Offshore companies that are, directly or indirectly, owned by South African residents may be regarded as Controlled Foreign Companies (‘CFC’) for South African income tax purposes.
As such, a proportionate amount of the ‘net income’ of such entity may be taxed in the hands of its South African shareholders, unless an exemption or exclusion applies.
One of the key exclusionary exemptions relates to the “substance” of the ‘business establishment’ of the foreign company. In this regard, the CFC must have a 'fixed place of business ‘that comprises the physical infrastructure - in the form of 'suitable’ premises, staff, equipment and facilities - to perform the primary operations of that business.
It may happen that a CFC does not itself meet the substance requirements, for example by not renting premises in its own name, or not itself having full-time employees.
However, it is able to carry on its business because it can occupy premises of another CFC forming part of the same group of companies and use the facilities and employees of that other company. In these circumstances, the first-mentioned CFC may nevertheless be able to qualify for the substance based exemption.
This usually takes place where the businesses of different CFCs are substantially similar (for example, banking subsidiaries), so that two or more CFCs use common office space and the employees working in that space are able to perform the administrative and operational functions of all of the CFCs.
Typically, the lease, equipment and employees are assigned to one of the CFCs, but they are occupied by, used by or perform functions for and on behalf of all of the CFCs located in that space.
If this principle were applied to companies in South Africa, there would typically be a recharge of all of the expenses by the ‘host’ CFC to the ‘guest’ CFC for facilities and services enjoyed by the latter. This recharge would largely be driven by domestic tax considerations in terms of which: Companies in South Africa are subjected to tax on an entity-by-entity basis; and, deduction of expenses is denied if the expenditure is incurred otherwise than in the production of the entity’s income and for the purposes of the entity’s trade.
However, not all jurisdictions tax on an entity-by-entity basis. A number of countries in Europe and the US tax groups of companies as a single entity on the basis of common economic ownership. Where group taxation applies, the taxable income is based upon the income derived from the expenditure incurred by the various entities in transactions with third parties, being persons who do not form part of the consolidated tax group or fiscal unity. Transactions between the members of the group are ignored.
Where employees and facilities are common to a number of companies in a fiscal unity, there is no necessity to perform a reallocation of expenses between the entities, as the reallocation would be neutral for the purpose of determining the tax liability of the entity. In these circumstances, it may practically be more difficult to substantiate the sharing of resources if the matter is only viewed from a South African perspective.
How does a resident prove to the South African Revenue Service (SARS) that two or more CFCs have conducted business through a foreign business establishment based upon the ‘shared substance’ principle?
Financial records are however not the only way in which sharing of employees and facilities can be proved. The use of a common operational base is demonstrated by reference to addresses on letterheads and invoices. Furthermore, employee e-mails can substantiate that the employees perform functions for all of the businesses interchangeably and seamlessly. Internal telephone lists and organograms can show that individuals deal with customers of all of the businesses and have roles and tasks assigned to them that necessitate that they perform services for all of the businesses. Documents of original entry used for accounting purposes typically identify the originator and the approver. All of these forms of evidence may be assembled to form a coherent and clear picture.
Where, for whatever reason, costs have not been recovered or recharged, shared substance is still a question of fact and must be proved by gathering alternative evidence.
Multinationals may be called upon by SARS to substantiate ‘shared substance’ of their CFCs and they should be prepared to defend their presence in these countries. They need to be adequately prepared for the eventuality as there does not seem to be a clear and exhaustive definition of commercial activity in the context of shared substance. Failing which, additional South African tax liabilities for South African shareholders may arise.
Cor Kraamwinkel is a Tax Partner at PwC International.