The various changes to the so-called debt waiver provisions in section 19 of the South African Income Tax Act, 1962 (the “Act”) and paragraph 12A of the Eighth Schedule to the Act in terms of the Taxation Laws Amendment Acts of 2017 and 2018 have come and gone. It is understood that there is now finality in terms of the debt waiver provisions as contained in the Act, which we discussed in a previous article. However, the tax implications for controlled foreign companies or (“CFCs”) in relation to debt capitalisations may be different despite section 19 and paragraph 12A of the Eighth Schedule. This is especially so in the context of a capitalisation of debt owing by one CFC to another CFC that is a shareholder of the first CFC.
A CFC is a foreign company in which more than 50% of the participation rights/voting rights are held/exercisable (directly or indirectly) by South African residents who are not headquarter companies. A foreign subsidiary that is 100% held by that CFC will also automatically be a CFC due to the proviso (ii) of paragraph (a) of the “controlled foreign company” definition in section 9D of the Act.
If there is a CFC, the effect is as follows: the “net income” of a CFC as determined in accordance with section 9D(2A) of the Act is included in the taxable income of resident shareholders which hold 10% or more of the voting rights/participation rights in that CFC, in proportion to the shareholding held in the CFC, and taxed at the corporate income tax rate, unless certain exclusions apply.
In determining the “net income” of a CFC, section 9D(2A) of the Act provides that:
“… the ‘net income’ of a controlled foreign company in respect of a foreign tax year is an amount equal to the taxable income of that company determined in accordance with the provisions of this Act as if that controlled foreign company had been a taxpayer, and as if that company had been a resident for purposes of the definition of ‘gross income’, sections 7(8), 10(1)(h), 25B, and paragraphs 2(1)(a), 24, 70, 71, 72 and 80 of the Eighth Schedule.” (our emphasis added)
The aforementioned means that the tax calculation, from a South African perspective, must be performed on the CFCs as if they were taxpayers in South Africa. When determining such net income, the CFCs are also treated as residents for purposes of certain provisions of the Act applicable only to “residents”. As a result, section 19 and paragraph 12A of the Eighth Schedule will apply to CFCs to determine their “net income” for attribution purposes.
Hence, where one CFC capitalises its shareholder loan to its subsidiary (where that subsidiary is also a CFC), section 19 and paragraph 12A of the Eighth Schedule will apply if a debt benefit arises, ie, if the face value of the debt so capitalised exceeds the market value of the shares received in the other CFC. Moreover the exclusion for capitalisations between group companies (section 19(7)(e) and paragraph 12A(6)(f) of the Eighth Schedule) will not apply for purposes of section 19 and paragraph 12A of the Eighth Schedule, as the reference to “group of companies” is to the section 41 definition and not the section 1 definition (ie, it excludes foreign companies, consequently CFCs from the equation).
So, in these circumstances, the CFCs would have “net income” for purposes of section 9D(2A) of the Act. Yet, section 9D(9) of the Act states, inter alia, that “in determining the net income of a controlled foreign company in terms of subsection (2A), there must not be taken into account any amount which:
“…(fA) is attributable to…
…(iv) the reduction or discharge by any other controlled foreign company of a debt owed by that company to that other controlled foreign company for no consideration of for consideration less than the amount by which the face value of the debt has been so reduced or discharged,
where that controlled foreign company and that other controlled foreign company form part of the same group of companies;…” (our emphasis added)
Interestingly, even though section 19 and paragraph 12A of the Eighth Schedule have undergone significant changes, it seems that section 9D(9) of the Act has not “kept up with the times”, ie, it still uses the old language for the debt waiver rules pre- the 2017 and 2018 amendments. Also, the tests based on the wording used are substantially different – a “debt benefit” for purposes of section 19 and paragraph 12A of the Eighth Schedule may not be a “reduction or discharge” under the inter-CFC exemption in section 9D(9)(fA)(iv) of the Act.
Is it therefore intended that CFCs forming part of the same “group of companies” (section 1 of the Act’s definition in this case, we might add) are exempt from the debt waiver rules given that more specific sections override more general sections? Or are taxpayers with potential CFC net income required to do separate tests and market valuations that will inform which of these sections will apply or not? In some instances, it may give rise to some possibly unintended consequences given the confusion as to the lack of alignment with the final wording of section 19 and paragraph 12A of the Eighth Schedule.
Therefore, it is probably best for National Treasury to consider aligning the wording to prevent any uncertainty or unintended tax consequences. The CFC rules are complex enough on their own, it would be unduly burdensome for taxpayers to concern themselves with two sets of “debt waiver” rules for CFCs.
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.