Articles

Amendments to South Africa’s CFC legislation and the foreign business establishment exemption

Turnstone News/ Business Money October 2009
By Robyn de Kock

This article sets out the amendments to the "foreign business establishment" exemption contained in South Africa's "controlled foreign company" (CFC) legislation, as introduced in the Taxation Laws Amendment Act of 2009.

Before dealing with the amendments we will briefly summarise the most important provisions of the section dealing with CFCs (namely, section 9D of the Income Tax Act).

Section 9D is essentially an anti-avoidance provision that aims to prevent South African taxpayers from diverting certain types of income from the tax net of the South African Revenue Service (SARS) and from preventing the deferral of taxes by ensuring that undistributed income of a CFC is taxed in the hands of the South African shareholders on a current basis.

The section only becomes applicable where more than 50% of the right to share in the profits and capital of a foreign company ("participation rights") are held by South African taxpayers or where more than 50% of the voting rights in the foreign company are exercisable by South African taxpayers.

It is therefore necessary that the foreign entity is a company and that the foreign company is not a South African tax resident in its own right (by virtue of being effectively managed in South Africa).

The aim of the section is that where a South African tax resident holds participation rights in a CFC, unless an exemption exists, that resident shareholder must include in his taxable income in South Africa a proportionate amount of the net income of the CFC. Irrespective of whether an exemption is applicable, the taxpayer must submit an IT10 form to SARS together with his tax return.

One of the most important exemptions available is where the CFC constitutes a "foreign business establishment".

The requirements for a foreign company to constitute a "foreign business establishment" are as follows:

The company must have a fixed place of business outside of South Africa that is used for at least a year, where:

• The business of the foreign company is conducted through one or more offices, factories, warehouses or similar structures.

• The fixed place of business is suitably staffed with on-site managerial and operational employees of that CFC who conduct the primary operations of that business.
 
• The fixed place of business is suitably equipped for conducting the primary operations of the business.
 
• The fixed place of business has suitable facilities for conducting the primary operations of that business.

• The fixed place of business is located outside of South Africa solely or mainly for a purpose other than the postponement or reduction of any South African tax.

Previously it was only required that the foreign business establishment had some non-tax purpose for its existence (no matter how minor that business purpose was in relation to the tax benefits of the company). As a result of the amendments it is now required that the business rationale for locating the company in a country other than South Africa be the sole or main reason for the choice of jurisdiction for the company.

However, a concession has been granted in the amendments in that in assessing whether the foreign company has the necessary employees, equipment and facilities, the employees, equipment and facilities of another company can be taken into account if:

• Those items are located in the same foreign country as the fixed place of business of the CFC.

• The other CFC is subject to tax in the foreign country.

• The other company is part of the same "group of companies" (ie there is a 70% share linkage).

It must be noted, however, that even where the above requirements are met and the CFC meets the definition of a "foreign business establishment", certain types of income may still be attributed to the South African resident shareholder under certain circumstances. This will mostly apply where “passive” income is received or where income is earned from transactions between the CFC and related South African companies. We therefore advise that any South African investors invested in potential CFCs obtain tax advice on the impact of section 9D prior to the submission of tax returns in South Africa.