Various changes have been made to the controlled foreign company ("CFC") tax rules. The question now arises whether these changes mean that rental income from an operating lease received by a foreign company with South African shareholders gives rise to South African tax under the CFC rules.
In terms of the CFC rules contained in section 9D of the Income Tax Act (" the Act") where more than 50% of the shares in a foreign company are held by South African residents that company qualifies as a CFC. For South African tax purposes an amount equal to the taxable income of a CFC is allocated to the South African resident shareholders unless, inter alia, the income in question is attributable to a foreign business establishment ("FBE") of the CFC. This is essentially a foreign place of business of the CFC.
In terms of section 9D(9A)(iv) of the Act even if the CFC has a FBE, an allocation to its South African resident shareholders will be made in circumstances where the CFC receives rental in respect of any movable property unless the movable property is leased by the CFC in terms of- (aa) an operating lease; and (bb) a lease that constitutes a financial instrument.
The question therefore arises whether, in order to ensure no allocation of income is made under the CFC rules, the lease needs to be both an operating lease and a financial instrument. At first glance it would appear so due to the word "and" which appears between the reference to an operating lease and a financial instrument. However, the provision may be read in a way where any movable property leased by a CFC in terms of an operating lease qualifies for exemption from the CFC rules and, separately, any movable property leased by a CFC in terms of a lease that constitutes a financial instrument also qualifies for exemption from the CFC rules.
In order to answer this question it is necessary to determine the true intention of the legislature. A critical question that arises in this regard is whether an "operating lease" as defined can ever constitute a "financial instrument", as defined. If an "operating lease" cannot constitute a "financial instrument" then it would seem that the provision cannot be read in a manner which requires both of these requirements to be fulfilled in respect of the same lease.
An "operating lease" is defined in the Act as meaning:
"a lease of movable property concluded by a lessor in the ordinary course of business of letting such property if -
(aa) such property may be hired by members of the general public directly from that lessor in terms of such a lease, for a period of no more than five years;
(bb) either -
(A) the cost of maintaining such property and of carrying out repairs thereto required in consequence of normal wear and tear is ultimately borne by the lessor; or
(B) the activities of maintaining and repairing such property that are required in consequence of normal wear and tear are performed by the lessor; and
(cc) subject to any claim that the lessor may have against the lessee by reason of the lessee's failure to take proper care of the property, the risk of destruction or loss of or other disadvantage to such property is not assumed by the lessee."
A "financial instrument" in turn is defined as including:
"(a) a loan, advance, debt, bond, debenture, bill, share, promissory note, banker's acceptance, negotiable certificate of deposit, deposit with a financial institution, a participatory interest in a portfolio of a collective investment scheme, or a similar instrument;
(b) any repurchase or resale agreement, forward purchase arrangement, forward sale arrangement, futures contract, option contract or swap contract;
(c) any other contractual right or obligation the value of which is determined directly or indirectly with reference to -
(i) a debt security or equity;
(ii) any commodity as quoted on an exchange; or
(iii) a rate index or a specified index;
(d) any interest-bearing arrangement; and
(e) any financial arrangement based on or determined with reference to the time value of money or cash flow or the exchange or transfer of an asset."
The Explanatory Memorandum suggests that an operating lease cannot constitute a financial instrument. In discussing the provisions regarding the leasing of movables by an FBE, the Explanatory Memorandum states (pp 108-109), firstly, that "(r)entals derived by a CFC from the leasing of movables will be fully taxable unless the lease is an operating lease or a financial instrument" (my emphasis). It then goes on to say that "the exemption of operating leases covers genuine leasing operations where the lessor substantially bears the economic risk of the assets involved". Such leases are contrasted with "finance leases", which are described as financial instruments and which are excluded from the relief granted "under this dispensation" (that is, in respect of income derived from leasing of movable property) because "these leases will instead be tested under the financial instrument provisions". Under a typical finance lease, explains the Explanatory Memorandum, "the lessee bears the ultimate risk and rewards associated with ownership of an asset"; that is the opposite of an operating lease as defined in the Act.
These observations are reinforced by consideration of, in particular, paragraphs (a) and (e) of the definition of financial instrument.
- An operating lease as defined is a lease of movable property
that must or can be maintained and repaired if necessary. It must
therefore be a lease of corporeal property. Certainly that suggests
that it is none of the specific instruments mentioned in paragraph
(a) of the definition of "financial instrument". Nor
could it then be said to be a "similar instrument". The
instruments listed in paragraph (a) are all documents evidencing an
indebtedness, in most cases the debt being to pay a sum of money to
the holder of the instrument; in the case of shares and
participatory interests in a portfolio of a collective investment
scheme, the instrument can readily be converted into cash. So too
it seems that the instruments listed are all capable of negotiation
or transfer to third parties, conforming therefore to the ordinary
sense of the term "financial instrument". By their very
nature, such negotiable certificates and instruments bear little
similarity to a contract for the leasing of movable property.
- Can a contract for the letting and hiring of movable, corporeal property be described as a financial arrangement based on or determined with reference to the time value of money, or cash flow, or the exchange or transfer of an asset? Whether it can be described as a financial arrangement at all is doubtful (contrast a finance lease, which comes very close to a loan to finance the acquisition of an asset); but assuming that hurdle is cleared, it is not an arrangement based on or determined with reference to the time value of money. In so far as the contract involves an obligation to pay a sum of money, there is cash flow involved; and in so far as the property leased is delivered into the possession (but not ownership) of the lessee, it may be said to involve the transfer of an asset. However, if these factors alone were sufficient to bring the contract within the definition of financial instrument, a whole host of agreements would likewise fall within that definition; every sale of an asset, for example, and every deposit of an asset for reward, would constitute a financial instrument.
It therefore seems that the better argument is that an operating lease as defined cannot constitute a financial instrument of the type contemplated in the definition of financial instrument in the Act. In terms of this argument, if a CFC with a FBE leases movable property in terms of an operating lease it should qualify for exemption from South African tax under the CFC rules. This is regardless of whether the lessee is located in South Africa.
It seems that where movable property is leased by a CFC in terms of a lease that constitutes a financial instrument then, in order to escape South African tax under the CFC rules, this must also qualify for the various other requirements relating to financial instruments
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