SECTION 9D – LENIENCY FOR ‘TAINTED INCOME’
Controlled Foreign Companies
Section 9D of the Income Tax Act, 58 of 1962 (the "Act") is an anti-avoidance provision aimed at preventing South African residents from excluding tainted forms of taxable income from the South African taxing jurisdiction through investment in Controlled Foreign Companies ("CFCs"). One of the main targets of the provision is diversionary foreign business income earned through suspect structures designed to avoid South African tax. However, CFCs are often used for legitimate business purposes and the changes to section 9D suggest that this has been recognized.
National Treasury has amended the CFC legislation numerous times over the past ten years in an attempt to close all perceived loopholes. Unfortunately, the amendments have led to overly complex legislative provisions with unintended consequences which impact on normal business transactions and create unwanted anomalies and uncertainties. The latest amendments, embodied in the Taxation Laws Amendment Act, 2011 (the "Amendment Act"), seek to remedy the position and are due to come into operation on 1 April 2012.
A CFC is any foreign company where more than 50 per cent of the total participation rights in that foreign company are directly or indirectly held, or more than 50 per cent of the voting rights in that foreign company are directly or indirectly exercisable, by one or more residents of South Africa. However, there are certain exceptions and exemptions to the definition.
The fundamental principle underlying the CFC attribution rules is that the net income of a CFC shall be included in the income of a South African resident in the proportion of such resident's participation rights to the total participation rights of the company. Net income is essentially determined as if the CFC is a South African taxpayer, and is determined at the end of the CFC's year of assessment.
However, certain exempt amounts must not be taken into account when calculating the net income of the CFC. The most widely used exemption is contained in section 9D(9)(b), which provides that amounts attributable to a foreign business establishment ("FBE") as defined are ignored for South African tax purposes.
Foreign Business Establishment Exemption
The current FBE exemption assumes that only the income relating to a substantive business can be "attributable to" a FBE. The amendment expands on this assumption by expressly providing that income will only be attributable to a FBE once arm's length transfer pricing principles are considered. Therefore, in order to attribute income to a FBE, the CFC must account for the functions performed, assets used and the various risks of the FBE. Mere legal agreements and similar pretenses will be insufficient to link income to an FBE.
In essence, taxpayers claiming the FBE exemption will be required to demonstrate that transfer pricing principles have been taken into account for every income stream connected to the FBE. This amendment is in line with modern transfer pricing and international tax principles, where multinational companies are expected to demonstrate that offshore companies are underscored by sufficient commercial substance.
From a policy perspective, the exemptions to the attribution rules are part of a framework that seeks to strike a fair balance between protecting the tax base and the need for South African multinationals to be internationally competitive.
It is notable that the existence of an FBE will not automatically protect all of the CFC's income from potential inclusion in the taxable income of the South African shareholder(s). Certain types of income are excluded from the exemption, specifically income sourced from so called "diversionary transactions".
Diversionary Transaction Rules
The diversionary transaction rules target tax avoidance, in that they deter South African taxpayers from entering into transactions which shift income which ought to be taxable in South Africa to a jurisdiction with a more beneficial taxing regime.
The Amendment Act has greatly simplified the rules governing diversionary income, which are currently very complex. The current provisions are very broad in their scope and unfortunately often catch transactions entered into on an arm's length basis which would not be considered problematic from a transfer pricing perspective.
Under current law, three sets of diversionary rules exist, relating to the import of goods, the export of goods and the import of services. In terms of the current rules, diversionary income is always viewed as tainted CFC income even if attributable to a FBE.
According to the Explanatory Memorandum to the Amendment Act, the overly mechanical nature of these diversionary rules has caused problems for both legitimate commercial activities and for the meaningful protection of the fiscus. This is due to the fact that non-tax motivated commercial activities often become trapped by the mechanical rules, while their overly rigid nature allow for tax avoidance in the case of more flexible non-tax motivated activities.
Under the new rules, the imported goods diversionary rules will only be triggered if three simplified conditions exist: firstly, the CFC must be disposing of goods directly or indirectly to a connected South African resident; secondly, the CFC must be located in a low tax jurisdiction, in that the sales income of a CFC must be subject to a foreign rate of tax that falls below 50 per cent of the South African company rate (i.e. 14 per cent) after taking tax credits into account; and thirdly, the sales income must not be attributable to the activities of a permanent establishment located in the CFC's country of residence. In other words, the CFC sale destined for South African import will be triggered if sales income is simply associated with various forms of "preparatory and auxiliary activities" or with activities outside the CFC's country of residence. It is clear that the amendments are aimed at ensuring that multinationals demonstrate genuine commercial reasons for importing through a CFC, otherwise there could be an imputation.
A potentially significant benefit to some South African multinationals is that the diversionary rules associated with South African exports to a CFC will be completely removed on the basis that transfer pricing principles will be used to manage these transactions. Additional protection is not required because the value-adding activities largely occur on-shore - all of which make the task of enforcing arm's length transfer pricing principles more manageable. This amendment is welcomed as transfer pricing will attack simulated transactions which take advantage of low tax jurisdictions without sufficient attention being given to the substance of the agreements. However, for multinationals such as mining companies who have established an offshore buying and selling company to be closer to international markets and for legitimate business reasons, this development will be welcomed.
The current diversionary rules associated with services imported from a CFC will be retained in their current form. Under these rules, CFC income relating to services rendered by a CFC to a South African connected party are taxable, unless the CFC meets a higher business activity test as measured by objective criterion.
While the amendments may not be sufficient to simplify the legislation which has evolved over the course of a decade, the changes will provide some relief to taxpayers, especially those who can evidence a genuine commercial reason for transacting with a CFC. The amendments will lead to a vast improvement for exporters, as the trading income of a foreign sales subsidiary will no longer be excluded from the FBE, as under current law.