1 University of Witwatersrand, Johannesburg A research report to be submitted to the Faculty of Commerce, Law and Management in the partial fulfilment of the requirements for the degree of Master of Commerce (Specilaising in Taxation) A critical analysis of the foreign business establishment exemption and its role in the prevention of base erosion and profit shifting 2 Abstract Section 9D of the Income Tax Act 58 of 1962 sets out the controlled foreign companies rules. This section contains anti-avoidance provisions that seek to prevent South African tax residents shifting their taxable income to foreign countries by way of a controlled foreign company. In terms of section 9D the net income of controlled foreign companies is taxed in the hands of the South African residents in proportion or their shareholding, unless the amount is subject to one of the specific exemptions. One such exemption is the foreign business establishment exemption. This exemption has been criticised as the definition of foreign business establishment is not adequate. The criticism arises from the fact that many controlled foreign companies meet the definition of a foreign business establishment by default even though they do not constitute a bona fide foreign business establishment. This paper critically evaluates this exemption considering the OECD BEPS Pillar Two Rules, the Income Tax Act 58 of 1962 and the Mauritian and UAE substance standards and whether the rules of this exemption should be more specific and stringent. The substance standards were found to be more stringent in comparison to the FBE definition and therefore enhanced the FBE definition. The scope of the Pillar Two blueprint meant that many South African companies would more likely than not be scoped out of its realms and therefore would not assist in enhancing the FBE definition. Key words: Controlled foreign company, Resident, Foreign business establishment, Exemption, OECD, Base erosion and profit shifting, Anti-avoidance, Tax avoidance, Substance standards, Multinational Enterprises 3 Declaration I declare that this research report is my own work. It is submitted in the partial fulfilment for the Masters in Commerce (specialising in Taxation) degree at the University of Witwatersrand in Johannesburg. It has not been submitted before for any other degree or examination at any other university. 4 Acknowledgments I would like to Praise God without whom this would not have been possible. My parents, husband and daughter for their support and sacrifices made in order to get me to this point and my supervisor Reinhard, who continued to encourage me throughout the process. 5 List of acronyms and abbreviations CFC Controlled foreign company FBE Foreign business establishment MNE Multinational enterprise ITA Income Tax Act 58 of 1962 BEPS Base erosion and profit shifting OECD Organisation for Economic Co-operation and Development SARS South African Revenue Service 6 Table of Contents Abstract ............................................................................................................................. 2 Declaration ........................................................................................................................ 3 List of acronyms and abbreviations .............................................................................. 5 Chapter 1: .......................................................................................................................... 8 Introduction: .............................................................................................................................. 8 The research problem ............................................................................................................ 13 The sub-problems ................................................................................................................... 14 Research methodology .......................................................................................................... 14 Chapter 2: Review of the controlled foreign company provisions as set out in the Income Tax Act 58 of 1962 ............................................................................................ 15 Chapter 3: A critical analysis of the foreign business establishment exemption and its role in preventing base erosion and profit shifting. ..................................... 32 CFC Rules ................................................................................................................................ 32 Foreign business establishment in the context of Section 9D of the ITA ....................... 33 Commissioner for the South African Revenue Service v Coronation Investment Management SA (Pty) Ltd: ..................................................................................................... 43 Commentary on the draft strengthening the CFC rules report ......................................... 47 Chapter 4: Examination of the new substance standards imposed by UAE and Mauritius. ......................................................................................................................... 50 Introduction of substance standards ................................................................................... 50 Mauritius: ................................................................................................................................. 55 United Arab Emirates: ............................................................................................................ 61 Chapter 5: The impact of the substance standards imposed by the UAE and Mauritius on the foreign business establishment definition and exemption as set out in section 9D of the Income Tax Act. .................................................................... 64 7 Mauritius: ................................................................................................................................. 66 United Arab Emirates: ............................................................................................................ 73 Chapter 6: An examination of the impact of the new OECD Blueprints on the foreign business establishment exemption. .............................................................. 79 Chapter 7: Conclusion ................................................................................................... 94 Reference list .................................................................................................................. 96 8 Chapter 1: Introduction: The international tax rules were developed in a past era, rendering them largely outdated in the current economic landscape. International tax has become a topical issue across the globe, as many markets and economies have become more integrated and globalisation of companies has become more prevalent. If these rules aren’t updated, opportunities will be created for taxpayers to shift profits to lower tax jurisdictions and erode the tax base of their resident country. This places significant importance on modernising international tax rules to ensure that they reflect the current economic environment and that the profits earned by companies reflect their economic activity in the countries they are resident in.1 In February 2013, the Organisation for Economic Co-operation and Development (OECD) released a report entitled Addressing Base Erosion and Profit Shifting. Subsequently, a 15-Point Action Plan was adopted by all OECD and G20 countries in September 2013 to address Base Erosion and Profit Shifting (BEPS). This 15-Point Action Plan is based on three pillars, being: “introducing coherence in the domestic rules that affect cross-border activities, reinforcing substance requirements in the existing international standards, and improving transparency as well as certainty”.2 Action 3 of the 15-Point Action Plan consists of “Designing effective controlled foreign company rules”. Controlled foreign companies (CFCs) create the opportunity for BEPS. 1 OECD, 2015. Designing Effective Controlled Foreign Company Rules, Action 3-2015 Final Report, p3 [Online]. Available: https://www.oecd-ilibrary.org/docserver/9789264241152- en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220 469B61 [2023, February, 15]. 2 OECD, 2015. Designing Effective Controlled Foreign Company Rules, Action 3-2015 Final Report, p3 [Online]. Available: https://www.oecd-ilibrary.org/docserver/9789264241152- en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220 469B61 [2023, February, 15]. https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220469B61 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220469B61 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220469B61 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220469B61 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220469B61 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220469B61 9 This is because resident taxpayers can obtain a controlling interest in a foreign company, the profits of which will be taxed in the foreign company’s resident jurisdiction. The residents who have a controlling interest in the entity will not be subject to taxes on these profits. This allows for profit shifting and the long-term deferral of taxation in the absence of rules to address this risk.3 From a South African perspective, section 9D of the Income Tax Act 58 of 1962 (ITA) governs the rules of controlled foreign companies (CFCs). In terms of section 9D(1) of the ITA, CFCs are foreign companies in which South African tax residents have a majority shareholding, either alone or collectively. The net income derived by these companies, despite being the income of the foreign company, will be taxed in the hands of the South African tax residents in proportion to their participation rights in accordance with section 9D(2) of the ITA. In terms of National Treasury’s Detailed Explanation to section 9D of the Income Tax Act, 4 the rationale behind the CFC rules of section 9D of the ITA is to prevent the deferral of tax through South African owned foreign entities. International law allows South Africa to tax non-residents on their South African source income. It does not, however, allow South Africa to tax foreign entities on their foreign source income even if South African residents hold a majority shareholding, thereby owning the entity.5 There are two instances in which the net income of a CFC is deemed to be nil and, therefore, no inclusion of section 9D will be taken into account in the taxable income of the resident that holds participation rights in the CFC. This essentially means that the CFC rules would not be applicable if the requirements for one of these exclusions have 3 OECD, 2015. Designing Effective Controlled Foreign Company Rules, Action 3-2015 Final Report ,p9 [Online]. Available: https://www.oecd-ilibrary.org/docserver/9789264241152- en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220 469B61 [2023, February, 15]. 4 National Treasury, 2002. National Treasury’s Detailed Explanation to Section 9D of the Income Tax Act, p.1 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 15]. 5 National Treasury 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 1 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 09]. https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220469B61 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220469B61 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220469B61 https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf 10 been met. In terms of the section 9D(2A) second proviso (i)(aa) of the ITA, the net income of the CFC is deemed to be nil where “the aggregate amount of taxes on income payable to all spheres of government of any country other than the Republic by the controlled foreign company in respect of the foreign tax year of that controlled foreign company is at least 67.5% of the amount of normal tax that would have been payable in respect of any taxable income of the controlled foreign company had that controlled foreign company been a resident for that foreign tax year.” The second exemption is the foreign business establishment exemption, as set out in the second proviso (i)(bb) to section 9D(2A). This exemption states that the net income of the CFC in respect of the foreign tax year shall be deemed to be nil where the receipts and accruals of the company are attributable to a foreign business establishment (FBE) as defined in section 9D(1). The definition of a foreign business establishment is set out in section 9D(1) of the ITA as: “a company with a fixed place of business located in a country other than the Republic that is used or will continue to be used for the carrying on of the business of the CFC for a period of not less than one year.” This definition follows the options for substance analysis as set out in the BEPS Action 3: Strengthening the CFC Rules issued by the OECD. In this report the OECD states that an option in designing a substance analysis test for jurisdictions, is to consider whether the CFC has the necessary business premises and establishment in the CFC jurisdiction and the necessary number of employees with the required skill to conduct the activities of the business.6 6 OECD, 2015. Designing Effective Controlled Foreign Company Rules, Action 3-2015 Final Report ,p48 [Online]. Available: https://www.oecd-ilibrary.org/docserver/9789264241152- en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220 469B61 [2023, February, 15]. https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220469B61 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220469B61 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676447590&id=id&accname=guest&checksum=D42E7C697A3960839FEAF60220469B61 11 The substance analysis options set out in the BEPS Action 3 Report, and, by extension, the concept of a foreign business establishment, has been criticised for being too narrow.7 According to Olivier and Honiball, the FBE exemption is one of the most complicated provisions in the ITA. The exemption aims to strike a balance between exempting income from legitimate offshore entities and that of entities set for non-substantive undertakings8. From this it is evident that the FBE exemption may be taken advantage of and can erode the tax base of South Africa. This could result in large multinational entities shifting profits of non-substantive undertakings offshore to pay less tax causing the South African tax base to suffer. The definition of the FBE lacks scope and specificity. Its application is also dependent on the nature of the business to define the facilities, equipment and people needed. This creates subjectivity. The subjectivity opens the definition up to interpretation9. This could result in many taxpayers taking advantage of the FBE exemption as specificity does not exist. It could also result in differences of opinions when applying these provisions between SARS and taxpayers resulting in disputes. This paper aims to discuss this exemption and the challenges created by it for South African tax residents and SARS as well as its role in base erosion and profit shifting (BEPS). Mauritius and Dubai have introduced substance standards with the purpose of ensuring that the profit earned by a foreign company is proportionate in size and nature to the activities that the entity undertakes in the foreign country in which the company is resident.10 7 OECD 2015. Comments received on Public Discussion draft BEPS Action 3: Strengthening CFC rules p234, para 9 [Online]. Available:]https://www.oecd.org/tax/aggressive/public-comments-beps-action-3- strengthening-cfc-rules-part1.pdf [2023, February 13]. 8 Olivier, L. & Honiball, M. 2011. International Tax: A South African Perspective 5th Edition, p. 581. Cape Town: Siber Ink. 9 Tickle, D. 2022. Controlled Foreign Companies and the Future of the Foreign Business Establishment Exemption. Tax Talk 2022 (96): 40-43. 10 Deloitte 2019. New economic substance rules introduced by “tax havens” brought into force from 1 January 2019 [Online]. Available: https://www.oecd.org/tax/aggressive/public-comments-beps-action-3-strengthening-cfc-rules-part1.pdf https://www.oecd.org/tax/aggressive/public-comments-beps-action-3-strengthening-cfc-rules-part1.pdf 12 The Dubai and Mauritius substance standards may have the ability to work in harmony with the FBE exemption of SA. Both Mauritius and Dubai are jurisdictions that have been identified by the European Union Code of Conduct Group as jurisdictions with no or nominal tax11 i.e., low tax jurisdictions and these standards may ensure that legitimate foreign companies are set up in Dubai and Mauritius, and that the profits of these entities match the activities of these entities in the country they are resident in. This may prevent residents from setting up FBEs simply to take advantage of the exemption as the substance requirements add an additional layer of conditions to be met in setting up the foreign company in Dubai and Mauritius. Consideration should also be given to whether the substance requirements that have been implemented by Mauritius and Dubai enhance the section 9D provisions of the ITA to ensure that only bona fide FBEs are taking advantage of the section 9D FBE exemption. The OECD released a framework to address the new challenges faced with regards to digitalisation from an international tax perspective. The OECD recognises that in this new economic environment, digitisation has become more popular which means that the tax rules need to keep up with these changes to ensure that they remain relevant. This framework is known as the OECD/G20 Inclusive Framework on BEPS: The Reports on the Blueprints of Pillar One and Pillar Two.12 https://www2.deloitte.com/content/dam/Deloitte/xe/Documents/tax/me_new-economic-substance- rules-introduced.pdf [2023, February 20]. 11 Deloitte 2019. New economic substance rules introduced by “tax havens” brought into force from 1 January 2019 [Online]. Available: https://www2.deloitte.com/content/dam/Deloitte/xe/Documents/tax/me_new-economic-substance- rules-introduced.pdf [2023, February 20]. 12 OECD 2020. Tax Challenges Arising from Digitalisation- Report on Pillar One Blueprint, p. 7 [Online]. Available: https://read.oecd-ilibrary.org/taxation/tax-challenges-arising-from-digitalisation-report-on-pillar-one- blueprint_beba0634-en#page9 [2023, February 15]. https://www2.deloitte.com/content/dam/Deloitte/xe/Documents/tax/me_new-economic-substance-rules-introduced.pdf https://www2.deloitte.com/content/dam/Deloitte/xe/Documents/tax/me_new-economic-substance-rules-introduced.pdf https://www2.deloitte.com/content/dam/Deloitte/xe/Documents/tax/me_new-economic-substance-rules-introduced.pdf https://www2.deloitte.com/content/dam/Deloitte/xe/Documents/tax/me_new-economic-substance-rules-introduced.pdf https://read.oecd-ilibrary.org/taxation/tax-challenges-arising-from-digitalisation-report-on-pillar-one-blueprint_beba0634-en#page9 https://read.oecd-ilibrary.org/taxation/tax-challenges-arising-from-digitalisation-report-on-pillar-one-blueprint_beba0634-en#page9 13 The Two Pillars are a consensus-based solution. Pillar One focuses on “nexus and profit allocation and Pillar Two focuses on a global minimum tax intended to address remaining BEPS issues”.13 The OECD BEPS Pillar Two Blueprint will impose a 15% minimum tax rate on all multi- national entities (MNE) with a consolidated group revenue of at least EUR 750 million from 2023.14 This may act as an enhancement to the current CFC rules and FBE exemption by imposing a minimum tax on all in scope entities in every country that they operate in. This forces FBEs that are set up to be liable for a minimum tax of 15% rendering the setting up of a FBE simply to take advantage of the FBE exemption less appealing as a minimum tax is still to be imposed on the FBE in all countries that the entity operates in. This research also aims to consider whether the OECD Blueprints and the substance standards of Mauritius and Dubai aid in enhancing the FBE exemption or if they are merely superficial in nature and add no value in enhancing the local standards. The research problem This research will critically evaluate the controlled foreign company rules as a deterrent for base erosion and profit shifting by tax residents of South Africa, with particular focus on the foreign business establishment exemption. 13 OECD 2020. Tax Challenges Arising from Digitalisation- Report on Pillar One Blueprint, p. 7 [Online]. Available: https://read.oecd-ilibrary.org/taxation/tax-challenges-arising-from-digitalisation-report-on-pillar-one- blueprint_beba0634-en#page9 [2023, February 15]. 14 OECD 2021. OECD releases Pillar Two model rules for domestic implementation of 15% global minimum tax. 2021 [Online]. Available: https://www.oecd.org/newsroom/oecd-releases-pillar-two-model-rules-for-domestic- implementation-of-15-percent-global-minimum-tax.htm [2023, February 1]. https://read.oecd-ilibrary.org/taxation/tax-challenges-arising-from-digitalisation-report-on-pillar-one-blueprint_beba0634-en#page9 https://read.oecd-ilibrary.org/taxation/tax-challenges-arising-from-digitalisation-report-on-pillar-one-blueprint_beba0634-en#page9 https://www.oecd.org/newsroom/oecd-releases-pillar-two-model-rules-for-domestic-implementation-of-15-percent-global-minimum-tax.htm https://www.oecd.org/newsroom/oecd-releases-pillar-two-model-rules-for-domestic-implementation-of-15-percent-global-minimum-tax.htm 14 The sub-problems To answer the primary research problem, the following sub-problems need to be addressed: i. The first sub-problem involves determining what the CFC rules are in South Africa and how these entities are to be taxed from a South African perspective as well as any exemptions to these rules. ii. The second sub-problem is to critically evaluate the foreign business establishment exemption and its role in preventing base erosion and profit shifting. iii. The third sub-problem is to examine the new substance standards imposed by Dubai and Mauritius to determine if these standards aid in the prevention of the exploitation of the foreign business establishment exemption and whether they enhance local standards of the foreign business establishment exemption. iv. The fourth sub-problem is to examine the impact of the OECD Blueprints on the foreign business establishment exemption and whether these blueprints may reduce the exploitation of the foreign business establishment exemption or not. Research methodology This study is qualitative in nature and is carried out by way of a literature review. The main sources that will be analysed will be South African tax legislation, case law, journal articles of tax experts in published journals, OECD guidelines and international law and substance standards, where applicable. 15 Chapter 2: Review of the controlled foreign company provisions as set out in the Income Tax Act 58 of 1962 In the sphere of international tax, a distinction is made between two types of investments, namely, direct investment and portfolio investment. Direct investment refers to investments in which an investor has a large enough stake in a company to influence the operations of the company, while portfolio investment refers to investments whereby an investor does not have such influence.15 It is the direct investment, without anti-avoidance provisions, that poses a risk to the South African tax base. This is because earning foreign income in the name of a separate taxpayer may prove to reap many tax benefits such as the deferral of taxes on that income. It is in this context that the controlled foreign company rules are pertinent.16 Section 9D of the ITA sets out the provisions for controlled foreign companies. This section was introduced in the ITA in 2001 as part of South Africa’s shift to a “residence minus” tax system. This move to a “resident-minus” tax system stemmed from an effort to reduce South African tax rates by widening the South African tax base. This system was introduced by the Minister of Finance in the Revenue Laws Amendment Act 59 of 2000.17 The South African tax base was not as wide as it could have been because, under the “source plus” tax system only South African source income was taxed with a limited number of foreign source items being taxed as well. Under the “resident-minus” tax system, taxes are imposed on worldwide income with a limited category of foreign income not being taxed under this system.18 The current system therefore widens the South 15 Olivier, L. & Honiball, M. 2011. International tax: A South African perspective, 5th ed., p.559. Cape Town: Siber Ink CC. 16 Olivier, L. & Honiball, M. 2011. International tax: A South African perspective, 5th ed., p.559. Cape Town: Siber Ink CC. 17 National Treasury 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. iii [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 06]. 18 National Treasury 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. iii [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 06]. https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf 16 African tax base as more types and streams of income would be subject to South African tax and not only South African source income. The reason for the CFC rules is for them to act as anti-avoidance provisions which prevent taxpayers with interests in foreign companies from shifting profits into a CFC, thereby stripping the tax base of their resident country.19 Oftentimes these foreign entities are set up in a low tax jurisdiction and therefore the CFC rules specifically target these types of foreign investments.20 The aim of the CFC rules is for them to act as a deterrent, rather than to raise income tax on CFCs. The objective of these rules is to ensure that the profits earned by foreign companies remain within the tax base of the country of residence of the ultimate person holding a majority interest in the company, thereby preventing taxpayers from shifting profits into these CFCs to avoid paying taxes in their resident jurisdiction.21 It is important to note that the purpose of the CFC rules is anti-avoidance in respect of taxpayers diverting funds to CFCs to avoid paying taxes in South Africa and not to harm the South African international competitiveness. A balance needs to be struck with regards to the provisions of this section.22 The CFC legislation needs to remain globally competitive while also protecting the tax base of the country. By making the CFC rules too rigid, this may pose a risk that taxpayers would find it too cumbersome to apply and 19 OECD 2015. Designing Effective Controlled Foreign Company Rules, Action 3-2015 Final Report, p. 16 [Online]. Available: https://www.oecd-ilibrary.org/docserver/9789264241152- en.pdf?expires=1675681175&id=id&accname=guest&checksum=4C850D2BEACE677D001B2D9B6 B5C0846 [2023, February 06]. 20 Davis Tax Committee. Summary of DTC Report on OECD Action 3: Strengthening Controlled Foreign Company Rules Annexure 3 [Online]. Available: https://www.taxcom.org.za/docs/New_Folder3/5%20BEPS%20Final%20Report%20- %20Action%203.pdf [2023, February 28]. 21 OECD 2015. Designing Effective Controlled Foreign Company Rules, Action 3-2015 Final Report, p. 13 [Online]. Available: https://www.oecd-ilibrary.org/docserver/9789264241152- en.pdf?expires=1675681175&id=id&accname=guest&checksum=4C850D2BEACE677D001B2D9B6 B5C0846 [2023, February 06]. 22 National Treasury 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. iii [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 06]. https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1675681175&id=id&accname=guest&checksum=4C850D2BEACE677D001B2D9B6B5C0846 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1675681175&id=id&accname=guest&checksum=4C850D2BEACE677D001B2D9B6B5C0846 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1675681175&id=id&accname=guest&checksum=4C850D2BEACE677D001B2D9B6B5C0846 https://www.taxcom.org.za/docs/New_Folder3/5%20BEPS%20Final%20Report%20-%20Action%203.pdf https://www.taxcom.org.za/docs/New_Folder3/5%20BEPS%20Final%20Report%20-%20Action%203.pdf https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1675681175&id=id&accname=guest&checksum=4C850D2BEACE677D001B2D9B6B5C0846 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1675681175&id=id&accname=guest&checksum=4C850D2BEACE677D001B2D9B6B5C0846 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1675681175&id=id&accname=guest&checksum=4C850D2BEACE677D001B2D9B6B5C0846 https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf 17 comply with these rules. This may result in them giving up tax residency in South Africa for a country where the tax laws are easier to comply with and are more favourable.23 This would hurt the South African tax base. Section 9D therefore makes provision for exemptions to these rules, as many companies may meet the definition of a CFC but undertake legitimate business activities offshore or may already be highly taxed. Imposing section 9D in these instances may stifle international competitiveness. Accordingly, section 9(2) states that the net income of the CFC is to be included in the taxable income of the resident that holds voting rights or participation rights in the CFC in proportion to their participation rights unless there is an exemption available that deems net income to be in nil in terms of section 9D(2A) second proviso (i). A natural person is a resident of South Africa for tax purposes as defined in section 1 of the ITA as a person who is ordinarily a resident of South Africa or by way of the physical presence test. ‘Ordinarily resident’ is not defined in the ITA and therefore case law must be referred to for further guidance in this regard. Residents are taxed on worldwide income in terms of the gross income definition in section 1 of the ITA. In terms of the gross income definition in section 1 of the ITA, South African residents are taxed on worldwide income. This is in accordance with South Africa’s policy of applying a residency-based tax system. It is therefore imperative that the residency of taxpayers is established to determine what constitutes local income and foreign income. In terms of section 1 of the ITA, a foreign company is defined as a company that is not a resident. Section 1 of the ITA defines a resident as a person: 23 Olivier, L. & Honiball, M. 2011. International tax: A South African perspective, 5th ed., p.559. Cape Town: Siber Ink CC. 18 “… (other than a natural person) which is incorporated, established or formed in the Republic or which has its place of effective management in the Republic.” Section 9D(1) defines a CFC as any foreign company: “where more than 50 percent of the total participation rights in that foreign company are directly or indirectly held, or more than 50 per cent of the voting rights in that foreign company are directly or indirectly exercisable, by one or more persons that are residents other than persons who are headquarter companies: Provided that- (a) No regard must be had to any voting rights in any foreign company- (i) Which is a listed company; or (ii) If the voting rights in that foreign company are exercisable indirectly through a listed company. (b) Any voting rights in a foreign company which can be exercised directly by any other controlled foreign company in which that resident (together with any connected person in relation to that resident) can directly or indirectly exercise more than 50 per cent of the voting rights are deemed for the purposes of this definition to be exercisable directly by that resident..…” It is important to note that the first requirement for a company to meet the definition of a CFC and be classified accordingly, is that the company needs to be a foreign company. This means that if a company is effectively managed in South Africa, that company would not be a CFC as it would meet the definition of a resident as set out in section 1 of the ITA. Participation rights are defined in section 9(1) as: (a) “the right to participate in all or part of the benefits of the rights (other than voting rights) attaching to a share, or any interest of a similar nature, in that company; or 19 (b) In the case where no person has any right in that foreign company as contemplated in paragraph (a) or no such rights can be determined for any person, the right to exercise voting rights in that company; and…” Participation rights comprise shares that represent equity share capital as well as well other forms of share such as non-participating preference shares. The benefits enjoyed with regards to participation rights would be rights to profits and capital of the entity.24 Simply put, this definition includes all rights of shareholders, whether in the form of equity shares or non-participating preference shares, to the profits and capital of the foreign company. 25 If a person does not have any participation rights as mentioned above, then the participation rights would be equivalent to the voting rights exercisable by that person in the foreign company. The abovementioned definition is very broad, as to prevent South African taxpayers from entering into convoluted share arrangements aimed at preventing section 9D from being applicable.26 It is also noted that for the purpose of the participation rights definition set out in terms of section 9D(1), where that are no participation rights held then participation rights are deemed to be equal to the voting rights. This makes voting rights an alternative test to participation rights.27 24 National Treasury 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 3 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 15]. 25 National Treasury 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 3 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 15]. 26 National Treasury 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 3 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 15]. 27 Olivier, L. & Honiball, M. 2011. International tax: A South African perspective, 5th ed., p.567. Cape Town: Siber Ink CC. https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf 20 Section 9D(1)(a) further states that no regard is given to voting rights in a foreign company that is a listed company or if the voting rights in that foreign company are exercisable indirectly through a listed company. The reason for this is because in the definition of participation rights as set out in section 9D, states that voting rights should only be considered when a person does not have any participation rights or cannot determine the participation rights in that foreign company (an alternative test). In the context of a listed company, it is highly unlikely that the rights of shareholders would not be clearly defined.28 Section 9D(1)(b) states that any voting rights in a foreign company exercisable by another CFC in which a resident, together with connected persons, holds more than 50 percent of the voting rights are deemed to be exercisable by that resident. The abovementioned provision was added to the definition of a CFC in 2017 under the Taxation Laws Amendment Bill, 2017. This addition came about after concern raised by the government that taxpayers were using interposed trusts to foundations to conceal the link between the South African resident and the foreign company which would have been a CFC in the absence of the trust or foundation.29 This addition essentially states that any foreign company in which its financial results are reflected in the consolidated financial statements, in terms of IFRS 10, of a South African resident, will be a CFC.30 The reason for this is because voting rights do not dilute with indirect shareholdings while participation rights do. In terms of IFRS 10, control is a basis for consolidation31 which 28 Olivier, L. & Honiball, M. 2011. International tax: A South African perspective, 5th ed., p.567. Cape Town: Siber Ink CC. 29 Taxation Laws Amendment Bill, 2017 30 Taxation Laws Amendment Bill, 2017 31 Taxation Laws Amendment Bill, 2017 21 means if a South African resident taxpayer has more than 50 per cent of the voting rights in a foreign company (foreign company 1) and that foreign company has more than 50 per cent of the voting rights in another foreign company (foreign company 2), both foreign companies would be deemed to be CFCs per section 9D(1)(b). This is because the South African tax residents who control foreign company 1 through more than 50 per cent of the voting rights, they essentially control foreign company 2 as foreign company 1 has more than 50 per cent of the voting rights in it. Both companies would therefore be CFCs. Per Section 9D(1)(c), a person is not deemed to be a resident, when determining whether residents hold more than 50 percent of the voting or participation rights, if: (i) “In the case of a listed or foreign company, the participation rights held by that person indirectly through a listed company are less than 5 percent of the participation rights of that listed company; or (ii) In the case of a collective investment scheme or a foreign company, the participation rights held and the voting rights exercisable in that scheme is less than 5 percent of the scheme or arrangement (Section 9D (1)(c)(ii)(aa)(bb) Unless more than 50 per cent of the voting rights are exercisable or participation rights held, are held by persons who are connected persons to each other.” Section 9D(1)I(i) was added in The Second Revenue Laws Amendment Act in 2001 as an exception to the general rule for listed foreign companies and foreign trusts. The reason for this exception is a practical one as it aims to avoid tracking problems as in many jurisdictions disclosure of shareholders in larger entities are limited to shareholders with a shareholding of at least 5 per cent.32 The practical effect of section 9D(1)(c)(ii) is that if there is a collective investment scheme held offshore and a resident is able to exercise less than 5 per cent of the voting rights or 32 National Treasury 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 5 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 15]. https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf 22 has less than 5 per cent of the participation rights that resident would not be deemed a resident and therefore section 9D would not be applicable in respect of the offshore collective investment scheme of that resident. The reason for this exclusion is the same as the one in section 9D(1)(c)(i) which is to reduce the administrative burden of determining the identify of shareholders in larger-scale entities who hold less than 5 per cent of the shares.33 Section 9D(1)(c) is not applicable if more than 50 per cent of the voting or participation rights are held by connected persons. This caveat is aimed at preventing economically related parties from each owning less than 5 per cent in order avoid the more than 50 per cent threshold set out in section 9D(1) definition of a CFC.34 In terms of section 9D(2)(a)(i), the income for the year of assessment of any resident who directly or indirectly holds any participation rights in a CFC shall include, on the last day of the foreign tax year of the CFC, if the CFC has been a CFC for the entire foreign tax year, an amount equal to the net income of the CFC in proportion to the participation rights held by that resident. Section 9D(2)(a)(ii) goes on further to state that where a foreign company became a CFC during any stage of the foreign tax year, the resident may elect to either: “(aa) include in their taxable income their share of the net income in proportion to their participation rights apportioned for the number of days the company was a CFC to the number of days in the foreign tax year or; 33 Olivier, L. & Honiball, M. 2011. International tax: A South African perspective, 5th ed., p.569. Cape Town: Siber Ink CC. 34 National Treasury 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 5 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 15]. https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf 23 (bb) include in their taxable income their share of the total net income in proportion to their participation rights from the day the foreign company became a CFC to the end of the foreign tax year.” This apportionment ensures that only the net income of the CFC for the duration that the company has been a CFC during the foreign tax year, will be included in the taxable income of the residents who individually or collectively have more than 50 per cent of the voting or participation rights. The taxpayer would likely elect the lower of the two amounts as this would be the most tax beneficial. Section 9D(2)(A) of the ITA states that, there shall be no inclusion of the net income of a CFC in the taxable income of a resident, where a resident together with other connected persons holds less than 10 percent of the participation rights and may not exercise at least 10 percent of the voting rights of that CFC. In terms of section 9D(2)(b)(B) the same holds true if the participation rights are held indirectly by a resident through a resident company. The reason for this is to exclude minority shareholders who do not have a say in the affairs of the company from having to include the net income of the CFC in their taxable income. 35 The net income of a CFC in respect of the foreign tax year is defined, in section 9D(2A) as the taxable income of the CFC determined in: “accordance with the provisions of this Act as if the controlled foreign company had been a taxpayer, and as if that company had been a resident for the purposes of the definition of gross income, sections 7(8), (10)(1)(h), 25Band paragraphs 2(1)(a), 24, 70, 71,72 and 80 of the Eighth Schedule.” 35 National Treasury 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 5 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 15]. https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf 24 This provision in essence means that all provisions of the ITA will be applicable to the CFC when determining its net income including the provisions set out specifically in section 9D(2A) as stated above. This provision is, however not without its provisos. In terms of section 9D(2A)(a), any deductions, allowances or set-offs against income of the CFC will be limited to the amount of such income. This means that the deductions or allowances cannot create a negative net amount but can only net off to nil. This proviso exists because South African tax residents cannot use the assessed losses of foreign companies against their taxable income. The amount by which the deductions or allowances exceed the amount of income can be carried forward to the succeeding foreign tax year and be deemed to be a balance of assessed loss to be set off against the income of the CFC in the succeeding foreign tax year for the purposes of section 20, in terms of section 9D(2A)(b). This provision aims to protect the South African tax base from erosion by ensuring that the assessed loss is ring-fenced and can only be used against the CFC’s future taxable income and not that of the South African tax resident.36 Section 9D(2A)(c) of the ITA states that, there shall be no deduction allowed for: (i) “Interest, royalties, rental, insurance premium or income of a similar nature which is paid or payable or deemed to be paid or payable by that company to any other controlled foreign company (including any amount adjusted in terms of Section 31 [of the ITA]. 36 Olivier, L. & Honiball, M. 2011. International tax: A South African perspective, 5th ed., p.576. Cape Town: Siber Ink CC. 25 (ii) Exchange differences determined in terms of section 24I [of the ITA in respect of any exchange item to which that company and any other controlled foreign company are parties (iii) Exchange differences in respect of any forward exchange contract or foreign currency option contract entered into to hedge the item referred or in subparagraph (ii); or (iv) Reduction or discharge by that company of a debt owed to that company by any other controlled foreign company for no consideration or for consideration less than the amount by which the face value of the debt that has been so reduced or discharged where that controlled foreign company and that other controlled foreign company form part of the same group of companies, unless that interest, rental, royalty, insurance premium, other income, adjusted amount, exchange difference, reduction or discharge is taken into account to determine the net income of that other controlled foreign company”. Section 9D(9)(fA) states that when determining the net income of a CFC in terms of subsection (2A) there must not be taken into account any amount which- Is attributable to- (i) “Interest, royalties, rental, insurance premium or income of a similar nature which is paid or payable or deemed to be paid or payable by that company to any other controlled foreign company (including any amount adjusted in terms of section 31 [of the ITA] (ii) Exchange differences determined in terms of section 24I [of the ITA] in respect of any exchange item to which that company and any other controlled foreign company are parties 26 (iii) Exchange differences in respect of any forward exchange contract or foreign currency option contract entered into to hedge the item referred or in subparagraph (ii); or (iv) Reduction or discharge by that company of a debt owed to that company by any other controlled foreign company for no consideration or for consideration less than the amount by which the face value of the debt that has been so reduced or discharged where that controlled foreign company and that other controlled foreign company form part of the same group of companies”. The purpose of section 9D(9)(fA) is to allow South African multinational entities to utilise finance or foreign treasury subsidiaries as a tax-free means to channel group loans, leases, and licenses. These types of structures allow a group to obtain financing within a single administrative structure thereby creating opportunities for reduced group rates.37 It is noted from the abovementioned provisions that section 9D(2A)(c) states that no deductions are allowed for the items listed above when the amounts relate to transactions between CFCs within the same group. Conversely section 9D(9)(fA) states that no amount of the items listed above shall be included when determining the net income of a CFC when the amounts relate to transactions between CFCs within the same group. It is therefore noted that section 9D(2A)(c) should be read together with Section 9D(9)(fA) as these rules work in harmony to prevent an artificial mismatch of deductible payments and receipts not included between companies within the same group. 38 37 National Treasury 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 22 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 15]. 38 National Treasury 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 22 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf 27 Where a foreign company becomes a CFC after 1 October 2001, the valuation date for the purposes of determining the taxable capital gain or loss in terms of the Eighth Schedule will be the day before the company becomes a CFC as set out in section 9D((2A)(e). Where the resident of whom the net income of the CFC is to be included in their taxable income is a natural person, special trust or insurer in respect of its individual policyholder fund, the taxable capital gain of the CFC will be 40 per cent of the net capital gain for the purposes of paragraph 10 of the Eighth Schedule for the relevant foreign tax year. There are exemptions to the CFC rules aimed at excluding entities that pose little risk of base erosion and profit shifting. These exemptions also assist in the prevention of stiffing global competitiveness. By introducing these exemptions, the CFC rules become more targeted and effective and reduce the overall administrative burden by ensuring that certain companies are not affected by the CFC rules.39 In South Africa, this mainly takes the form of the ‘highly taxed’ exclusion and the ‘foreign business establishment’ exclusion. The second proviso (i)(aa) to section 9D(2): “that the net income of the controlled foreign company for the foreign tax year shall be deemed to be nil where the aggregate amount of taxes payable to all spheres of government of any country other than the Republic by the controlled foreign company in respect of the foreign tax year of that controlled foreign company is at least 67.5 per cent of the amount of normal tax that would have been payable in respect of taxable income of the controlled foreign company has the controlled https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 15]. 39 OECD 2015. Designing Effective Controlled Foreign Company Rules, Action 3-2015 Final Report, p. 33 [Online]. Available: https://www.oecd-ilibrary.org/docserver/9789264241152- en.pdf?expires=1675681175&id=id&accname=guest&checksum=4C850D2BEACE677D001B2D9B6 B5C0846 [2023, February 06]. https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1675681175&id=id&accname=guest&checksum=4C850D2BEACE677D001B2D9B6B5C0846 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1675681175&id=id&accname=guest&checksum=4C850D2BEACE677D001B2D9B6B5C0846 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1675681175&id=id&accname=guest&checksum=4C850D2BEACE677D001B2D9B6B5C0846 28 foreign company had the controlled foreign company been a resident for that foreign tax year..” This exemption is often referred to as the highly taxed exemption 40 and demonstrates that a CFC which is already highly taxed in countries other than the Republic would pose a low risk to base erosion and profit shifting as the CFC is already paying a high percentage of taxes. The other exemption which deems net income of the CFC to be nil is stated in Section 9D(2) second proviso (i)(bb) of the ITA and reads as follows: “all receipts and accruals of the controlled foreign company are – (i) Attributable to any foreign business establishment of that controlled foreign company as contemplated in subsection (9|)(b); and (ii) Not required to be taken into account in terms of subsection (9A)…” The intention of this exemption is to strike a balance between exempting income derived from legitimate business activities and that of non-substantive business undertakings.41 This exemption therefore recognises that some companies are set up offshore for legitimate business purposes and earn an active income in the country of residence. This exclusion creates relief for the resident taxpayers who hold participation or voting rights in these companies as the net income inclusion would be deemed to be nil. The income of the CFC will not fall within the ambit of section 9D should a CFC meet the definition of an FBE unless section 9D(9A) applies. A foreign business establishment is defined in section 9D(1) as: 40 The Tax Faculty 2020. Comparable Tax Exemption (Section 9D(2A)) [Online]. Available:https://taxfaculty.ac.za/news/read/comparable-tax-exemption-section-9d-2a [2023, February 28]. 41 Olivier, L. & Honiball, M. 2011. International tax: A South African perspective, 5th ed., p.581. Cape Town: Siber Ink CC. https://taxfaculty.ac.za/news/read/comparable-tax-exemption-section-9d-2a 29 “a fixed place of business located in a country other than in the Republic that is used or will continue to be used for the carrying on of a business of that CFC for a period of not less than one year where: (i) The business is conducted through offices, shops, factories, warehouses or other structures; (ii) The fixed place of business is suitably staffed with on-site managerial and operational employees of that CFC who conduct the primary operations of the business; (iii) A fixed place of business suitably equipped for conducting the primary operations of the business; (iv) The fixed place of business has suitable facilities for conducting primary operations of that business; and (v) The fixed place of business is located outside the Republic solely or mainly for the purpose other than the postponement or reduction of tax imposed by the government of the Republic. This exemption excludes the net income derived from South Africa of foreign companies that are carrying on legitimate business activities and “illusory or non-substantive business undertakings…”42 Section 9D(1) of the ITA should be read together with section 9D(9) and section 9D(9A) of the ITA as these provisions recognize that CFC are used for legitimate purposes and active income should be exempt in order for the foreign company to remain competitive.43 Section 9D(9) of the ITA states that: 42 Olivier, L. & Honiball, M. 2011. International tax: A South African perspective, 5th ed. p.581. Cape Town: Siber Ink CC. 43 National Treasury 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 8 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 15]. https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf 30 “Subject to subsection (9A), in determining the net income of a controlled foreign company in terms of subsection (2A), there must not be taken into account any amount which- (b)Is attributable to any foreign business establishment of the controlled foreign company (whether or not as a result of the disposal to deemed disposal of any assets forming part of that foreign business establishment) and, in determining that amount and whether that amount is attributable to a foreign business establishment- (i) that foreign business establishment must be treated as if that foreign business establishment were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the controlled foreign company of which the foreign business establishment is a foreign business establishment; (ii) that determination must be made as if the amount arose in the context of a transaction, operation, scheme, agreement or understanding that was entered into on the terms and conditions that would have existed had the parties to that transaction, operation, scheme, agreement or understanding been independent persons dealing at arm’s length.” Section 9D(9A) aims to ensure the FBE’s income is not subject to an exemption to the extent that this income does not meet certain criteria and would be considered to be diversionary and not at arm’s length. These amounts include: • The sale of goods by the CFC (that is a FBE) to any connected person to that CFC who is a South African tax resident in terms of section 9D(9A)(a)(i). • The sale of goods by that CFC (that is a FBE) to a person, who is not a connected person to that CFC, and is a South African tax resident whereby the goods (or any 31 tangible intermediary inputs thereof) were initially purchased from one or more connected persons to that CFC who are tax residents of South Africa in terms of section 9D(9A)(a)(iA). • The supply of services performed by that CFC (that is a FBE) to a connected person who is a South African tax resident unless the service is performed outside of South Africa in terms of section 9D(9A)(a)(ii). • An amount in respect of a financial instrument unless this financial instrument is attributable to the principal trading activities of the FBE and those activities are of a bank, financial service provider or insurer and excludes a treasury operation or captive insurer in terms of section 9D(9A)(a)(iii). • Rental income in respect of movable property unless the property is lease via an operating lease or the lease constitutes a financial instrument in terms of section 9D(9A)(a)(iv). • Income for the use or right to intellectual property as defined in section 23I of the ITA, unless the CFC regularly creates, develops, or substantially upgrades the intellectual property and does not constitute tainted intellectual property as defined in section 23I, in terms of section 9D(9A)(a)(v). • Income from insurance premiums unless those amounts are attributable to the principal trading activities of insurers and do not constitute activities of a captive insurer in terms of section 9D(9A)(a)(vi). From the above it is noted that all active business income would still not be included in the net income of the FBE while income that may be earned from transactions with connected persons or income that is passive in nature continues to be included in the net of section 9D of the ITA. 32 A further analysis will be done on the FBE exemption in Chapter 3. Chapter 3: A critical analysis of the foreign business establishment exemption and its role in preventing base erosion and profit shifting. CFC Rules During 1997, the Katz Commission performed an inquiry with regards to the South African tax system’s ability to deal with the effects of globalisation. The Katz Commission recommended that the residence-based tax system be gradually adopted by South Africa. This led to the introduction of the CFC rules.44 In 1997, CFC rules were added to the ITA in the form of section 9D. This was being used to act as an anti-avoidance provision for tax on investment income that was included in the tax net under section 9C, through a foreign company or trust. When South Africa shifted to a residence-based tax system this resulted in section 9C being repealed. Section 9D then became applicable to all income including capital gains and not only investment income. 45 The Revenue Laws Amendment Act 59 of 2000 saw the introduction of the term business establishment to section 9D of the ITA and thereafter this term was replaced by the term foreign business establishment in the Revenue Laws Amendment Bill of 2006. National Treasury opted to apply a mechanical ‘employees and establishment’ test as opposed to a ‘facts and circumstance’ based test which is used by the United States of America. The intention of the mechanical application was to remove the complexity of fact intensive tests. The approach by National Treasury is similar to that which was applied by the UK’s exempt activities test which has been abolished as part of the UK’s relaxation of CFC rules. 46 44 Grimm, W. & Kraamwinkel, C. 2018. CFC’s: have we gone too far? Tax Talk 2018(72):28-31. 45 Olivier, L. & Honiball, M. 2011. International tax: A South African perspective, 5th ed. Cape Town: Siber Ink CC. 46 Grimm, W. & Kraamwinkel, C. 2018. CFC’s: have we gone too far? Tax Talk 2018(72):28-31. 33 Since the introduction of the CFC rules in 2001, the rules have remained principally unchanged. These rules however have become arguably more onerous and less flexible over time. This is particularly in regard to the definition of the FBE and its substance test.47 Historically a section 9D(10)(a) and (b) existed in the ITA. This section allowed the Minister of Finance discretionary powers to deem the FBE threshold to have been met in certain circumstances where the risk to the South African tax base was very small or none at all.48 This section has been abolished which resulted in the old mechanical substance rules being applicable. These rules may have been deemed appropriate in 2001, however, 22 years later in the modern business era, the world differs substantially making the mechanical approach outdated.49 From a practical point of view, the South African CFC rules are time-consuming for taxpayers to comply with and for SARS to review 50. This is further supported by the fact that the Davis Tax Committee commented that the South African CFC rules are some of the most sophisticated and complicated within the G20. 51 Foreign business establishment in the context of Section 9D of the ITA A foreign business establishment is defined in section 9D(1) of the ITA. As noted above however that this definition follows a mechanical approach and not one of facts and circumstances. This could result in many taxpayers taking advantage of the mechanical nature of the definition by using it to set up non bona fide FBE with the intention of obtaining the FBE exemption. By using this exemption, taxpayers are able to set up FBEs in low tax jurisdictions, and shift profits into these FBEs without having the inclusion of the FBEs net income in its taxable income. 47 Grimm, W. & Kraamwinkel, C. 2018. CFC’s: have we gone too far?. Tax Talk 2018(72):28-31. 48 Grimm, W. & Kraamwinkel, C. 2018. CFC’s: have we gone too far?. Tax Talk 2018(72):28-31. 49 Grimm, W. & Kraamwinkel, C. 2018. CFC’s: have we gone too far?. Tax Talk 2018(72):28-31. 50 Grimm, W. & Kraamwinkel, C. 2018. CFC’s: have we gone too far?. Tax Talk 2018(72):28-31. 51 Grimm, W. & Kraamwinkel, C. 2018. CFC’s: have we gone too far?. Tax Talk 2018(72):28-31. 34 The South African FBE test is based on the mechanical substance analysis as set out in Action 3: Designing effective controlled foreign company rules Report.52 These substance analyses have been criticised for being too narrow.53 The fact the that substance analysis which the FBE definition is based off has been criticised as being too narrow may lead to a lack of scope and specificity. The introduction of the definition of a FBE was added to the ITA in 2006 following the deletion of the definition of a business establishment. The reason for this change as stated by the Explanatory Memorandum on the Income Tax Bill 2006 “[t]he current definition of business establishment is too rigid, making it difficult for South African companies that are conducting genuine non-tax business activities” .54 It was also found that the definition did not properly account for the country in which active business should take place. Confusion also existed with regards to the locations of active business for international transport.55 Paragraph (a)_of the definition of ‘foreign business establishment’ in section 9D(1) defines a FBE as: “a fixed place of business located in a country other than in the Republic that is used or will continue to be used for the carrying on of a business of that CFC for a period of not less than one year where: 52 OECD 2015. Designing effective controlled foreign company rules, p48, para 85 [Online]. Available: https://www.oecd-ilibrary.org/docserver/9789264241152- en.pdf?expires=1676283251&id=id&accname=guest&checksum=5F75A956488F8B01485E0EAEA8 18C429 [2023, March 13]. 53 OECD, 2015. Comments received on Public Discussion draft BEPS Action 3: Strengthening CFC rules p234, para 9 [Online]. Available:]https://www.oecd.org/tax/aggressive/public-comments-beps-action-3- strengthening-cfc-rules-part1.pdf [2023, February 13]. 54 SARS, 2006. Explanatory Memorandum on the Revenue Laws Amendment Bill, p53 [Online]. Available: https://www.sars.gov.za/lapd-lprep-em-2006-01-explanatory-memorandum-revenue-laws- amendment-bill-2006/ [2023, February 13]. 55 SARS, 2006. Explanatory Memorandum on the Revenue Laws Amendment Bill, p53 [Online]. Available: https://www.sars.gov.za/lapd-lprep-em-2006-01-explanatory-memorandum-revenue-laws- amendment-bill-2006/ [2023, February 13]. https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676283251&id=id&accname=guest&checksum=5F75A956488F8B01485E0EAEA818C429 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676283251&id=id&accname=guest&checksum=5F75A956488F8B01485E0EAEA818C429 https://www.oecd-ilibrary.org/docserver/9789264241152-en.pdf?expires=1676283251&id=id&accname=guest&checksum=5F75A956488F8B01485E0EAEA818C429 https://www.oecd.org/tax/aggressive/public-comments-beps-action-3-strengthening-cfc-rules-part1.pdf https://www.oecd.org/tax/aggressive/public-comments-beps-action-3-strengthening-cfc-rules-part1.pdf https://www.sars.gov.za/lapd-lprep-em-2006-01-explanatory-memorandum-revenue-laws-amendment-bill-2006/ https://www.sars.gov.za/lapd-lprep-em-2006-01-explanatory-memorandum-revenue-laws-amendment-bill-2006/ https://www.sars.gov.za/lapd-lprep-em-2006-01-explanatory-memorandum-revenue-laws-amendment-bill-2006/ https://www.sars.gov.za/lapd-lprep-em-2006-01-explanatory-memorandum-revenue-laws-amendment-bill-2006/ 35 (vi) The business is conducted through offices, shops, factories, warehouses or other structures; (vii) The fixed place of business is suitably staffed with on-site managerial and operational employees of that CFC who conduct the primary operations of the business; (viii) A fixed place of business suitably equipped for conducting the primary operations of the business; (ix) The fixed place of business has suitable facilities for conducting primary operations of that business; and (x) The fixed place of business is located outside the Republic solely or mainly for the purpose other than the postponement or reduction of tax imposed by the government of the Republic. Provided that for the purposes of determining whether there is a fixed place of business as contemplated in this definition, a controlled foreign company must take into account the utilisation of structures as contemplated in subparagraph (i), employees as contemplated in subparagraph (ii), equipment as contemplated in subparagraph (iii) and facilities as contemplated in subparagraph (iv) of any other company - (aa) if that other company is subject to tax in the country in which the fixed place of business of the controlled foreign company is located by virtue of residence, place of effective management or other criteria of a similar nature; (bb) if that company forms part of the same group of companies as the controlled foreign company; and (cc) to the extent that the structures, employees, equipment and facilities are located in the same country as the fixed place of business of the controlled foreign company”. 36 A FBE also includes: “(b) any place outside the Republic where prospecting or exploration operations for natural resources are carried on, or any place outside the Republic where mining or production operations of natural resources are carried on, where that controlled foreign company carries on those prospecting, exploration mining or production operations;” It is noted that this definition does not include economic substance since the fixed nature of operations makes it almost impossible to fabricate them for tax planning purposes.56 “(c) a site outside the Republic for the construction or installation of building, bridges, roads, pipelines, heavy machinery or other projects of a comparable magnitude which lasts for a period of not less than six months, where that controlled foreign company carries on those construction or installation activities;” It is noted that the requirements for construction can take place at any location outside of the Republic and not just a country outside of the Republic as stated in section 9D(1) paragraph (a).57 “(d) agricultural land in any country other than the Republic used for bona fide farming activities directly carried on by that controlled foreign company; (e) a vessel, vehicle, rolling stock or aircraft used for the purposes of transportation of fishing, or prospecting or exploration for natural resources, or mining or production of natural resources, where that vessel, vehicle, rolling stock or aircraft is used solely outside the Republic for such purposes and is operated directly by that controlled foreign company or by any other company that has the same 56 Olivier, L. & Honiball, M. 2011. International tax: A South African perspective, 5th ed. p. 584. Cape Town: Siber Ink CC. 37 country of residence as that controlled foreign company and that forms part of the same group of companies as that controlled foreign company; (f) a South African ship[ as defined in section 12Q engaged in international shipping as defined in that section; (g) a ship engaged in international traffic used mainly outside the Republic” The FBE exemption that deems net income to be nil is stated in Section 9D second proviso (i)(bb). This exemption states that net income is deemed to be nil where all receipts and accruals of a CFC that are attributable to any foreign business establishment and are not required to be taken into account in terms of subsection (9A). The purpose of section 9D(9A) is to exclude certain amounts of income within the FBE from attracting a nil inclusion in the taxable income of the South African residents. This is because this income would be considered to be diversionary and not at arm’s length.58 The amounts included in section 9D(9A) have been discussed in further detail in Chapter 2. Accordingly, the net income of the CFC will not fall within the ambit of section 9D should a CFC meet the definition of an FBE, unless section 9D(9A) applies. Section 9D does recognise that there are foreign companies that are set up for legitimate business reasons and earn active business income. This income is therefore exempt from the provisions of section 9D in terms of section 9D(9). This ensures that businesses are able to remain competitive in the international market.59 The purpose of the introduction of section 9D was to act as an anti-avoidance provision. Section 9D aims to protect the South African tax base by preventing South African tax 58 Ismail, F. 2018. The Foreign Business Establishment Exemption and Other Aspects of Section 9D of the Income Tax Act. Johannesburg: University of the Witwatersrand. 59 National treasury, 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 8 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 09]. https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf 38 residents from shifting income offshore to low tax jurisdictions using foreign companies. The FBE exemption promotes international competitiveness as the FBE exemption only applies to income that does not pose a risk to the South African tax base.60 Under section 9D(2A) second proviso (ii) read together with section 9D(9A), all foreign income of the CFC that is a FBE is exempt from the provisions of section 9D unless that income qualifies as mobile foreign business income, diversionary foreign business income, mobile foreign passive income.61 Mobile Foreign Business Income is income that is generated by companies that are simply companies on paper i.e., shell companies, but have no actual or economic substance. The main economic activity of these companies may be to maintain a website or post office, however, they have no real non-tax business reason to exist.62 The income of such companies will be included in net income in terms of section 9D(2) as these companies are unlikely to meet the definition of an FBE in terms of section 9D(1) paragraph (a). These companies are not likely to have a fixed place of business that is conducted though a shop, office, warehouse, factory, or other structure as set out in the definition of a FBE in section 9D(1) paragraph (a). Due to this, the provisions of section 9D(2) and 9D(2A) of the ITA will apply, resulting in this income of the CFC being included in the resident’s taxable income for the relevant year of assessment. This type of income 60 National treasury, 2002. [Online]. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 8 Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 09]. 61 National treasury, 2002. [Online]. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 8 Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 09]. 62 National treasury, 2002. [Online]. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 8 Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 09]. https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf 39 poses a risk to the South African tax base due to it arising from a company that has no business substance or purpose, which creates a strong argument that the company was simply set up to shift profits offshore to a lower tax jurisdiction. Diversionary income refers to income that is made by the CFC from sales and service dealings with connected South African tax residents.63 This type of income is largely associated with the transfer pricing regime as set out in section 31 of the ITA, as well as transfer pricing tax avoidance. This type of income is to be included in the net income of the CFC regardless of whether it qualifies as a FBE in terms of sections 9D(9A)(a)(i) and (ii) of the ITA. These sections aim to prevent South African residents from entering into transactions that shift profits to a more beneficial tax jurisdiction when the profits should actually form a part of the South African tax base and therefore these types of transactions pose a risk to the South African tax base.64 Mobile foreign passive income refers to income derived from dividends, interest, and royalties. The risk with this type of income is that South African residents may shift the passive assets from which these incomes are derived to a CFC to avoid paying tax.65 Section 9D(9A)(a)(iii) to (vii) of the ITA however makes provision for these types of income to be included in the net income of the CFC regardless of whether the CFC is a FBE as defined. As stated above a FBE is defined in section 9D(1) paragraph (a)-(g). This definition essentially states that the business must have locational permanence, economic 63 National treasury, 2002. [Online]. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 8 Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 09]. 64 Ismail, F. 2018. The Foreign Business Establishment Exemption and Other Aspects of Section 9D of the Income Tax Act. Johannesburg: University of the Witwatersrand. 65 National treasury, 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 8 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 09]. https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf 40 substance, and a non-tax business reason for operating abroad instead of locally.66 These three requirements therefore exclude businesses that are simply businesses on paper but have no economic substance and, consequently, the income earned by these types of businesses will be subject to the CFC rules in terms of section 9D of the ITA. These three requirements will be discussed in further detail below. Locational permanence: This concept involves the business having a fixed or permanent location from which the business operates. This ensures that the business is not simply a website, post box address or mailing address but does truly have a place from which it operates. Locational permanence can be demonstrated (using the section 9D definition of the FBE as guidance) by the use of an office, shop, factory, warehouse, farm or other structure for use of not less than one year. Direct ownership or a valid lease agreement can prove that the structure exists however it will not be sufficient to satisfy the ”use” requirement.67 Economic substance and business purpose: In addition to the locational permanence a foreign company must demonstrate, in order to be a FBE, business and economic substance. The way this is demonstrated is through business operations and purpose. To show that the business is operational it must show that it is suitably equipped with on-site staff members who are responsible for operations 66 National treasury, 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 9 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 09]. 67 National treasury, 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 9 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 09]. https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf 41 and are at all skill levels within the company. Equipment and other facilities necessary to conduct the core operation of the business is also necessary to be presented.68 By demonstrating these tangible items above it proves that the business is not simply just a business on paper or a way to disguise passive income but actually exists and has the necessary skills and equipment to conduct business. Bona fide non-tax reason for existence abroad: It must be demonstrated that the business has some reason for being set up abroad other than to avoid paying taxes at a higher rate i.e., the business must have a purpose and reason to be set up in the foreign country other than the fact that it is a low tax jurisdiction 69. The proportion of income earned by these foreign companies should also match the business activities conducted in these foreign countries. An issue that was brought to light is that it appears that the definition of a FBE as set out in section 9D(1) paragraph (a) does not define or further explain what the primary operations of a business should be, neither does it limit the scope thereof. The emphasis is mainly on the location of the business and not on what the term ‘primary operations’ should be defined as. This term is not defined in the ITA.70 While the locational permanence protects the South African tax base by ensuring that taxpayers will not be able to open ‘shell’ or ‘paper’ companies abroad simply to shift profits 68 National treasury, 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 9 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 09]. 69 National treasury, 2002. National Treasury’s Detailed Explanation of Section 9D of the Income Tax Act, p. 10 [Online]. Available: https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section %209D%20of%20the%20Income%20Tax%20Act.pdf [2023, February 09]. 70 Ismail, F. 2018. The Foreign Business Establishment Exemption and Other Aspects of Section 9D of the Income Tax Act. Johannesburg: University of the Witwatersrand. https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf https://www.treasury.gov.za/divisions/tfsie/tax/legislation/Detailed%20Explanation%20to%20Section%209D%20of%20the%20Income%20Tax%20Act.pdf 42 to these companies and avoid paying taxes, the term ‘primary operations’ has no specific definition in the ITA or the Tax Administration Act71 leaving a gap in the legislation. The fact that the ‘primary operations’ of the business is not defined, creates a potential opportunity for taxpayers to set up companies with a structure from which it operates with a few staff members, but have no economic activities taking place in the country it is resident of thereby abusing the FBE exemption. The lack of definition of the phrase ‘primary operations’ also doesn’t address how, for example a business where the primary operations would be to actively manage service providers and agents, as with a business that manages outsourced services to other businesses should be accounted for in terms of section 9D of the ITA.72. Ambiguity is created due to the lack of further explaining what primary operations should consist of, thereby creating a situation where the taxpayers and receiver would find it time consuming to comply with and review respectively.73 This may lead to a company being treated as a CFC and not meeting the FBE definition, therefore, making the FBE exemption not available while the company may well be a FBE operating for bona fide business reasons in a foreign country and not simply to avoid tax. Conversely, the same holds true and a company may be set up for non bona fide tax purposes, however, may meet the definition of a FBE and is able to take advantage of the FBE exemption. Neither scenario is not good for the South African tax base and make applying the CFC rules cumbersome on the taxpayer to apply and SARS to review. This also creates difficulty for taxpayers to comply with the legislation as the analysis is to a certain extent subjective which could lead to SARS and the taxpayers coming to different conclusions resulting in disputes. These disputes are not well received by resident shareholders and all shareholders alike of these CFCs. 71 Ismail, F. 2018. The Foreign Business Establishment Exemption and Other Aspects of Section 9D of the Income Tax Act. Johannesburg: University of the Witwatersrand. 72 Ismail, F. 2018. The Foreign Business Establishment Exemption and Other Aspects of Section 9D of the Income Tax Act. Johannesburg: University of the Witwatersrand. 73 Grimm, W. & Kraamwinkel, C. 2018. CFC’s: have we gone too far?. Tax Talk 2018(72):28-31. 43 Commissioner for the South African Revenue Service v Coronation Investment Management SA (Pty) Ltd: This concept is demonstrated in Commissioner for the South African Revenue Service v Coronation Investment Management SA (Pty) Ltd.74 The original case was heard in the Western Cape Tax Court under ABCDE SA Proprietary Limited v Commissioner for the South African Revenue Service (24596) [2021] ZATC 19; 84 SATC 251. The Coronation Group describes itself as ‘an active investment manager following a long- term valuation-driven investment philosophy’.75 Coronation Global Fund Managers (Ireland) Limited (CGFM) is tax resident of the Isle of Man and therefore met the definition of a CFC. This is because its holding company Coronation Investment Management SA (Pty) Ltd (CIMSA), is a South African tax resident, holding 100% of CGFM. For this reason, section 9D of the ITA became applicable and, consequently, CGFM’s net income was to be inclusive in the taxable income of CIMSA, unless an exemption applied in terms of the CFC rules set out in the ITA in section 9D. The issue arose with regards to CGFM being a FBE as defined in section 9D(1) paragraph (a) and consequently, whether the net income of CGFM would be exempt from being included in the taxable income of CIMSA. This was dependent on what the primary functions of CGFM were as conducted in Ireland. If the primary operations took place in Ireland then CGFM would be a FBE and qualify for the FBE exemption. It is important to note that CGFM opted to apply an outsource business model which created contention when determining what the primary operations were from a tax perspective. It had therefore became questionable whether the primary business of CGFM was that of 74 Commissioner for the South African Revenue Service v Coronation Investment Management SA (Pty) Ltd (1269/2021) [2023] ZASCA 10 (07 February 2023) 75 Coronation Fund Managers, About us Overview [Online]. Available: https://www.coronation.com/en- za/personal/about-us/ [2023, March 14]. https://www.coronation.com/en-za/personal/about-us/ https://www.coronation.com/en-za/personal/about-us/ 44 investment which didn’t take place in Ireland or that of license maintenance and management of service providers which did take place in Ireland.76 SARS argued in the appeal that the definition has not been met as economic substance was not demonstrated. CIMSA argued in the appeal that the definition had been met. The main issue was what the ‘primary operations’ of CGFM were. Upon its incorporation in Ireland in 1997, CGFM provided its clients with opportunities for investment in South African and Irish domiciled collective investment funds. It obtained a license from the Central Bank of Ireland in 2007 as a management company.77 According to CIMSA, the primary operations of CGFM are not the actual performance of investment management but rather the management of outsourcing the investment management functions in accordance with its license from the Central Bank of Ireland.78 CIMSA argued in Commissioner for the South African Revenue Service v Coronation Investment Management SA (Pty) Ltd)79 that the primary operations of CGFM were: • To ensure compliance with all regulatory requirements of any regulators under their license; • To ensure compliance by funds with all regulatory and constitutional document requirements; • To appoint and continuously supervise and monitor service providers including investment service providers; 76 Commissioner for the South African Revenue Service v Coronation Investment Management SA (Pty) Ltd (1269/2021) [2023] ZASCA 10 (07 February 2023) 77 Commissioner for the South African Revenue Service v Coronation Investment Management SA (Pty) Ltd (1269/2021) [2023] ZASCA 10 para 12 78 Commissioner for the South African Revenue Service v Coronation Investment Management SA (Pty) Ltd (1269/2021) [2023] ZASCA 10 para 15 79 Commissioner for the South African Revenue Service v Coronation Investment Management SA (Pty) Ltd (1269/2021) [2023] ZASCA 10 para 15 45 • Communication with and reporting to investors including management of complaints, disputes and investment reporting; • The overall risk management of CGFM and other funds it was responsible for; • The compliance with all legal corporate requirements of the Republic of Ireland; • The financial control and reporting for CGFM and other funds it was responsible for; and • Investment change management which involved informing investment managers when changes occurred to investment objectives, policies and restrictions of any of the portfolios and constitutional documents. CIMSA also argued that it is common practice for investment functions to be outsourced by fund managers in Ireland, Europe and South Africa and that it is recognised as a legitimate practice by the fund managers by the Central Bank of Ireland.80 SARS found that all the requirements of the FBE were met based on the definition set out in section 9D(1) paragraph (a) of the ITA exempt for economic substance. SARS accepted and did not dispute that the CGFM offices were situated Dublin with a staff complement of four whom were all Irish residents. The staff members consisted of a managing director, a compliance officer and two accounting officers. It was not argued either that CGFM had been operating for over a year (section 9D(1) paragraph (a)(i)) and had a fixed place of business as set out in section 9D(1) paragraph (a)(ii) which was suitably staffed with suitable equipment and facilities (section 9D(1) paragraph (a)((iii)(iv)). SARS was also satisfied that the business of CGFM was not set up in Ireland for a reason other than the postponement or reduction in South African tax (section 9D(1) paragraph (a)(v)). 81 80 Commissioner for the South African Revenue Service v Coronation Investment Management SA (Pty) Ltd (1269/2021) [2023] ZASCA 10 para 16 81 Commissioner for the South African Revenue Service v Coronation Investment Management SA (Pty) Ltd (1269/2021) [2023] ZASCA 10 para 16 46 The issue that SARS disputed was that CGFM did not have economic substance as the primary operations referred to in section 9D(1) paragraph (a)(ii)(iii)(iv) were not based in Ireland and a