South Africans have created offshore companies for various reasons. A fairly common reason is simply to diversify risk, in that the SA person will then have some assets offshore. This seems to be an increasingly common trend.
Such offshore entities would usually be controlled foreign companies (“CFCs”) for tax purposes. An important issue that SA shareholders should be aware of, is that the income of such CFC can be taxed in their hands in SA even if no income or dividend is repatriated to SA. This is in terms of our CFC rules.
There are two broad categories within our CFC rules which prevent the attribution of income from a CFC to a SA resident.
The first is the so-called high tax exemption. The hypothetical question is asked whether, if the CFC had been a SA tax resident, its theoretical SA income tax payable would have been at least 67.5% of the actual foreign income tax payable.
The second is an exemption for income that is attributable to a foreign business establishment (“FBE”) in the foreign country. There are some peculiarities and exceptions to this rule, but in essence the question in simple terms is whether the CFC has sufficient ‘substance’ in the foreign county.
The requirements of the FBE exclusion are set out in the Income Tax Act. Recently, and for the first time in SA, the issue of whether a company had a FBE went to court and was the subject of the judgment ABCDE SA (Pty) Ltd v CSARS (IT 24596).
We would certainly agree with the observation of the Judge in this case that the CFC rules are lengthy, with multiple subsections, and that they been subject to numerous amendments over the years.
In terms of the case, SARS was of the view that ABCDE’s CFC (“AB”) did not have a FBE, and hence that ABCDE should, in terms of section 9D, include the income of AB in its income for SA tax purposes.
The Judge had to consider whether the five requirements of the definition of FBE were applicable.
These five requirements can be summarized as whether the CFC has:
A fixed place of business located outside SA that is used or will be used for the carrying on of the business of that CFC for a period of not less than a year, where -
- that business is conducted through a physical structure (offices, shops, factories, warehouses or other structures);
- that fixed place of business that is suitably staffed with on-site employees who conduct the primary operations of that business;
- that fixed place of business is suitably equipped to conduct the primary operations of that business;
- that fixed place of business has suitable facilities to conduct the primary operations of that business; and
- that fixed place of business is located outside of South Africa solely or mainly for non-tax purposes.
It is important that all the above requirements are met.
An issue which was not so simple in this case was what the primary operations of AB were. Further, whether such primary operations were conducted in Ireland at AB’s offices there.
Briefly, AB was a financial company. Clients gave AB funds, and AB used such funds to generate income for its clients. AB earned a fee based on the funds provided. For AB to make a return to pay to its clients, it invested the funds.
AB ensured that it maintained its financial licence, made policy decisions and oversaw its operations. Four employees undertook this function in Ireland at the company’s offices there. These employees were the managing director, two accountants and a compliance officer.
An obvious question is who managed the investment of the funds? This was outsourced to another company in the UK.
SARS was of the view that the management of the company was not the primary operation of AB, but the actual investment management was, and this was outsourced, hence there was no FBE of the company as defined. SARS held the view that of the above five requirements, the last four were not met.
The court held that investment management concerns the use of the clients’ funds and falls under investment management trading activities. This is the day-to-day use of the money and plays a relatively minor role in the overall picture of fund management. The court also stated that fund management and not investment management was the core activity of AB, which includes maintaining its financial licence. Therefore, AB had a FBE as it is a fund management company and not an investment management company.
While we can see the distinction one can understand where SARS was coming from – without anyone managing the investment of the funds, no-one would provide funds to AB.
We briefly mention that in terms of the last (anti-avoidance) requirement in the definition of FBE, various non-tax reasons were provided for incorporating AB in Ireland. A company may be incorporated outside of SA for many reasons that are unrelated to taxation. The Court was satisfied that AB had been incorporated in Ireland mainly for non-tax reasons.
It is unclear whether or not SARS is taking the above decision on appeal.
So where does that leave you and your CFC?
Firstly, a question is asked in the annual income tax return, whether the taxpayer is a shareholder in a CFC. Then there is a further question of whether you have submitted an IT10B with your income tax return.
Firstly, a question is asked in the annual income tax return, whether the taxpayer is a shareholder in a CFC. Then there is a further question of whether you have submitted an IT10B with your income tax return.
On your IT10B you can claim the FBE exemption as described above.
The above case was unusual in that it would not normally be a point of contention what the primary operations of a company are. Before claiming the FEB exemption, one should check whether or not the exemption applies with reference to all five bullets above. It should also be noted that, regardless of whether or not income is actually attributable to a FBE, there are various situations in which income is still deemed to be taxable in the SA shareholders’ hands, despite the existence of a FBE.
In summary, the CFC rules are complex. However, in our view, if correctly established for commercial reasons, CFC’s can be used very effectively to house your off-shore business.