CFCs and the High Foreign Tax exclusion – Some Observations
CFCs and the High Foreign Tax exclusion – Some Observations
By Associate Professor David Warneke, Tax Partner
This article first appeared in the July 2025 edition of SAICA’s Integritax Journal
Section 9D of the Income Tax Act 58 of 1962 (the Act) deals with ‘controlled foreign companies’(CFCs). It is an extraordinary anti-avoidance provision in that it has the effect of treating the ‘net income’ of a company as that of other persons for income tax purposes - more specifically, that of the South African (SA) tax resident holders of ‘participation rights’ in the CFC. In broad terms, the provision applies if the company is a non-resident and more than 50 percent of the participation or voting rights are collectively held by SA residents. Although in many cases companies have different classes of shares each with different rights, for simplicity’s sake, below I refer to the holders of the company’s participation rights as the company’s shareholders.
The provision was introduced into the Act when SA changed from a source-based to a residency-based income tax system. It was designed to counter schemes that avoided the new system by the relatively simple expedient of inserting a non-resident company between SA residents and their foreign-sourced income. The provision has undergone many refinements over the years and its present form is somewhat cumbersome and overly rigid, especially when viewed against the backdrop of modern economic developments. There are, unfortunately, also numerous areas of uncertainty.
The term ‘net income’ in relation to a CFC is defined and calculated in accordance with complex rules. With some exceptions, it is calculated according to SA income tax principles with the added fictional suppositions that the CFC had been an SA taxpayer for its foreign tax year and that the CFC be treated as a ‘resident’ for certain provisions of the Act. Among these exceptions is that in various circumstances, some of the CFC’s income or deductions are disregarded.
If the calculation of ‘net income’ results in a negative i.e. a loss, such loss is not imputed to the SA resident shareholders. Instead, it is carried forward for set-off against possible future positive ‘net income’ of the CFC and may thus reduce the ‘net income’ inclusion of such shareholders in future years of assessment.
There are two cases in which the ‘net income’ is deemed to be nil, thereby obviating the pro-rata inclusion thereof in the hands of the CFC’s SA resident shareholders. The first, which is the focus of this article, is the so-called high foreign tax (HFT) exclusion and the second, the ‘foreign business establishment’ (FBE) exclusion. The FBE exclusion came under the spotlight in the fairly recent dispute between SARS and Coronation Investment Management (Pty) Ltd, that culminated in a Constitutional Court judgment in favour of Coronation (Coronation Investment Management SA (Pty) Ltd v Commissioner for the South African Revenue Service CCT47/23).
The HFT exclusion states that the ‘net income’ of a CFC is deemed to be nil if the aggregate amount of foreign income taxes payable by the CFC in respect of its foreign tax year is at least 67.5 percent of the (notional) SA income tax that would have been payable by the CFC, had it been SA tax resident for that foreign tax year. In determining the aggregate amount of tax payable by the CFC for this purpose applicable double taxation agreements, tax credits, rebates and other rights of recovery of foreign tax must be taken into account. Also, losses arising during foreign tax years ending after the date on which the CFC became a CFC must be disregarded for purposes of the calculation of the aggregate amount of tax payable. The explanation for the disregarding of such losses appears from the Explanatory Memorandum to the Taxation Laws Amendment Bill 17B of 2016 to be to allow the CFC to disregard the set-off of foreign tax losses that arose after the CFC became a CFC, in the calculation of its effective foreign tax rate. Such set-offs are permitted in terms of the group taxation laws of certain foreign jurisdictions and would have the effect of reducing the effective foreign tax rate of the CFC, thereby prejudicing the calculation from the perspective of its SA resident shareholders. The wording also appears broad enough to support the interpretation that neither foreign tax losses nor notional SA tax losses should be carried forward to subsequent years for purposes of the HFT exclusion calculations, which are intended to be performed based on a strict ‘in-year’ comparison.
The reason for the HFT exclusion is that tax avoidance motives are likely to be absent where the foreign company is subject to substantially the same level of taxation as would have been the case had it been SA resident. The HFT exclusion operates on an annual basis: for each foreign tax year of the CFC, one must compare the aggregate foreign income tax payable with the hypothetical SA income tax that would have been payable. The exclusion either operates for the foreign tax year or not. If the latter, the ‘net income’ must be calculated and dealt with in accordance with the requirements of the provision. If the ‘net income’ is positive and the other possible escape – the foreign business establishment exclusion - also does not avail, each shareholder’s pro-rata share of the ‘net income’ must be included in their ‘gross income’ if they, together with their ‘connected persons’, on the last day of the foreign tax year of the CFC, together hold at least 10 percent of the participation or voting rights in the CFC.
For years of assessment that ended prior to 1 January 2020, the HFT exclusion required the aggregate amount of foreign taxes payable by the CFC to be at least 75 percent of the hypothetical SA tax that would have been payable had the CFC been SA tax resident for its foreign tax year. The decrease to 67.5 percent was to cater for the fact that SA’s corporate income tax rate had become relatively high when compared to that of our major trading partners, for example the United Kingdom, which had a corporate income tax rate of 19 percent at that time. Although the UK corporate tax rate has since increased, SA’s corporate tax rate is still relatively high, at 27 percent.
Therefore, if the notional SA ‘taxable income’ of the CFC for a foreign tax year is say R100 resulting in notional SA tax of R27, under the current 67.5 percent regime, payable and unrecoverable foreign taxes of anything upwards of the equivalent of R18.23 would satisfy the HFT exclusion and deem the CFC’s ‘net income’ to be nil, whatever the result of the calculation of its ‘net income’ may be.
The notional SA income tax calculation implies that a calculation of notional SA ‘taxable income’ for the foreign tax year must first be performed, since it is ‘taxable income’ on which liability for SA income tax is calculated. Importantly, this notional SA ‘taxable income’ calculation is different from the CFC’s ‘net income’ calculation. Although, as noted above, the calculation of a CFC’s ‘net income’ is also a hypothetical calculation on the basis of what the CFC’s ‘taxable income’ would have been had it been SA tax resident, differences would normally arise between the two calculations because the various exceptions and exclusions that apply in the calculation of ‘net income’ are ignored in the calculation of the notional SA ‘taxable income’. In other words, the notional SA ‘taxable income is calculated based on what the SA ‘taxable income’ of the CFC would have been for the foreign tax year had the CFC been SA tax resident, without consideration of the complicated exceptions and exclusions inherent in the ‘net income’ calculation. Thus, where the requirements of the HFT exclusion are met, the more onerous requirement to calculate the CFC’s ‘net income’ becomes redundant: the CFC’s ‘net income’ is simply deemed to be nil for the foreign tax year concerned, resulting in no section 9D inclusion of the CFC’s ‘net income’ in the hands of its SA resident shareholders.
It is unclear how far the fiction of South African residency extends in the notional calculation of the CFC’s ‘taxable income’. In many cases there are instances where expenditure would not have been incurred or would have been incurred to a greater or lesser degree, had the CFC been SA resident, and the same with the earning of income. However, this sort of analysis is not what the HFT exclusion is aimed at, which is a comparison of taxes between the two jurisdictions given the actual income earned and expenditure incurred by the CFC during its foreign tax year, and so the actual income and expenditure of the CFC must be used for comparative purposes.
It also appears that the provisions of section 31 of the Act, dealing with transfer pricing, should not be applied to items in the notional ‘taxable income’ calculation. Assume for the sake of illustration that the CFC incurred interest on a loan from a non-resident ‘connected person’ where the rate of interest incurred was above a market-related, arm’s length rate. Had the CFC been SA resident, an adjustment in terms of section 31 would have been required to reduce the interest incurred by the CFC to an arm’s length rate. This is because one of the requirements for the application of section 31 is that a ‘tax benefit’ must be derived by a party to the transaction and, absent a reduction in the interest expense, a ‘tax benefit’ would have been derived by the CFC. However, because the notional ‘taxable income’ calculation is just that – notional – no ‘tax benefit’ is actually derived by the CFC. In fact, the opposite is likely to be true: by increasing its notional ‘taxable income’ in terms of a transfer pricing adjustment in terms of section 31, the notional SA tax payable by the CFC would increase, which means that it is more likely that the HFT exclusion would apply. By contrast, when performing the ‘net income’ calculation, section 31 would apply in the above scenario because this is what the provision specifically provides.
Section 23M also warrants examination in this regard. Essentially, it provides that where ‘interest’ is sought to be deducted by a debtor and the interest is not fully subject to tax in the hands of the creditor, the amount that may be deducted is limited in terms of a formula that is roughly modelled on 30 percent of the EBITDA of the debtor. The term ‘interest’ as defined for purposes of this provision is much broader than interest in the legal sense – it includes, among other things, foreign exchange differences. Again, it does not appear that section 23M should be applied in the notional ‘taxable income’ calculation for purposes of section 9D. Apart from the few cases where the beneficial owner of the interest income is a SA resident, it is clear that the interest income will not be subject to SA taxation in the hands of the creditor, simply because of the fiction imposed by the notional calculation of ‘taxable income’, that the CFC, which is actually non-resident, is SA resident. If the CFC had actually been SA resident, then withholding tax on interest or inclusion of the interest income in the hands of the creditor may potentially have applied and thus the application of the section 23M limitation would have made sense.
A question that often arises in practice is whether foreign tax actually has to have been payable in relation to the foreign tax year before the HFT exclusion can apply. Although the wording of the HFT exclusion refers to ‘the aggregate amount of taxes on income payable’, it is submitted that a sensible interpretation includes the situation in which no foreign taxes are payable, since the HFT exclusion is concerned with situations in which the differential between the notional SA tax and foreign tax is less than 67.5 percent of the notional SA tax. For example, if the notional SA taxable income in a given year is a loss and there are also no foreign taxes payable - possibly because the foreign equivalent of ‘taxable income’ is a loss- resulting in neither hypothetical SA taxes nor foreign taxes being payable, the HFT should apply. On this interpretation, I should add that if the hypothetical SA ‘taxable income’ is a loss, clearly any amount of foreign taxes payable would result in the application of the HFT exclusion.
It sometimes occurs that the notional SA ‘taxable income’ calculation results in a loss and the ‘net income’ calculation would also result in a loss (were ‘net income’ to be calculated, given that in such circumstances the HFT exclusion must apply for the reasons posited above, and thus there would be no need to calculate the ‘net income’). Although the HFT exclusion obviates the need for the performance of the (more complex) calculation of the CFC’s ‘net income’, by deeming the ‘net income’ of the CFC to be nil, the loss on the ‘net income’ calculation would effectively be wiped out and may thus not be carried forward for setoff against future positive ‘net income’ of the CFC. The SA resident shareholders of the CFC would therefore be in a worse tax position than they would have been, but for the HFT exclusion. Unfortunately, the HFT exclusion is not elective in these circumstances or any other and it either applies or does not.
To compare the foreign tax payable with the notional SA tax payable in the HFT exclusion, a translation of the foreign tax amount to rands will be required. A translation to rands of the amounts included in the notional ‘taxable income’ calculation, invariably earned or incurred by the CFC in a foreign currency, will also be required. Although section 9D(6) determines rules for the translation of the ‘net income’ of a CFC to rands, it does not determine how the items comprising the notional ‘taxable income’ should be translated. Although, in theory, one could compare the tax rates by translating the rand amounts into foreign currency, the Act only caters for the translation of foreign denominated amounts into rands, and this would therefore seem more likely to be the correct approach. It is submitted that the amounts earned and incurred by the CFC for purposes of the notional SA ‘taxable income’ should be translated using the standard translation rules in the Act, namely s25D and, if relevant, paragraph 43 of the Eighth Schedule. Regarding the translation of foreign tax payable by the CFC, on the basis that tax payable by the CFC is an ‘expenditure’ of the CFC, arguably the translation provisions of section 25D should also be applied thereto.
In conclusion, the HFT exclusion often provides a welcome escape from the burden of the complex calculations of a CFC’s ‘net income’. However, various areas of interpretational uncertainty exist which, as is invariably the case, would best be explicitly clarified by the legislature.