South African shareholders in businesses with offshore operations beware
South African shareholders in businesses with offshore operations beware
A few weeks ago, in the case of CSARS v Coronation Investment Management SA (Pty) Ltd (1269/2021)  ZASCA 10 (07 February 2023), SARS continued its winning streak in the Supreme Court of Appeal (SCA). The SCA held in that case that an Irish company, forming part of the Coronation group of companies, was not conducting its primary business operations in Ireland and therefore the South African holding company of the Coronation group had to impute the profits of that Irish entity for South African tax purposes.
At a glance
- The South African Supreme Court of Appeal ruled in the case of CSARS v Coronation Investment Management SA that an Irish company in the Coronation group was not conducting its primary business operations in Ireland, leading to the imputation of its profits for South African tax purposes.
- The case revolved around the interpretation and application of the controlled foreign company (CFC) rules, which aim to tax South African residents on the net income of CFCs. The court determined that the Irish entity's primary operation was fund management, including investment management, and that these operations were not conducted in Ireland.
- In response to concerns about outsourcing of CFC operations, the government plans to introduce additional amendments to the CFC regime, requiring all important functions for which a CFC is compensated to be performed by the CFC or another company meeting specific conditions. This aims to restrict outsourcing under the FBE exemption.
This was because of the SCA’s interpretation and application of the controlled foreign company (CFC) rules to the specific facts of the case. It is therefore notable that on the back of this victory, it was announced in the Budget that certain additional amendments to the CFC regime would be introduced that will provide further clarity to the findings in the Coronation case.
Context: Controlled foreign company regime
Section 9D of the ITA contains anti-avoidance rules aimed at taxing South African residents on the net income of a CFC. The purpose of this provision is to strike a balance between protecting the South African tax base and enabling South African multinationals to compete offshore. Given this, the CFC rules contain various exclusions and exemptions for certain types of income. For instance, if the CFC is located in a high-tax jurisdiction then the CFC’s net income will not be imputed in the hands of the South African tax residents.
Furthermore, amounts that are attributable to a foreign business establishment (FBE) of a CFC, as defined in section 9D, are excluded from the net income of the CFC. This aligns with the thought that if the foreign company has a suitable physical presence in the foreign country that has sufficient substance, then it should only be taxed in the source country. In simple terms, an FBE consists of a fixed place of business located outside South Africa that is used or will continue to be used for the business of the CFC for at least one year.
However, to fully benefit from the FBE exemption, an FBE must also satisfy requirements relating to the nature of the business. In this context, the fixed place of business should be suitably staffed with onsite managerial and operational employees of that CFC and its offices should be suitably equipped and have suitable facilities for conducting the “primary operations” of the business. Determining what constitutes the “primary operations” of the business is therefore critical.
In the Coronation case, the SCA had to determine whether the Irish Coronation group company had sufficient substance to its operations and complied with all the requirements of the FBE definition. To the extent that it did not qualify for the FBE exemption, the Coronation holding company in South Africa would have to impute profits of the Irish entity in its South African tax return.
It was accepted that the Irish entity had a fixed place of business that was staffed by on-site operations and managerial employees. However, the key issue was whether the office was suitably equipped and staffed for conducting the “primary operations” of the Irish entity. Coronation contended that its primary operation in Ireland was “fund management” which included the active management of its service providers, plus regulatory compliance.
It furthermore submitted that the functions that it outsourced and did not conduct in Ireland comprised the larger fund management services (i.e. “investment management”) provided to investors in conjunction with the investment manager, which was not its primary operation. The argument was therefore that because it outsourced its investment management functions to other entities, that was not its primary business operation and therefore its FBE in Ireland did not need to be suitably staffed by individuals conducting the “investment management” services.
The SCA disagreed with Coronation’s submissions and held that the argument that “investment management” is not the Irish entity’s core business was at odds with what was stated in its founding documents, which specifically referred to establishing specified collective investment undertakings and carrying on the business of investment and financial management. In addition, the fact that the Irish entity’s primary source of income was from investment was, according to the SCA, another indication that its core function was investment management.
The SCA also discussed the concept of outsourcing and commented that even though the Irish entity was permitted to outsource functions, this did not mean that the scope of its business was confined to the supervision of the functions which it has outsourced, together with regulatory compliance. Instead, its operations must be determined with reference to the activities under which it was granted its licence. If it chooses to outsource those activities to another entity, this does not mean those functions fall outside of its business. It was specifically held as follows:
“These functions had to fall within the ambit of its business in order to be outsourced. An agent cannot perform a function which does not form part of the business of the principal. In other words, [the Irish entity] could not outsource a function that it did not possess in the first place.”
The SCA thus determined that the primary operation of the Irish entity’s business (and, therefore, the business of the CFC as defined) was that of “fund management” which included “investment management” and that these operations were not conducted in Ireland. It was commented that such an interpretation would give credence to the rationale that the CFC regime is in force for purposes of limiting a situation where a tax exemption is obtained in relation to earnings in a low-tax jurisdiction when the primary operations of the business are not conducted there.
Tightening of the screws on outsourcing of operations by CFCs
Despite SARS’ victory in the SCA, it was announced in the Budget that Government has identified that some taxpayers are retaining certain management functions but outsourcing other important functions for which the CFC is also being compensated by its clients. National Treasury states that this is against the policy rationale of the definition of an FBE. It has therefore been proposed that tax legislation be clarified such that, to qualify as an FBE, all important functions for which a CFC is compensated need to be performed by the CFC or by the other company meeting certain conditions.
In this manner, National Treasury states that the definition of an FBE does allow for the structures, employees, equipment and facilities of another company to be taken into account if these are all located in the same country as the CFC’s fixed place of business; the other company is subject to tax in the same country where the CFC’s fixed place of business is located; and it forms part of the same group of companies as the CFC. In other words, outsourcing of certain functions is theoretically allowed but only under certain conditions.
While the judgment in the Coronation case may have been a bitter pill to swallow for many taxpayers, their medication just got even more unpalatable. It is anticipated that the proposed amendments will build on the commentary and findings in the Coronation case to ensure that outsourcing in the context of the CFC regime is only allowed under certain strict conditions and circumstances. All South African tax resident shareholders with CFCs would be well advised to analyse their existing offshore operations in light of these developments.
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