Bronwin Richards | Tax Attorney | Tax Consulting SA | mail me |
Micaela Paschini | Tax Attorney | Tax Consulting SA | mail me |
To the relief of Coronation Investment Management SA (Coronation), the Constitutional Court has overturned the Supreme Court of Appeal’s (SCA) judgment in favour of the South African Revenue Service (SARS).
The long-awaited conclusion to this dispute will save one of South Africa’s top fund management companies a tax bill of almost R800 million.
Quick recap
The journey to the Constitutional Court was initiated when Coronation disputed an assessment raised by SARS, which imputed the net profits of its Irish subsidiary, Coronation Global Fund Managers (Ireland) Limited (CGFM), to Coronation.
The adverse finding was as a result of CGFM being considered a controlled foreign company (CFC) of Coronation. Effectively, as a CFC, CGFM’s profits would be included in Coronation’s taxable income.
Coronation’s dispute of SARS’ assessment was based on the contention that CGFM meets the foreign business establishment (FBE) exemption. This relief mechanism is specifically included in section 9D of the Income Tax Act (ITA), to exempt the income of a CFC where it can substantiate that the CFC amounts to an FBE as defined.
SARS maintains that CGFM does not meet the requirements of an FBE, and its income should thus be imputed to Coronation. While the Tax Court sided with Coronation, the SCA ruled in favour of SARS and determined that CGFM’s profits should be included in Coronation’s taxable income.
The SCA judgment considered the requirements which a taxpayer must fulfil in order to successfully rely on the FBE exemption. A core aspect of this enquiry was whether CGFM’s primary operations included investment management functions.
After hearing testimony from key representatives of the Coronation Group, the SCA held that that CGFM outsourced its investment management functions, and which formed part of its primary functions. The outsourcing of these primary functions meant that CGFM did not meet the “economic substance” requirements under section 9D of the act, and did not qualify as an FBE.
Constitutional Court’s analysis
In the unanimous judgment of Majiedt J, the Constitutional Court disagreed with SARS and the decision of the SCA.
The court considered the business of CGFM, and found that it consisted of fund management activities, and not of investment management activities. This means that the investment management activities which CGFM outsourced were not its primary functions.
The evidence before the court, including the licence conditions under which CGFM could operate, the prudential considerations, coupled with the fact that the evidence went uncontested, conclusively proved that CGFM’s core business did not extend to investment management.
In finding that the primary operations of CGFM were not outsourced, the court held that CGFM’s day-to-day operations in Ireland met the “economic substance” requirements of the FBE exemption. The net income of CGFM could therefore not be imputed to Coronation, and should accordingly not be included in its taxable income.
Lessons to learn
This groundbreaking ruling underscores the importance of a substantial business presence abroad to qualify for the FBE exemption and reminds us of the enormous tax consequences that may follow when this exemption is not correctly applied.
The clear disconnect between the judgments of the SCA and Constitutional Court, notwithstanding that the same evidence and tax principles were considered, reveals that there remains a large degree of varying interpretation of the law concerning the taxability of CFCs.
Taxpayers with offshore entities are cautioned to obtain robust tax advice, in light of the contradicting judgments handed down.
Related FAQs: Economic Substance Doctrine
Q: What is the economic substance doctrine in relation to income tax?
A: The economic substance doctrine is a principle in tax law that requires transactions to have a substantial economic effect beyond merely creating tax benefits. It aims to prevent taxpayers from obtaining tax benefits without a corresponding real economic rationale.
Q: How does the economic substance doctrine affect tax treatment of transactions?
A: Under the economic substance doctrine, if a transaction lacks economic purpose and is primarily aimed at achieving tax benefits, SARS can disallow tax benefits associated with that transaction. This means that taxpayers must demonstrate that their transactions have a genuine business purpose.
Q: What are the implications of the economic substance test for taxpayers?
A: The economic substance test requires that a taxpayer has a substantial non-tax purpose for entering into the transaction. If SARS determines that a transaction does not meet this test, it may disallow certain deductions or credits, affecting the taxpayer’s tax liability.
Q: Can you explain how the South African Revenue Services (SARS) applies the economic substance doctrine?
A: SARS applies the economic substance doctrine by examining whether a transaction has a substantial economic effect. This involves assessing both the expected net tax benefits and whether the taxpayer’s economic position is significantly improved by the transaction.
Q: What role does the common law doctrine play in the economic substance doctrine?
A: The economic substance doctrine is rooted in common law principles that require transactions to have a real economic basis. This means that the doctrine draws on established legal precedents to determine whether a taxpayer’s actions are legitimate from a business perspective.
Q: How can tax professionals assist clients in applying the economic substance doctrine?
A: Tax professionals can help clients structure transactions in a way that meets the economic substance doctrine requirements. They provide guidance on ensuring that transactions have a substantial purpose beyond tax benefits and advise on documenting the economic position effectively.
Q: What are the consequences of failing to meet the economic substance requirements?
A: If a taxpayer fails to meet the economic substance requirements, SARS may disallow tax benefits associated with the transaction, leading to potential underpayment of tax. This can result in additional tax liabilities, penalties and interest charges.
Q: Why is it important to consider the economic effect of transactions for tax purposes?
A: Considering the economic effect of transactions is crucial for tax purposes because it helps ensure compliance with tax law. Transactions that lack economic substance may attract scrutiny from SARS, leading to audits and adjustments that can negatively impact a taxpayer’s financial position.
Q: How does the economic substance doctrine relate to substantial economic effect?
A: The economic substance doctrine requires that transactions not only achieve tax benefits but also have a substantial economic effect. This means that the economic benefits derived from the transaction must be significant in relation to the expected net tax benefits that would be gained.
