re SA’s controlled foreign company rules aligned with economic globalisation? - HR Future helps people prepare for the Future of Work and is South Africa's leading print, digital and online Human Resources magazine.

re SA’s controlled foreign company rules aligned with economic globalisation?


SA’s international tax laws regarding controlled foreign companies (CFCs) have not entirely kept pace with the advent of globalisation and technology – they are rigidly mechanical and may not cater for the bona fide business operations of modern business and specialist industries.
In addition, mismatches in the domestic laws of different countries can lead to gaps and frictions in the way in which multinationals are taxed.

The concept of a CFC was introduced into the Income Tax Act almost 15 years ago, long before the advent of Facebook, Uber and the mainstream use of smartphones. Essentially CFC rules are an anti-avoidance mechanism designed to prevent a company from artificially moving its profits abroad to a country with a more favourable or lower tax rate. The CFC rules will broadly speaking apply if South African residents hold more than 50% of the shares and/or voting rights in an offshore company. Section 9D will not apply to a resident who holds less than 10% of the shares in a CFC.

Unless an exemption applies, the South African Revenue Service (SARS) can ‘look through’ the offshore company and include the notional net income of the company in the South African shareholder resident’s taxable income, where it will be subject to South African tax. If an exemption applies then the income of the CFC may not be taxed in the South African resident’s hands or some may be partially included.

One of the most important exclusionary exemptions relates to the “substance” of the ‘business establishment’ of the foreign company – that is the people, equipment and facilities required to run the foreign company’s business. The purpose of the exemption is to exempt bona fide established businesses from the provisions of section 9D. Even if a company is located in a foreign country such as New Zealand, if it does not meet the foreign business establishment “substance” requirements prescribed by SA CFC legislation, the (notional) net income of that company may be imputed to the South African shareholder, and therefore subject to tax in this country.

The policymakers have carefully crafted a definition for identifying whether a self-contained foreign business establishment has been set up. It requires that: the business be carried on from a fixed place of business occupied by the CFC for a period of at least 12 months. Furthermore, the premises should be suitably staffed by on-site managerial and operational employees who conduct the primary operations and the premises should be suitably equipped and have suitable facilities for the conduct of the primary operations.

The definition is dependent on two key concepts: the primary operations of the business and suitability. Although it may be possible to identify the nature of the operations and the purpose for which they are directed with relative ease, account should also be taken of the business model applied in operating the business enterprise, which is a question of fact.

Failure to properly account for the business model may lead to a rigid insistence that there should be on-site managerial and operational employees who conduct all the primary operations associated with a particular industry, even though all these operations may not be “primary” in the context of the operating model of the company being tested. By way of an example, a courier service carries on the primary business of document delivery from a small office in city A. It receives documents from customers and warrants same day delivery within a radius of 200 km. It owns no vehicles and has no employees who perform the delivery service. Instead, it contracts with Uber to collect and deliver parcels four times per day. The depot is staffed by one person, who receives the parcels, issues an invoice, enters the details in a computerised system housed on a personal computer, makes up bundles for delivery, hands the bundles to the Uber drivers and receives proof of delivery documentation from Uber. This individual enters into all contracts with service providers, processes all payments and prepares the financial statements.

On a rigid application of the requirements for a FBE, this operation may be found lacking. Its primary operation is document delivery, yet it has no equipment or facilities to make delivery. It does not have separate managerial and operational employees as these functions are combined in a single person. Yet, it carries on the business successfully and efficiently. In the context of its business model, it is suitably staffed and equipped for the conduct of its primary operations, and does not offend CFC policy. The manner in which it is equipped is by outsourcing certain functions through appropriate contractual relationships. Outsourcing is a recognised business practice and does not necessarily detract from the core or primary operations. It is critical in applying the definition of a foreign business establishment that sight not be lost of the business model applicable to the operation.

Other difficulties may arise where the management and administration are centralised and operations are decentralised – which is not catered for in the existing FBE exemption rules. Globalisation has impacted the way in which multinationals are managed and structured. They are increasingly being managed from a centralised function at a global or regional level rather than their operations being managed within individual countries. There is no longer a need for a multitude of offices, staff, equipment and other resources to be physically present in each office that is set up in a country offshore. The growing digital economy has also made it possible for a company to have a virtual presence in a number of countries with little physical presence.

In the “pre-Facebook and Uber era” during which South Africa introduced CFC legislation, the policymakers may have not envisaged the way in which the business world will undergo change. It is a fast-paced environment where virtual offices are becoming the norm and can be linked to one another by way of a communications network in order to function as a coherent business operation. Interestingly, in the latest attritions of SARS’ Interpretation Note 6 (Issue 2) dealing with place of effective management, SARS explicitly recognises the changes in modern business practices brought about by advancements in telecommunications, business travel and information technology. This is however not recognised in existing CFC rules.

The South African CFC rules fall towards the mechanical end of the CFC policy spectrum. The legislation is largely based on mechanical rules, unlike that of other developed countries, such as the UK and the US which are more facts and circumstances-based. The ease of application of the more mechanical rules should be weighed against the international competitiveness of South African multinationals competing with their non-South African global peers. A more facts and circumstances based CFC system arguably allows for more flexibility in dealing with the ever evolving modern business practices without compromise to the fundamental anti-tax avoidance purpose of CFC rules.

Considering the ever increasing transparency of multinational businesses in line with the OECD’s country-by-country reporting requirements, the difficulties in administering a “facts and circumstances” type CFC system are arguably becoming fewer.

Significant legislation changes will be required to level the playing fields and provide a solution. A considered and balanced approach is required. However, the legislation needs to be developed so that it is consistent and takes into account changes in the way in which business is conducted.

Cor Kraamwinkel is a Partner in PwC’s International Tax Division.

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