South African taxpayers commonly form companies in foreign jurisdictions to seize investment and expansion opportunities. However, often the intention of the taxpayer is also to benefit from no or low tax rates in these foreign jurisdictions. These actions have resulted in an erosion of the South African tax base and the controlled foreign companies' regime was introduced to prevent this and discourage taxpayers from shifting their income into such jurisdictions.
Taxpayers that own foreign companies need a clear understanding and awareness of the controlled foreign company regime as the foreign company in question, although incorporated in a country outside of South Africa, may still be subject to tax in South Africa.
The place of "effective management" of a company that is not a South African resident must be determined with absolute certainty where a company is considered to be a controlled foreign company. A 'controlled foreign company" (CFC) is:
- a company that is incorporated and considered to be effectively managed outside of South Africa and
- 50% or more of the participation rights or voting rights of that company are held directly or indirectly by South African residents.
It follows that, the place where a company is considered to be effectively managed is where it will be resident for tax purposes. Interpretation Note 6 (IN 6) issued by SARS during 2002, outlines and provides guidance to taxpayers on SARS' view on the meaning of effective management and conducts a "three-stage inquiry" in practically determining this.
- Where the management functions of a company are carried out at a single location, that location will be the place where the company is effectively managed.
- Where the management functions are carried out at multiple locations for instance the use of videoconferencing or email, then the place of effective management is where the regular or day-to-day business operations and activities are run and where operational and commercial decisions are implemented.
- Where management functions and operations are carried out from various locations and in this instance the place of effective management is the place with the "strongest economic nexus". It is cautioned that IN 6 serves only as a guideline and has no legal standing.
Taxing CFCs in South Africa
CFCs are subject to section 9D of the South African Income Tax
Act. The provisions of section 9D subject to specific exclusions
prescribes that the net income of the CFC be included in the
taxable income of the South African resident in proportion to the
resident's rights in that company. This is congruent with the
basis that South African residents are taxed on their worldwide
income and is aimed at taxing residents who invest their
income-earning assets in foreign companies and earn passive or
"diversionary" income as a result.
The net income of a CFC will be excluded from the taxable income of the South African resident in the following three instances:
- If the net income of the CFC is attributable to a "foreign business establishment";
- Where the de minimus exemption applies; and
- Where the income of the CFC is taxed at a specific rate in a foreign jurisdiction.
It is apparent that the concept of effective management and the
provisions envisaged in section 9D are riddled with complexities
that taxpayers should understand and consider on a case by case
basis to ensure compliance.
An IT10 return is required to be submitted to SARS for statutory disclosure purposes of the CFC and in terms of section 72A of the Income Tax Act. The annual financial statements of the CFC will be requested by SARS and must be retained for review. Taxpayers should note that with respect to the foreign business establishment exemption claimed by most taxpayers, SARS audits and reviews the exemptions claimed by most multinationals.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.