Coronation Fund Managers on Friday withdrew its cautionary announcement to shareholders after the Constitutional Court ruled in its favour in its tax dispute with the South African Revenue Service (SARS).
Coronation has been engaged in protracted litigation with SARS over whether the profits of its Irish business, Coronation Global Fund Managers (CGFM), should be included in the taxable income of Coronation Investment Management SA, its South African holding company.
The judgment is significant for South African corporates with offshore operations that rely on the foreign business establishment (FBE) tax exemption in section 9D of the Income Tax Act (ITA). If the Constitutional Court had ruled in favour of SARS, the tax implications would have made it difficult for these subsidiaries to compete internationally.
Coronation established CGFM in 1997 as a fund management company, which delegates investment management trading activities to Coronation Asset Management (Pty) Ltd (CAM) in South Africa and Coronation International Limited (CIL) in the United Kingdom.
CGFM is a “controlled foreign company” (CFC) in terms of the ITA. Its parent company is CIMSA (Coronation), which is resident in South Africa.
The main issue in the litigation was whether CGFM’s net income should be included in Coronation’s taxable income, or whether CGFM was an FBE subject to the tax exemption.
To qualify for the FBE exemption, a CFC must have a fixed place of business in the foreign country, and it must be suitably staffed and equipped to conduct its “primary operations” (important functions) in that country.
The judgment clarified how the FBE exemption applies to foreign profits. Coronation needed to prove that its primary operations occurred in Ireland to qualify for the tax exemption. The Constitutional Court’s recognition that CGFM’s active fund management functions met this criterion was pivotal to the outcome of the appeal.
The apex court recognised that outsourcing is a legitimate and essential business practice. By ruling that the FBE definition is not anti-outsourcing, the judgment allows South African companies to set up and operate foreign businesses more flexibly, promoting global competitiveness and operational efficiency.
Tax Court agrees with Coronation
The dispute between Coronation and SARS dates to 2012. SARS determined that CGFM’s net income must be included in Coronation’s taxable income because its operations in Ireland did not qualify for the FBE exemption. SARS also imposed understatement penalties and interest.
Coronation objected, arguing that CGFM is an FBE and is subject to the exemption. As such, its net income should not be included in Coronation’s taxable income.
Coronation appealed to the Tax Court, which ruled in its favour.
The Tax Court distinguished between the functions of fund management and investment management, and understood CGFM’s primary operations to be fund management, which it conducts in Ireland, and not investment management, which it delegates outside of Ireland.
It accordingly held that CGFM met the requirements of the FBE definition and therefore qualified for the tax exemption. The Tax Court also dismissed SARS’s claims for penalties and interest.
SCA says CGFM doesn’t quality as an FBE
SARS appealed to the SCA, which reversed the Tax Court’s decision.
The SCA understood CGFM’s primary operations to include both fund management and investment management. The court SCA said because CGFM outsourced some of its functions for which it was licensed in Ireland to Coronation in South Africa and the UK, it failed the economic substance test.
Consequently, the SCA held that CGFM did not meet the requirements of the FBE definition and Coronation was required to pay tax on CGFM’s net income.
However, the SCA dismissed SARS’s claim for the penalties. In doing so, it relied mainly on a recent decision of that court, Commissioner for the South African Revenue Service v The Thistle Trust.
Coronation’s case in the apex court
In its appeal to the Constitutional Court, Coronation submitted that the SCA erred in its interpretation of the FBE definition.
Coronation submitted that the SCA employed a “notional-business interpretation”, under which the business and primary operations of a CFC must be determined by having regard to the operations the company could perform, not what it does perform.
Coronation maintained that the correct interpretation is the “actual-business interpretation”, under which the business and primary operations of a CFC must be determined by having regard to what the company in fact does, not what it could do. It submitted that it cannot perform operations that are not part of its chosen, or authorised, licensed business.
Coronation further submitted that the FBE definition does not use the word “outsource” and its focus is squarely on economic substance.
Conversely, SARS submitted that CGFM outsources all its functions for which it is licensed as a management company, including its primary function of investment management, to offshore entities, CIL and CAM.
SARS’s submissions
SARS contended that the proviso to the FBE definition expressly permits outsourcing of the location permanence and the economic substance of a CFC, provided the requirements in the proviso are met.
SARS submitted that a proviso is not a separate and independent enactment. It maintained that CGFM’s delegation of functions to CIL and CAM did not meet the requirements in the proviso and CGFM therefore did not meet the requirements of the FBE definition. SARS submitted that the words of the proviso cannot be read as though divorced from their context.
SARS also brought a cross-appeal against the SCA’s findings in respect of the penalties, which Coronation opposed.
Among other things, SARS submitted that Coronation was deliberate in claiming the FBE exemption and, even if the tax position taken by Coronation was in good faith, it was not unintentional and therefore fell outside the scope of “inadvertence”, making SARS liable for the understatement penalty.
Coronation submitted that SARS failed to engage with the substantial evidence, demonstrating that Coronation was acting in good faith by relying on an opinion from a tax expert and did not deliberately misstate its tax liability or act with the intention to deceive. It also argued that SARS’s approach in declaring that “inadvertence” requires only a “slip of the pen”, as opposed to a tax position deliberately adopted, was flawed.
SARS misconceived the central issue
In a unanimous decision, the Constitutional Court held that CGFM met all the requirements of an FBE in terms of section 9D of the ITA. Thus, CGFM’s net income ought to have been exempted from tax. For that reason, it was not necessary to deal with the cross-appeal.
The court held that SARS fundamentally misconceived the central issue in the case, which was the distinction between fund management and investment management. The court found that the SCA committed the same error, leading to its fallacious conclusions.
In accordance with its business plan, presented as part of its licence application, CGFM employed a delegated business model through which it could conduct specified fund management functions. It would delegate investment management trading activities (which it is not authorised to do by its licence) to third parties, CAM and CIL, while retaining overall supervision of, and responsibility to, the regulator for those functions.
CGFM performed a number of core management functions under its licence, including the supervision of delegates such as CAM and CIL as investment managers. Moreover, its day-to-day operations from its Dublin office in pursuit of these management functions met the “economic substance” requirements of the FBE definition, namely that the company must have a fixed place of business that is suitably staffed and equipped to conduct the primary operations of its business.
Therefore, the Court determined that the Tax Court was correct in holding that CGFM qualified for a tax exemption and SARS must issue a reduced tax assessment, excluding from it any amount that was included in Coronation’s income pertaining to CGFM’s income.
‘Notional business’ approach is flawed
The SCA held that “the regulations indicate that the purpose of delegation is to enhance the efficiency of the company’s business. It does not detract from the business of the company, nor is it possible for delegation to alter that business.”
The Constitutional Court found the SCA erred in adopting this “notional business” approach, which ultimately led to its holding that CGFM does not meet the requirements for an FBE exemption.
The court said the SCA should have had regard to CGFM’s business model (the way it elects to do business) and its licensing conditions (what it may lawfully do).
The Constitutional Court further held that the SCA failed to draw the important distinction between investment management in its wide sense and the narrower concept of investment management trading.
The ultimate effect of the SCA’s erroneous “notional business” approach is that CGFM’s primary business is that which it calculatedly chose not to do, did not apply to do, and by law was not able to do, namely investment trading.
The Constitutional Court reasoned that is inconceivable that the business of a CFC as envisaged in section 9D is everything that the CFC can in theory and notionally do in pursuing a commercial endeavour, even if that company does not actually do it.
Ensuring competitiveness of SA companies
The SCA also concluded that “the FBE definition is not aimed solely at advancing international competitiveness for offshore businesses. Nor is the legislation concerned only to prevent diversionary, passive or mobile income eroding the South African tax base. It is also to limit a situation where an exemption is obtained over earnings in a low-tax jurisdiction when the primary operations for the business are not conducted there.”
The Constitutional Court found that these statements undermine the stated objects of section 9D – to ensure that offshore companies remain competitive in relation to their foreign rivals. Thus, these statements by the SCA lost sight of the fact that a South African company is legally constrained to move offshore to service its investor clients who want to take up the opportunities created abroad after the relaxation of the foreign exchange controls.
