NATIONAL TREASURY'S DETAILED EXPLANATION TO SECTION 9D
Under the proposed residence (i.e., worldwide) taxing system, South African residents will be subject to tax on all their income earned domestically and abroad. One important question is how to address income earned by South African owned foreign subsidiaries (plus other South African owned foreign entities of a similar nature). If this latter form of income goes untaxed, South African residents can avoid tax simply by shifting their income to foreign entities, and the income earned by the foreign entity will be taxed only when repatriated as a dividend (current section 9E). This failure to impose immediate tax is known as "deferral." This delay in tax until repatriation is of great significant because taxpayers often delay repatriation for years or never repatriate funds at all.
Example. Facts. In 2000, South African Individual earns R100 of interest from foreign bonds. On January 1, 2001, South African Individual transfers the
bonds to a newly formed foreign subsidiary in exchange for all the subsidiary’s shares. The bonds generate another R100 of interest in 2001.
Result. South African Individual is fully taxed on the R100 of interest income under a worldwide taxing system. If the treatment of South African owned foreign subsidiaries is ignored, South Africa will not tax the interest on the bonds transferred in 2001, even though South African Individual continues to fully own these bonds indirectly through the foreign subsidiary. South African tax will apply only when the subsidiary distributes the bond interest as a dividend to South African Individual.
Section 9D is designed to prevent the avoidance of immediate South African tax by holding assets in foreign-owned entities. However, international law only allows South Africa to tax South African residents on their worldwide income and to tax foreign residents on their South African source income. International law does not permit South African tax to fall on foreign source income earned by foreign entities, even if those foreign entities are completely owned by South African residents.
In order to both remedy the avoidance and international law concerns just described, section 9D (like other regimes of this kind) tax South African owners on the income earned by their foreign entities as if those foreign entities immediately repatriated their foreign income when earned. For instance, returning to the example above, section 9D does not tax the foreign subsidiary on its R100 of earnings. Section 9D instead taxes South African Individual as if South African Individual received the R100 of interest in 2001 as a deemed dividend (i.e., the same year the interest is earned by the foreign subsidiary). No additional South African tax applies when the R100 of earnings are actually repatriated to South African Individual.
II. Structure of Section 9D
Section 9D falls into three analytical parts:
Before going into detail, section 9D can be summarised as follows. Section 9D mainly applies to foreign companies that are mostly owned by South African residents. South African residents owning 10 percent or more of the shares in these foreign companies must generally include a proportional ownership percentage of net income earned by that foreign company. Lastly, only limited forms of net income of a foreign company will create an inclusion for South African residents. These limited forms of foreign company income mainly involve income subject to low foreign tax that represent a potential threat to the South African tax base, while presenting few international competition concerns.
III. Foreign Entities Within Section 9D
Cite Location: Subsection 9D(1)(Definitions after "business establishment").
Section 9D applies only to a foreign entity that qualifies as a "controlled foreign entity" (a "CFE"). A "foreign entity" means any entity that fails to qualify as a South African resident under the South African Income Tax Act or a South African Income Tax Treaty. Foreign entities within section 9D mainly include foreign companies or foreign business organisations of a similar tax nature under foreign law. Foreign entities do not include foreign partnerships or similar flow-through regimes because all foreign partnership income is deemed to be immediately received by the partners (i.e., without deferral) in any event. Entities also do not include trusts, which are governed by section 25B and elsewhere.
In order for a foreign entity to qualify as "controlled," South African residents must additionally own, directly or indirectly, more than 50 percent of the entity’s participation rights (e.g., rights to share in profits and capital), voting rights, or control. South African residents typically have control if they own (whether acting individually or in concert) more than 50 percent of the voting shares or shares that represent more than 50 percent of the undistributed profits or capital. Options, warrants, and similar interests are disregarded from this analysis because these instruments do not represent a participation right until converted into shares.
Example (1). Facts (direct and indirect ownership). Foreign Company X has 400 common shares outstanding. South African Individual #1, South African Company, Foreign Company Y, and Foreign Individual each respectively own 100 shares in Foreign Company X. South African Individual #2 owns 40 percent of the shares in each of Foreign Company Y and South African Company.
Result. Foreign Company X qualifies as a CFE because Foreign Company X is more than 50 percent South African owned. South African Individual #1 and South African Company collectively own a 50 percent direct interest in Foreign Company X, and South African Individual #2 owns an additional indirect 10 percent in Foreign Company X (i.e., 40 percent of 25 percent through Foreign Company Y). The shares of Foreign Company X indirectly owned by South African Individual #2 through are ignored because the same South African owned shares cannot be counted twice.
Example (2). Facts (participation rights). Foreign Company X, a company with a R5 million value, has 500 common shares and 100 preferred shares. South African Company owns all the preferred shares, and foreign individuals own all the common shares. The preferred shares have no voting rights but provide the holder with the cumulative right to dividends equal to 20 percent of the profits and the preferred shares have a right to R2 million of value if Foreign Company X liquidates. The common shares hold all the voting rights and the rights to any remaining profits and liquidation proceeds. In 2000, Foreign Company X generates R400,000 but distributes no dividends.
Result. Foreign Company X does not qualify as a CFE. South African Company has no voting power within Foreign Company X. South African Company also does not have more than 50 percent of the rights to the underlying undistributed profits and capital of Foreign Company X (having a right to only R2,080,000 of the total R5 million value).
Cite Location: Subsections 9D(2)("proportional inclusion").
South African residents that own participation rights (e.g., shares) in a CFE are potentially subject to tax on the "net income" of that CFE as if that net income were immediately repatriated as earned. South African residents are deemed to receive CFE net income only to the extent of their proportional ownership in the CFE. However, no tax applies to South African residents who own less than a 10 percent amount (after taking into account connected persons). The 10 percent rule is a de minimis rule designed to eliminate tax on minority owners who have no practical say over the CFE’s affairs.
Example. Facts. Foreign Company has 100 shares outstanding. South African Company owns 45 shares, South African Individual owns 6 shares, and various foreign individuals own the remaining 49 shares. None of the parties are connected persons in relation to one another. Foreign Company earns R500,000 of net income.
Result. Foreign Company qualifies as a CFE because South African Company and South African Individual collectively own more than 50 percent of the participation rights (i.e.., 51 of the total 100 shares). South African Company must include its 45 percent proportional share of Foreign Company’s net income or R225,000 (45% of R500,000). South African Individual need not include any CFE income because South African Individual holds less than 10 percent of the participation rights (i.e., 6 of the total 100 shares). Had South African Individual and South African Company been connected persons to one another, South African Individual would have had to include R30,000 (6% of R500,000).
V. Forms of Foreign Entity Income Subject to Section 9D
A. General CFE Net Income and Loss
Cite Location: Subsections 9D(2A)(but not (c)).
As previously stated, South African residents are generally subject to tax on their proportional share of "net income" of a CFE (unless that South African resident holds a less than 10 percent interest). Most of the issues in section 9E revolve around what receipts and accruals (which include associated expenses) of a CFE qualify as "net income," thereby being subject to immediate taxation.
A CFE generally determines its net income as if that CFE were a South African resident. This determination admittedly requires the CFE to maintain two sets of tax books – one set for the home country and one set for South Africa. This is a necessary administrative price for CFE regimes around the world if CFE income is to be kept on par with domestic income. However, the definition of net income is subject to a myriad of exceptions described in the following segments.
Special rules apply if a CFE has net losses. While net income of a CFE is added to the income of a South African resident, South African residents cannot deduct net losses of a CFE. This anti-loss rule ensures that the move to a worldwide system of taxation does not result in a net revenue loss. This rule is consistent with the loss rules for foreign branches, which similarly cannot be used as an offset against South African source income. The net loss of one CFE also cannot be used as an offset against the net income of another. This second anti-loss rule exists because South Africa normally does not have grouping rules for corporate groups and because such grouping rules can become very complex.
However, if a CFE has net losses in a given year, these net losses are not simply eliminated. A CFE with net losses instead carries forward any excess losses, which can then be used to reduce future CFE net income.
Example. Facts. South African Company owns all the shares of CFE X and CFE Y. South African Company earns R500,000 of South African source income. CFE X generates R100,000 of receipts and R140,000 of associated expenses that are part of the CFE X net income calculation. CFE Y generates R200,000 of receipts and R90,000 of associated expenses that are part of the CFE net income calculation.
Result. CFE X has a net loss of R40,000, and CFE Y has net income of R110,000. CFE X cannot use the net loss of R40,000 against the R500,000 of South African source income. South African Company also cannot use the net loss of R40,000 from CFE X to offset the R110,000 of net income earned by CFE Y. The R40,000 of net loss of CFE X can only be carried forward to offset future net income of CFE X.
B. Exemptions
1. General Background
Cite Location: Section 9D(9) and (11).
The amount of income and loss included as net income of a CFE is subject to the following five exemptions:
Of these five exemptions, the Business Establishment Exemption is the most contentious. This exemption allows net income of a CFE to be exempt from section 9D unless that income qualifies as Mobile Foreign Passive Income, Mobile Foreign Business Income, or Diversionary Foreign Business Income.
2. Exemption #1 – The Designated Country Exemption
Cite Location: Section 9D(9)(a).
The designated country exemption generally eliminates CFE receipts and accruals that are subject to foreign income taxes if those taxes are comparable in amount to that imposed by South Africa. The reason for this exemption relates to the foreign tax credit.
As previously stated, international law allows South Africa to tax its residents on their worldwide income, including foreign source income earned indirectly through controlled foreign entities. However, whenever South Africa taxes its residents on foreign source income, international law requires that the South African tax be reduced for foreign income taxes imposed on that same income. In other words, international law requires a country that taxes foreign source income to yield its tax to the country imposing tax on a source basis. South Africa, like other countries taxing foreign source income, yields its tax on foreign source income in favour of the source country through foreign tax credits (see section 6quat).
The net effect of the foreign tax credit system is that South Africa can only tax foreign source income to the extent the South African tax rate exceeds the rate imposed by the foreign country in which the foreign income arises. Therefore, if the foreign tax rate is roughly equal to or higher than the South African tax rate, little or no South African tax will result. The Designated Country Exemption simply eliminates this comparably taxed income from the CFE rules for administrative reasons. Little reason exists for SARS and taxpayers to analyse income that generally results in little or no South African tax. Second, taxpayers can often manipulate the foreign tax credit system when they have high-taxed foreign source income because that high-taxed foreign source income can be balanced against the low-taxed foreign source income (known as "cross-crediting"). In this latter instance, the Designated Country Exemption essentially eliminates cross-crediting by eliminating high-taxed foreign source income from the foreign tax credit system.
In mechanical terms, the Designated Country Exemption eliminates net income when that income is generally subject to a statutory rate of 27 per cent or more in a "designated country" after taking into account any applicable tax treaties. The 27 per cent rate closely approximates the normal 30 per cent South African tax rate on corporations (and the delayed secondary tax on dividends). A country will qualify as a designated country if that country imposes a statutory rate of 27 per cent or more and that country calculates income on substantially the same basis as income is calculated in South Africa. The Minister publishes the designated country list. Under prior law, the list was limited to treaty countries. The proposed legislation allows any country that satisfies the above criteria to fall within the designated country list.
Example (1). Facts. South African Company owns all the shares of CFE, a Country X corporation. CFE generates R1 million of income from Country X sources. Country X generally imposes a 28 per cent tax on corporate income and calculates income in substantially the same way as income is calculated in South Africa. CFE is subject to the general 28 per cent rate.
Result. The Designated Country Exemption applies because Foreign Subsidiary is subject to tax at a statutory rate of 27 per cent or more in a Designated Country. Note: If this exemption did not exist, South African could impose a full 30 percent tax on the CFE income as it is earned less the 28 per cent tax credits for a total of 2 percent or R20,000 (R300,000 South African tax on R1 million of income less the R280,000 of Country X tax).
Example (2). Facts. South African Company owns all the shares of CFE, a Country X corporation. CFE generates R500,000 in royalties from unconnected persons located in Country Y. Country X generally imposes a 10 per cent tax on corporate income earned by its residents. Country Y generally imposes a 30 per cent rate of tax on Country Y source income and calculates income in substantially the same way as income is calculated in South Africa. CFE’s royalties would normally be subject to a Country Y 30 per cent rate of tax, but a Country X-Country Y tax treaty eliminates the Country Y tax.
Result. The Designated Country Exemption does not apply. After taking the Country X-Country Y tax treaty into account, CFE’s royalties are subject to only a 10 percent foreign rate of tax.
3. Exemption #2 – The Business Establishment Exemption
Cite Location: Section 9D(9)(b) and (1)("business establishment).
a. General Background
CFEs may alternatively be eligible for an exemption if that income stems from certain activities. The purpose of this exemption is to balance the desire for horizontal equity (equity among South African residents earning income at home versus those earning income abroad) against international competitiveness (allowing South African owned foreign subsidiaries to operate on the same level tax field as foreign owned rivals operating in the same low-taxed foreign country).
The exemption essentially allows CFEs to operate free from tax to the extent an objective rationale exists for maintaining operations abroad and such operations pose no threat to the South African tax base. The proposed legislation accounts for these concerns by exempting all CFE income unless that income qualifies as:
Mobile Foreign Passive income involves income from passive assets, such as dividends and interest from portfolio stocks and bonds. These items do not involve any direct international competitiveness concerns because no business is directly involved. Moreover, without this rule, the mobile nature of the income would mean that South African residents could avoid the ambit of worldwide taxation merely by shifting mobile passive assets to a foreign subsidiary.
Mobile Foreign Business Income involves income from paper shell businesses that attract taxable income without economic substance. Shell businesses include companies whose sole economic activity is maintaining a post office address or a website. The fungible nature of these businesses again means that no real non-tax rational exists for keeping this income offshore versus generating the income at home.
Diversionary Foreign Business Income involves income that a CFE generates from certain sales and services transactions conducted with related South African residents. This aspect of the test acts as a proxy for current transfer pricing under section 31. Diversionary Foreign Business Income arises when a CFE engages in transactions with a related South African resident that most likely lead to transfer pricing abuse. Diversionary Foreign Business Income also targets situations that call into question whether a transaction so closely linked with South Africa should be located abroad.
Restated in technical terms as drafted in the proposed legislation, the Business Establishment Exemption applies only if:
b. CFE Income Attributable to a Business Establishment
Cite Location: Section 9D(9)(b)(top flush) and (1)("business establishment").
As just described, in order for CFE income to be exempt, the income must first be attributable to a "business establishment" (Non-mobile Foreign Business Income). A business establishment essentially involves a business that has some permanence, some substance, and a non-tax business reason for operating abroad rather than at home. These three tests effectively exclude paper businesses that would otherwise be located in South Africa but for the tax savings (much like passive assets). The paper-like nature of these businesses also suggest that no real business is at stake that would undermine international competitiveness.
In order to qualify as a business establishment, the CFE must first operate its business through one of a variety of fixed locations that suggest some permanence (i.e., that the business is somewhat immobile). For example, ownership of a building or a mine suggests permanence. The use of an office or other similar structure for a period of not less than 1 year similarly suggests some permanence. The fixed location requirement ensures that the business involved is not a mere mailing address, website, or a single business project that is readily mobile.
The place of business must additionally have some substance. In order to demonstrate this substance element, the business must be suitably equipped with on-site operational managers and employees, equipment and other facilities, to conduct the primary (e.g., core daily) operations of the business. The substance element ensures that the business is more than just a paper transaction or a disguised form of passive income (such as a lease masquerading as a contract service arrangement).
Lastly, the business must have a bona fide non-tax business reason for operating abroad rather than at home. Similar to the tax avoidance rule of section 103, a bona fide business reason exists only when that reason bears some significance to the tax advantage of operating abroad. While the proposed legislation does not attempt to hinder otherwise legitimate businesses that operate abroad, the proposed legislation recognises that South Africa should not actively encourage business to go abroad versus continuing at home. The movement of businesses abroad mainly for tax reasons essentially deprives the South African economy of jobs and creates an unnecessary erosion of the tax base.
Example (1). Facts (suitably equipped nature). South African Company owns all the shares of CFE #1, a Country X corporation. CFE #1 leases a building in Country X for a 5-year period. CFE #1 makes pills purchased from ingredients made by CFE #2, a Country Y corporation that is also wholly owned by South African Company. CFE #1 owns all the machinery and employs 35 on-site fulltime and part-time employees, all of which are used to make the pills. CFE #1 relies on outside independent contractors for security, cleaning, garbage disposal, and other incidental functions. CFE #1 also employs 2 full-time managers to oversee the production process and local record keeping. Foreign Subsidiary sells its pills to various connected CFEs indirectly owned by South African Company.
Result. Setting aside the issue of whether a bona fide nontax reason exists for operating in Country X as opposed to South Africa, the bottling and packaging operations satisfy the business establishment standard. The building is under a 5-year lease, the on-Cite managers and employees are overseeing and conducting the primary operations of the business. The work performed by the independent contractors is only incidental.
Example (2). Facts (suitably equipped nature). South African Company owns all the shares of CFE, a Tax Haven corporation. CFE owns a 100 unit apartment building located in Country X. CFE hires an independent contractor to run all the daily operations of the apartment building, paying the independent contractor a flat annual fee. CFE has two office employees located in a Country X office. The Country X office has been leased for many years; the office employees occasionally visit the apartment building; and all the apartment accounting functions are handled at the Country X office.
Result. Even assuming this arrangement does not amount to a passive lease, CFE does not have a business establishment. CFE does not have a place of business which is suitably equipped to run the primary daily operations of the business, all of which are conducted by an independent contractor.
Example (3). Facts (bona fide business purpose). South African Company owns all the shares of multiple foreign subsidiaries, including CFE. CFE is a resident of a Mediteranean Island with a 10 percent statutory tax rate. CFE leases a large warehouse within its country of residence under an annual leasing contract. CFE operates as a central delivery point for products delivered to customers located in Southern Europe and the Middle East. CFE employs 2 managers and 5 employees that handle all storage and shipment contracts. CFE hires independent contractors for trucking and airline transportation. The Mediteranean Island location was chosen partly due to its convenient delivery location and partly due to its low tax rate.
Result. The warehouse operations qualify as a business establishment. Even though the choice of location provides tax savings over the South African rate, the location has a bona fide non-tax business purpose because the location offers significant shipment cost advantages over locating the business in South Africa.
Example (4). Facts (bona fide business purpose). South African Company owns all the shares of a CFE, a Tax Haven corporation. CFE engages in an electronic sales distribution business within a Tax Haven. Foreign Subsidiary leases a Tax Haven office under a 2 year contract. The office has 1 local manager and 3 local employees. The sales distribution business purchases products from various unrelated South African businesses for resale in Europe. CFE never has physical delivery to the goods. CFE simply places the order with the South African suppliers being responsible for delivery. The employees receive a total of R200,000. Had the employees been employed in South Africa, the employees may have cost R240,000. Had the electronic sales business been located within South Africa, CFE would have had to pay R5 million in additional tax.
Result. South African Company does not have a business establishment. The place of location is not for a bona fide non-tax business purpose. The employee cost savings of R40,000 is insignificant when compared to the total South African additional R5 million tax that would have applied.
c. Sales and Services with a Connected South African Resident
General Background
Cite Location: Section 9D(9)(b)(i) and (ii).
CFEs with income attributable to a business establishment receive the benefit of the business establishment exemption only if that income does not result from certain sales or services with a related South African person (i.e., does not result from Foreign Business Diversionary Income). The purpose of this rule is to ensure that CFE activities are not being employed to shift taxable income offshore through artificial transfer pricing. Although transfer pricing rules currently exist under section 31 of the Income Tax Act, these rules are difficult to enforce. The anti-diversionary rule essentially acts as a backstop to section 31.
The anti-diversionary rule attacks the problem of transfer pricing between CFEs and related South African residents in two ways. First, the anti-diversionary rule increases the penalty for artificial transfer pricing. Second, the anti-diversionary rule creates a higher business activity standard.
Increased Penalty
Cite Location: Section 9D(9)(b)(i).
Under the first prong, if a CFE engages in a sales or services transaction with a connected South African resident, transfer pricing between the CFE and the South African resident that is inconsistent with section 31 creates deemed income under section 9D. This deemed income under section 9D exists for all the CFE income involved, not just the disparity in price. Under current law, section 31 allows only for a reallocation of the price back to an arm’s length standard.
Example. Facts. South African Company owns all the shares of a CFE, a Country X corporation with a 20 percent tax rate. South African Company assembles televisions for R600 each and sells those televisions to CFE for R700 each. CFE has a business establishment that customises the televisions for customers within the Country X market at a cost of R80 each, reselling the televisions for R1,500 each. The arm’s length price between South African Company and CFE under section 31 amounts to R1,000.
Result. All the profits of CFE are taxed immediately under section 9D. The Commissioner additionally has the discretion under section 31 to reallocate the sales price for either or both South African Company and/or CFE.
Higher Business Activity Standard
Cite Location: Section 9D(9)(b)(ii).
Under the second prong, if a CFE engages in sales or services with a connected South African resident, the sales or services again create deemed income under section 9D without regard to section 31. The purpose of this rule is to target structures that most likely contain artificial pricing. This second prong achieves this goal by subjecting all CFE sales and services with a connected South African resident to section 9D unless the CFE’s conduct falls within a higher business activity standard than that prescribed by the business establishment rule. This higher business activity standard serves as a proxy method for preventing artificial pricing because revenue auditors typically have more expertise at identifying categories of transactions than calculating an arm’s length price, the latter of which often requires a significant economics background. This higher business activity standard is typically found in CFE legislation throughout the world.
The higher business activity standard is also aimed at another concern. Sales ad services transactions with connected South African residents are so closely linked with South Africa that these transactions call into question the reason why these operations are being conducted offshore. While the business establishment test already takes into account this concern, the business establishment threshold is fairly light. The higher business activity threshold ensures that the business offshore must have substantial substance so that South African businesses are not induced offshore for tax reasons to the competitive disadvantage of their brethren operating wholly within South Africa.
The higher business activity standard is divided into three sets of transactions: (i) CFE inbound sales, (ii) CFE outbound sales, and (iii) CFE South African connected services. CFE inbound sales exist when a CFE sells goods to a connected South African resident. CFE outbound sales exist when a South African resident sells goods to a connected CFE. CFE South African connected services exist when a CFE provides services for a connected South African resident. Each set does not receive the benefit of the business establishment exemption unless that structure contains objective criteria that demonstrate the CFE has a non-tax economic nexus within its country of residence (i.e., where it is subject to foreign tax) and/or that the transaction is most likely not subject to transfer pricing abuse.
Set A: CFE Inbound Sales of Goods: The CFE sale of goods to a connected South African Resident fails to qualify for the higher business activity standard unless the sale falls into one of three categories. Cite Location: Section 9D(9)(b)(ii)(aa).
Local Purchases - The first category applies when a CFE purchases goods that are physically located within the same country in which the CFE is a resident (i.e., is subject to foreign tax). The physical location of the goods purchased establishes that the CFE has an economic nexus to the country of residence, and the country of residence most likely has a high infrastructure used to produce the goods. Such countries with a high infrastructure typically do not tax their local sales at artificially low tax haven rates. These factors indicate that the CFE is most likely purchasing and reselling the goods at a convenient location for non-tax business reasons, and that the CFE is not over-inflating the price on resale to a connected South African resident. Cite Location: Section 9D(9)(b)(ii)(aa)(A).
Local Production - The second category applies when a CFE engages in foreign production activities that amount to more than minor assembly or adjustment, packaging, repackaging, and labelling. Significant production activities of this kind again typically occur within countries that have a high infrastructure (i.e., those which do generally not tax local production at artificially low tax haven rates). Significant foreign production activities also indicate that the foreign location was chosen mainly for non-tax reasons. Whether foreign production activities are significant is a facts and circumstances test. This test takes into account a variety of factors, such as how the CFE’s physical production costs (e.g., labour, physical overhead, leasing, and machinery repair) compares to the CFE’s total cost of goods sold or how special skills exist within the local foreign labour market. Cite Location: Section 9D(9)(b)(ii)(aa)(B).
Comparable sales – The third category applies when a CFE sells a significant number of goods of the same or a similar nature to unconnected parties and the price sold to the connected South African resident is comparable (after taking into account the level of the market, volume discounts, and costs of delivery). Little transfer pricing is likely to occur in this circumstance because independent outside pricing is fully available. Under these circumstances, section 31 is fairly easy to enforce for most revenue auditors, meaning that the higher business activity standard is unnecessary. In addition, the sales to unconnected parties by the CFE demonstrates that the CFE has a viable business purpose for operating independently of any connected South African resident. Cite Location: Section 9D(9)(b)(ii)(aa)(C).
Example (1). Facts. South African Company owns all the shares of CFE, a Country X resident. CFE does not engage in any production activities, but maintains a purchasing office and a warehouse within Country X that qualifies as a business establishment. CFE purchases 75 desks from an unrelated Distributor, another Country X resident. CFE resells 25 desks to various retailers located within Country Z and 50 desks to South African Company. All contract negotiations and signatures between CFE and Distributor occur within Country X. Upon completion of all contract agreements, Distributor orders the desks from its Country Y Parent, which Country Y Parent ships directly to South Africa Company and the Country Z retailers. CFE sells the desks to South African Company for R450 each and the desks to the various retailers for R500 each (the difference in price reflects the volume discount for the sales to South African Company).
Result. The CFE sales to South African Company satisfy the higher business activity standard. Admittedly, CFE does not engage in any local purchases (since none of the goods purchased were ever located within Country X) nor any production activities. However, CFE is selling the desks to a significant number of unconnected persons at comparable prices.
Example (2). Facts. South African Company owns all the shares of CFE, a Country X resident. CFE assembles machinery in a 100-person factory located within Country X, which CFE then resells to South African Company. CFE purchases the machinery parts from various parties outside Country X at a cost of R800 per unit. Each machine has 250 parts to assemble. The physical factory overhead, equipment, and labour cost to produce the machinery amounts to R200 per machine. The management, accounting, and administrative fees amount to R70 per machine. CFE sells each machine to South African Company for R1,600.
Result. The machinery sales satisfy the higher business activity standard. The factory conducts more than minor assembly or adjustment. The 250 part assembly is significant and so are the physical production costs which amount to 20 percent of the total (R200/R1,000).
Set B: CFE Outbound Sales of Goods: If a CFE sells goods that were initially purchased from connected South African residents (or goods that represent the resultant product of intermediary inputs (e.g., materials, parts, or ingredients) purchased from a related South African resident), the CFE sale fails the higher business activity standard unless the sale falls into one of three categories. Cite Location: Section 9D(9)(b)(ii)(bb).
Insignificant South African Purchases – The first category applies when the CFE purchases only an insignificant amount of goods or intermediary inputs from connected South African residents. Transfer pricing manipulation usually occurs when the item sold by a South African resident is roughly the same as the item resold by the CFE. A CFE that purchases only an insignificant amount of intermediary goods from related South African residents is probably structured offshore for mostly non-tax business reasons. Cite Location: Section 9D(9)(b)(ii)(bb)(A).
Local Production - The second category applies when a CFE engages in foreign production activities that amount to more than minor assembly or adjustment, packaging, repackaging, and labelling. This second category has the same rational and application as the local production rule for CFE inbound sales. Cite Location: Section 9D(9)(b)(ii)(bb)(B).
Local Sales – The third category applies when a CFE delivers the goods within the CFE’s country of residence. Customers for purchased goods are typically located in countries with significant infrastructure (and attendant high taxes). In addition, the CFE’s country of residence (i.e., where it is subject to foreign tax) has an economic nexus to the consumer market at issue. This category does not apply to foreign sales subsidiaries that sell products outside their country of residence since tax haven sales subsidiaries typically sell their products to consumers located outside their tax haven country of residence. Cite Location: Section 9D(9)(b)(ii)(bb)(C).
Example. Facts. South African Company owns all the shares of CFE #1 and CFE #2. CFE #1 is a Country X corporation, and CFE #2 is a Country Y corporation. CFE #1 assembles radios from its 20-person workshop located in Country X, which CFE #1 sells and delivers to CFE #2 in Country Y. CFE #1 purchases the internal mechanics from South African Company for R120 per unit and the coverings from unrelated parties at a cost of R30 per unit. In the hands of CFE #1, the radios require a 6-part assembly process for completion that requires little skill. The factory overhead, equipment, and labour cost incurred by CFE #1 to produce the radios amounts to R10 per machine.
Result. The CFE #1 sales do not satisfy the higher business activity standard. CFE #1 is purchasing a significant amount of the parts from a connected South African resident (R120 out of R150), and no delivery occurs within the Country X market. CFE #1 is also engaging in only minor assembly. The assembly process requires little skill and amounts to only 6.67 per cent of the total cost (R10/R150).
Set C: CFE Services for Connected South African Residents: CFE services performed for a related South African resident generally fail the higher business activity standard. The only CFE services of this kind that may qualify are those performed outside South Africa to the extent they directly relate to certain goods sold in terms of production or sales (as described below). CFE services of a more generalised nature, such as management fees, internal accounting fees, and fees to guarantee loans never satisfy the higher business activity standard. These more generalised fees typically bear the mark of transfer pricing (due to their mobile nature). Little non-tax business reason also exists for foreign subsidiaries to be servicing their South African parent companies in this manner. Cite Location: Section 9D(9)(b)(ii)(cc).
Example. Facts. South African Company owns all the shares of Country X CFE, among other CFEs. Country X CFE acts as a finance subsidiary for the group. In its capacity as a finance subsidiary, Country X CFE guarantees certain loans made by South African Company in order for South African Company to expand local factory operations. Country X CFE charges South African Company R1 million for this guarantee.
Result. The R1 million of guarantee fees charged by Country X CFE do not satisfy the higher business activity threshold. The guarantee fee does not directly relate to the goods in terms of production or sales.
Production Related Services – CFE services performed outside South Africa potentially satisfy the higher business activity standard if: (i) they directly relate to the creation, extraction, production, assembly, repair, or improvement of goods, and (ii) the goods are utilised outside South Africa. Such services do not represent a significant means for transfer pricing because the services have no relation to South Africa. Services relating to goods delivered within South African fall outside this category because little business reasons exists for shipping products offshore for foreign servicing followed by a repatriation of those products back to South Africa. Cite Location: Section 9D(9)(b)(ii)(cc)(A).
Selling Related Services – CFE services performed outside South Africa may alternatively satisfy the higher business activity standard if: (i) they relate to the sale and marketing of goods produced by a connected South African resident, and (ii) the goods are sold to unconnected persons for delivery within the CFE’s country of residence. This rule is the service analogue to local sales rule for CFE outbound sales. Again, the CFE’s country of residence (i.e., where the CFE is subject to tax) has an economic nexus to the consumer market at issue. Tax haven commission sales subsidiaries typically sell goods to consumers located outside the tax haven country of residence (because tax haven countries often lack meaningful consumer markets). Cite Location: Section 9D(9)(b)(ii)(cc)(B).
Example. Facts. South African Company owns all the shares of CFE, a Country X corporation. South African Company sells refrigerators to various customers located in various foreign countries, including Country X. CFE provides services for installation and a 90-day warranty with respect to the refrigerators. CFE also markets and sells the refrigerators on South African Company’s behalf. South African pays R1 million to CFE for the installation and repairs, and R5 million for sales commissions and marketing fees.
Result. CFE satisfies the higher business activity standard for the R1 million of installation and repair fees because all of these fees relate to refrigerators utilised outside South Africa. However, the R5 million of commission sales and marketing fees cannot satisfy the higher business activity standard to the extent they relate to goods delivered outside Country X (CFE’s country of residence).
Ministerial Unified Market Waiver
Cite Location: Section 9D(10)(a).
Because non-tax business reasons may exist for a CFE to operate within multiple countries, the Minister may treat multiple foreign countries as one (for purposes of sections 9D(9)(b)(ii)(aa)(A), (bb)(C), and (cc)(B)) when those foreign countries reflect a single economic market and this unified treatment will not lead to an unacceptable erosion of the tax base. For instance, the Minister may treat one or more countries within the European Union as one country to the extent these countries impose a rate of income tax that is comparable to one another. Such treatment would mean, among others, that a CFE that resides in the European Union could satisfy the higher business activity threshold when acting as a sales distributor on behalf of connected South African goods for customers located within multiple European Union countries.
General Ministerial Waiver
Cite Location: Section 9D(10)(b).
Section 9D also contains a general Ministerial waiver from categorisation as a diversionary transaction under section 9D(b)(ii). The Minister (in consultation with the Commissioner) can exercise this waiver when diversionary categorisation "will unreasonably prejudice national economic policies or South African international trade and such exemption will not lead to an unacceptable erosion of the tax base." The purpose of this waiver is to ensure that certain offshore businesses are not unfairly affected by this rule and to ensure that section 9D can operate consistently with the proposed tax sparing provisions contained in section 9E.
d. CFE Income of a Passive Nature
Cite Location: Section 9D(9)(b)(iii).
General Background
Besides satisfying the diversionary rules, CFE income attributable to a business establishment can qualify for the exemption only if that income is not of a passive nature. Income of a passive nature includes dividends, interests, royalties, rents, annuities, insurance premiums, and similar income of a passive nature. Consistent with international practice, passive income is fully subject to tax because no direct competitiveness concerns are at stake where no active business is involved. The assets giving rise to passive income, such as portfolio stocks and bonds are also readily mobile, meaning that these assets can easily be shifted abroad without economic consequence (e.g., to wholly owned CFEs) whenever a foreign preference exists.
No working capital exception exists for this class of income. A CFE cannot claim that passive income is eligible for the business establishment exemption because that income acts as working capital or will be used for a future CFE business activity. Any exception of this kind would make targeting passive income meaningless because a CFE could always contend that the passive income at stake will ultimately be used for this or that business undertaking.
However, certain exceptions do exist for passive income. CFE passive income otherwise subject to section 9D can avoid taxation if the CFE passive income:
The first two exceptions are discussed below. The latter two exceptions are discussed in segments V.B.5 and 6, both of which provide some leeway for CFE holding companies.
The De Minimis Exception
Cite Location: Section 9D(9)(b)(iii)(aa).
Passive income is subject to a de minimis rule for administrative convenience. This rule prevents section 9D from applying when a CFE earns trivial amounts of income from passive investments. This de minimis rule applies only if the passive income does not exceed 5 per cent of the CFE’s total (i.e., gross) receipts and accruals. This rule is an "all-or-nothing" rule. The passive income either falls within or outside the 5 per cent threshold. If passive income exceeds the 5 percent level, all the passive income (not just the amounts exceeding 5 percent) are subject to section 9D.
Example (1). Facts. South African Company owns all the shares of CFE. CFE earns R20 million gross and incurs R13 million in expense with respect to its business establishment, including dividends of R800,000 from various foreign portfolio share investments.
Result. Although the dividends are normally subject to section 9D despite their connection to a business establishment, section 9D does not apply because the dividends are de minimis. These dividends of R800,000 amount to less than 5 percent of the total gross (R800,000/R20 million).
Example (2). Facts. The facts are the same as Example (1), except that CFE instead earns only R15 million total gross.
Result. None of the dividends qualify for the de minimis exception because the R800,000 exceeds 5 per cent of the total (R800,000/R15 million).
The Banking, Financial Services, Insurance, and Rental Business Exception
Cite Location: Section 9D(9)(b)(iii)(bb).
Passive income may alternatively be exempt from section 9D under the business establishment rule if that passive income directly arises from the activities of a bank, financial services, insurance, or rental business. While passive income is normally incidental to a business, passive income of this kind represents core activities of the businesses just described (thereby re-raising international competitiveness concerns).
However, this rule is limited to income from the principal trading activities of the bank, financial services, insurance, or rental business involved. The purpose of this principal trading activity requirement is to ensure that a CFE is not merely a holding company with a better label designed to avoid section 9D. CFEs also cannot shelter portfolio passive investments under this rule to the extent the passive income stems from portfolio investments unrelated to the principal trading activity of the business.
Example (1). Facts. South African Company owns all the shares of CFE, a Country X corporation. CFE is licensed to perform as a Country X bank. CFE earns R3 million in interest from making commercial and private loans, R2 million in interest from credit card charges and services, and R500,000 from issuing letters of credit and providing guarantees.
Result. Assuming the bank qualifies as a business establishment, CFE qualifies as a bank for purposes of the exception. All the income is exempt under section 9D because the income arises from the principal trading activity of the bank business.
Example (2). Facts. South African Company owns all the shares of CFE, a Country X corporation. CFE earns R2.6 million of rents from an apartment complex and R400,000 in interest from deposits in a local bank.
Result. Assuming the bank qualifies as a business establishment, CFE qualifies as a rental business for purposes of the exception. However, only the R2.6 million of rents are exempt; the remaining R400,000 are not derived from the principal trading activity of the rental business.
Example (3). Facts. South African Company owns multiple CFEs, including CFE X. CFE X, a finance subsidiary, is a tax haven company that borrows money from unrelated banks and lends that money to related CFEs. CFE X also generates dividends and interest from small holdings in publicly traded foreign stocks and bonds.
Result. The dividends and interest from the publicly traded foreign stocks and bonds do not fall outside passive income subject to section 9D. The dividends and interest do not represent the principal trading activity of CFE, whose main function relates to the lending of funds to related CFEs.
The banking, financial services, insurance, and rental business exception is subject to an anti-avoidance rule. Under this rule, income derived from these businesses are not eligible for the exception if the income is derived either: (i) from a connected South African resident, or (ii) from any other South African resident to the extent the income stems from a transaction that is effected as part of a scheme to avoid any South African tax. Cite Location: Section 9D(9)(b)(iii)(aa) thru (bb).
Example. Facts. South African Company owns all the shares of CFE, a corporation located in a tax haven. South African Company is a bank with many South African commercial customers. South African Bank normally charges a 15 percent interest rate to its commercial customers. However, South African Bank has entered into an arrangement with a group of unconnected South African companies, whereby the charge will amount to a 10 percent rate if the unconnected group undertakes the loans with CFE. CFE qualifies as a business establishment and is licensed to operate as a bank.
Result. Even though CFE derives its interest from a bank, the interest is not eligible for the banking exception. The transaction is effected as part of scheme to avoid South African tax. CFE is able to offer the reduced 10 percent interest rate only because of the CFE’s tax haven location. Without the tax haven rate, the unconnected group would have borrowed directly from South African Company.
4. Exemption #3 – The Already Included Exemption
Cite Location: Section 9D(9)(e).
A third exemption from section 9D applies to CFE net income that is already included as taxable income. This category of net income mainly includes South African sourced income subject to direct South African tax in the hands of a CFE. No reason exists to tax this income under section 9D because this income is already accounted for.
In a similar vein, CFE income whose tax is eliminated or reduced by virtue of a tax treaty does not receive the exemption; otherwise South African companies could reduce their tax burden by transferring assets to foreign subsidiaries within the South African tax treaty network. However, it should be noted that this exemption fully applies to CFEs that receive tax-free dividends from South African Companies. Section 9D does not apply to these dividends (i.e., are not part of the net income calculation) because South African residents are not subject to tax on this item in any event.
Example (1). Facts. South African Company owns all the shares of CFE, a Country X corporation. CFE generates R5 million of business income within South Africa from unconnected persons. CFE is fully subject to tax on the R5 million.
Result. Section 9D does not apply to the business income because CFE is directly taxed on the income.
Example (2). Facts. South African Company owns all the shares of CFE, a Country X corporation. CFE generates R600,000 in dividends from shares in South African companies and R200,000 in interest from bonds issued by South African companies. CFE is not subject to tax on the dividends by virtue of the South African Tax Act or on the interest by virtue of a tax treaty.
Result. Section 9D does not apply to the dividends, even though that income is exempt, because South African dividends are exempt from tax for both South African and foreign residents generally. However, section 9D does apply to the interest left untaxed by virtue of a tax treaty because that interest would have been fully taxable had that interest been earned by a South African resident.
5. Exemption #4 – The Related CFE Dividend Exemption
Cite Location: Section 9D(9)(f).
Although the proposed legislation does not specifically contain any special rules for holding companies per se, the proposed legislation exempts dividends (and other forms of income described in the next exemption), which effectively allow a CFE to act as a holding company for income already previously earned within the same international group. Under this exemption, a CFE can receive dividends from another connected CFE without being subject to section 9D, even though the dividend is passive in nature. These dividends are exempt because the underlying earnings giving rise to these dividends are generally either earnings from a CFE business establishment or are already included (i.e., taxed) directly.
Example. Facts. South African Company owns all the shares of CFE #1, a Country X corporation. CFE #1 owns all the shares of CFE #2, a Country Y corporation. CFE #2 generates R2 million of receipts and accruals from a business establishment. None of this R2 million amount stems from a transaction with South African Company, but R200,000 of this amount stems from dividends out of small portfolio interests held in various publicly traded shares. CFE #2 distributes a dividend of R2 million to CFE #1 from these receipts and accruals
Result. At the CFE #2 level, the R200,000 dividends from the publicly traded shares are fully subject to section 9D (and the other business establishment income is exempt). At the CFE #1 level, the R2 million dividend is exempt by virtue of the Related CFE Dividend Exemption because both CFEs are connected to each other (representing an internal movement of business establishment or already taxed earnings).
6. Exemption #5 – The Related CFE Interest, Royalties, and Rents Exemption
Cite Location: Section 9D(9)(fA).
The proposed legislation contains a second form of holding company exemption for related CFE interest, royalties, and rents. Under this exemption, a CFE can receive interest, royalties, and rents from another connected CFE without being subject to section 9D, even though these items are passive in nature. These items are again exempt because the underlying earnings generally stem from a qualifying business establishment or are already included (i.e., taxed) directly.
However, the CFE paying the interest, royalties, and rents will not receive any deduction against its "net income" for purposes of the section 9D calculation if these items are exempt by the recipient CFE under the related CFE interest, royalties, and rents exemption. Deductions are denied in this case to prevent related CFEs from artificially reducing their aggregate net incomes under section 9D.
Example (1). Facts. South African Company owns all the shares of CFE #1 and CFE #2, each of whom have a different country of residence. CFE #1 generates its receipts and accruals from a business establishment, and none of these items are of a diversionary or passive nature. The total receipts and accruals amount to R180,000 and the associated expenses amount to R70,000. These associated expenses include R50,000 of interest paid to CFE #2.
Result. CFE #1 has no net income because all its activities stem from a business establishment, and none of these amounts are of a diversionary or a passive nature. CFE #2 does not include the interest received from CFE #2 under the Related CFE Interest, Royalties, and Rents Exemption (i.e., because this interest simply represents an internal movement of business establishment earnings).
Example (2). Facts. The facts are the same as Example (1), except that R90,000 of the receipts and accruals earned by CFE #1 stem from diversionary transactions and all R50,000 of expenses similarly stem from these diversionary transactions.
Result. The R50,000 of interest paid by CFE #1 is not deductible against its net income because this interest is exempt by CFE #2 under the Related CFE Interest, Royalty, and Rents Exemption.