South Africa’s tax legislation contains controlled foreign company (CFC) rules which aim to prevent South African taxpayers from locating companies in low tax jurisdictions in an effort to avoid paying South African tax.
The CFC attribution or imputation rules apply in certain circumstances where South African tax residents hold majority stakes (shareholding/participation or voting rights) in foreign companies (directly or indirectly).
Section 9D of the Income Tax Act 58 of 1962 (ITA) treats a foreign company as a CFC where more than 50% of the total participation rights or voting rights in that company are directly or indirectly held by South African tax residents.
If a foreign company qualifies as a CFC, the ‘net income’ of the company for its foreign tax year is imputed to the South African resident participants in proportion to their participation rights in that company (unless that South African resident holds, together with any connected person, in aggregate, less than 10% of the participation rights and may not exercise at least 10% of the voting rights in a CFC). The amount so imputed is then included in the South African resident’s income and taxed at his marginal income tax rate.
Review of 75% high tax exemption
Various exemptions from the CFC rules are available, including the so-called ‘high tax’ exemption. This exemption applies to CFCs operating in countries where the tax payable by the CFC is at least 75% of the tax that the CFC would have paid had it been a South African tax resident.
Two calculations need to be done for the CFC at the end of its tax year, one determining its foreign tax liability, and another notional tax calculation to determine its South African tax liability (had it been a South African tax resident).
The two computations are then compared, and if the foreign tax is equal to or greater than 75% of the notional South African tax calculated, the net income of the CFC will be deemed to be nil (and therefore the imputation to the South African resident will be nil).
Generally, where a CFC is located in a jurisdiction which has a tax rate of at least 21%, it is likely to qualify for the high tax exemption.
There has been a global trend towards lowering corporate tax rates. The Davis Tax Committee (DTC) acknowledged this, pointing out that, for example, the United Kingdom plans to reduce its corporate tax rate to 16% by 2020, the average rate of corporate tax in Europe for 2015 was 20.24% and the average rate for Asia was 21.91%. Accordingly, taking into account South Africa’s relatively high corporate tax rate of 28%, the 75% factor needs to be reduced, in order for the exemption to be effective.
Extension of CFC rules to include foreign trusts and foundations
If a foreign discretionary trust/foundation is interposed between South African tax residents and a foreign company, that foreign company will not typically constitute a CFC, even if the trust/foundation meets the CFC participation or voting rights threshold in the foreign company.
This is because the South African resident beneficiaries have no ‘participation rights’ in the foreign company of which the trust/foundation is a shareholder, but merely a spes or a hope (which might never be realised) that the trustees of the trust/foundation council will vest any income or capital that might be derived by the foreign company in them in the future. The South African resident beneficiaries also have no voting rights in such foreign company.
There is concern that trusts or foundations may be deliberately interposed in offshore structures in order to avoid CFC implications. Changes to the CFC rules were proposed in the 2017 draft bills which were aimed at bringing income derived by foreign companies directly or indirectly held by non-South African tax resident trusts or foundations with South African beneficiaries, into the South African tax net.
The proposed section 25BC provided that if any resident (other than a company) was a beneficiary of a non-resident trust or a foreign foundation, and that trust or foundation held a participation right in a foreign company which would have constituted a CFC had that trust or foundation been a resident, any amount received by or accrued to or in favour of that person from that trust or foundation, had to be included in that person’s income.
However, the proposed changes were likely to apply to many structures which were in no way abusive or tax driven. For example, the use of the words ‘any amount’ in section 25BC appeared punitive as this suggested that all amounts vested in a resident beneficiary of a qualifying trust/foundation, whether or not derived from the applicable underlying foreign company, would be taxable as income in that resident beneficiary’s hands.
The proposed changes also had the effect that such amounts would be taxable as income no matter how proportionately small any distribution to the resident beneficiary may be (relative to distributions to other beneficiaries) and even where the beneficiary may have no control of any kind over the foreign company.
As the proposed changes were extremely broad in scope and controversial, they were withdrawn in the final 2017 bills. Nevertheless, Annexure C in the Budget Review 2018 has indicated that these proposed changes would be reconsidered in the 2018 draft bills.