.
In simple terms, an FBE consists of a fixed place of business located outside South Africa that is used or will continue to be used for the business of the CFC for at least one year.
To benefit fully from the FBE exemption, an FBE must also satisfy requirements relating to the nature of the business. In this context, the fixed place of business should be suitably staffed with on-site managerial and operational employees of the CFC, and its offices should be suitably equipped and have suitable facilities for conducting the “primary operations” of the business. Determining what constitutes the “primary operations” of the business is therefore critical.
Tax Court rules in favour of Coronation
When the matter was first raised by Sars in 2017, Coronation engaged with taxation experts and external legal counsel. Sars subsequently raised an assessment for the 2012 to 2017 financial periods that Coronation took on appeal to the High Court in Cape Town, which sat as a Tax Court.
Sars argued that Coronation Ireland did not have sufficient “economic substance” to meet the FBE exemption and thus wanted to impute the full Irish profits to the South African shareholder.
In September 2021, the Tax Court ruled that the FBE exemption did apply, finding that CGFM had demonstrated it was carrying out its business in Ireland and so the profits were not subject to South African tax.
‘Primary operations’ not conducted in Ireland, says SCA
Sars took the judgment to the SCA, which ruled in favour of Sars in February 2023 and ordered Coronation to pay the revenue service’s legal costs.
It was accepted that CGFM had a fixed place of business that was staffed by on-site operations and managerial employees, Jerome Brink, a director in the tax and exchange control practice at Cliffe Dekker Hofmeyr, said in a commentary on the SCA.
The key issue was whether the office was suitably equipped and staffed for conducting the “primary operations” of the Irish entity.
“Coronation contended that its primary operation in Ireland was ‘fund management’, which included the active management of its service providers, and regulatory compliance, Brink said.
“It furthermore submitted that the functions that it outsourced and did not conduct in Ireland comprised the larger fund management services (that is, investment management) provided to investors in conjunction with the investment manager, which was not its primary operation.
“The argument was therefore that because it outsourced its investment management functions to other entities, that was not its primary business operation and therefore its FBE in Ireland did not need to be suitably staffed by individuals conducting the investment management services.
“The SCA disagreed with Coronation’s submissions and held that the argument that investment management is not the Irish entity’s core business was at odds with what was stated in its founding documents, which specifically referred to establishing specified collective investment undertakings and carrying on the business of investment and financial management.
“In addition, the fact that the Irish entity’s primary source of income was from investment was, according to the SCA, another indication that its core function was investment management.”
Brink said the SCA also discussed the concept of outsourcing.
The court commented that even though the Irish entity was permitted to outsource functions, this did not mean that the scope of its business was confined to the supervision of the functions it has outsourced, together with regulatory compliance.
“Instead, its operations must be determined with reference to the activities under which it was granted its licence. If it chooses to outsource those activities to another entity, this does not mean those functions fall outside of its business,” Brink said.
The SCA determined that the primary operation of the Irish entity’s business (and, therefore, the business of the CFC) was that of “fund management”, which included “investment management”, and these operations were not conducted in Ireland.
Such an interpretation would give credence to the rationale that the CFC regime is in force for purposes of limiting a situation where a tax exemption is obtained in relation to earnings in a low-tax jurisdiction when the primary operations of the business are not conducted there, Brink said.
