The judgment by the Supreme Court of Appeal (SCA) in the Coronation case has found its way into South African tax legislation. National Treasury is proposing to “clarify” the controlled foreign company (CFC) rules.
Several commentators say the clarification is, in fact, a legislative change that narrows the qualifying provisions for the foreign business establishment (FBE) tax exemption of CFCs. They believe the change will render South African CFCs less competitive or even force some to close their doors.
In the 2023 draft Taxation Laws Amendment Bill, Treasury says it has come to its attention that “some taxpayers” are retaining certain management functions but outsourcing other “important functions” for which the CFC is being compensated.
Therefore, it is proposed that all important functions for which a CFC is compensated should be performed either by the CFC or by another CFC in the same group of companies that is located and subject to tax in the same country as the CFC’s fixed place of business.
If not, the FBE tax exemption will not apply.
Joon Chong, tax partner at Webber Wentzel, says the wording of the proposed amendment “over-reaches and is overly broad” because it effectively brings an end to outsourcing. The proposal is contrary to the policy intent: namely, to enable South African multinational companies to expand their international footprint.
Where it started
The Coronation case ended in the courts when the South African Revenue Service (Sars) slapped the company with a massive tax bill, arguing that its operations in Ireland did not qualify for the FBE exemption. The tax in dispute dated back to the 2012 tax year.
The Western Cape Tax Court found the exemption did apply, but the SCA upheld Sars’s appeal and found that it did not.
The issue was whether the net income of Dublin-based Coronation Global Fund Managers (CGFM) should have been included in the taxable income of its South African holding company, Coronation Investment Management SA (Cimsa).
Coronation (Ireland) was a CFC in terms of the Income Tax Act.
The SCA said because Coronation (Ireland) outsourced some of its functions for which it was licensed in Ireland to Coronation in South Africa and the United Kingdom, it failed the economic substance test.
A CFC must include its net income or gains in the South African company’s tax calculation if it did not qualify for the FBE exemption.
To qualify for the FBE exemption, the 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 issues
There are two issues at stake, namely the technical grounds on which the SCA’s judgment was based, and the policy intent behind the CFC rules, says Keith Engel, the chief executive of the South African Institute of Taxation, who was involved in drafting the CFC legislation while still at Treasury.
He says the technical grounds for the judgment are currently in dispute. Some agree that the judgment was technically sound, whereas others disagree.
Engel says the second issue is whether CFCs will remain internationally competitive (which was the intention behind the exemption) if the proposed amendment is implemented.
Chong believes the amendment introduces a very high degree of uncertainty as to what are “important functions” (primary operations).
She gives the example of a CFC distribution business that outsources its call centre or part of the logistics function. The question now is whether these functions are “important functions” for which the CFC is being compensated. She is hopeful that the Coronation judgment will be taken to the Constitutional Court to obtain clarity.
“If South African multinationals want to invest millions of rands abroad, they want certainty. They do not want to be in a position where they are audited years down the line and then get a massive tax bill.”
The SCA considered the objective facts of the business operations but not the common commercial practices of the industry. A narrow approach to “primary operations” without considering commercial intent makes the FBE exemption landscape very uncertain, Chong says.
“The business model should be for the business itself to determine. If they want to outsource the operations and manage the risk that way, then it is up to the foreign business, as long as it meets the requirements of a proper establishment and is not just a postal office.”
The process
The draft bill was published at the end of July, and there is now time for public participation.
“We do hope there will be enough time and that stakeholders’ views will be heard and taken into account before the bill is passed into law,” Chong says.
Charles de Wet, executive consultant at ENSafrica, notes that companies with FBEs should take careful note of the degree of scrutiny the court applied to drill down to establish what is meant by primary operations.
He says not many companies have made changes to their current operational structures, mainly because they were waiting for the proposed changes.
The judgment and the proposed changes have wider implications than for fund management companies. If the changes are implemented, some companies may have to rethink their current business models.
Amanda Visser is a freelance journalist who specialises in tax and has written about trade law, competition law and regulatory issues.
Disclaimer: The views expressed in this article are those of the writer and are not necessarily shared by Moonstone Information Refinery or its sister companies. The information in this article does not constitute financial planning, legal or tax advice that is appropriate to every individual’s needs and circumstances.
