Exemption of foreign business from CFC
IN TERMS of the section 9D(1) of the Income Tax Act, a controlled foreign company (CFC) is defined as: “any foreign company where more than 50% of the total participation rights in that foreign company are directly or indirectly held, or more than 50% of the voting rights in that foreign company are directly or indirectly exercisable, by one or more persons that are residents other than persons that are headquarter companies…”
A foreign company will therefore constitute a CFC if more than 50% of the total participation rights (shares) or more than 50% of the voting rights in that company are directly or indirectly held by one or more South African residents (other than headquarter companies).
Absent an applicable exemption, an allocation is made for tax purposes to all South African residents who hold 10% or more of the shares in the foreign entity.
The application of the CFC rules is excluded in a number of situations, including where an amount is attributable to any “foreign business establishment” of that CFC. A “foreign business establishment” refers to a place of business of the CFC which is located in a jurisdiction other than SA which is, among other things, conducted through an office and suitably staffed with employees.
However, in terms of amendments made in the Taxation Laws Amendment Act 2011, the foreign business establishment exemption will not apply in respect of amounts arising from financial instruments unless those financial instruments are attributable to the principal trading activities of the foreign business establishment and those principal trading activities:
Constitute the activities of a bank, financial service provider or insurer; and
Do not constitute the activities of a treasury operation or captive insurer.
It is therefore necessary to analyse the concept of a “financial service provider”.
In this regard the law previously required that the CFC carry out a financial services business. The issue therefore arises whether the introduction of the word “provider” limits the wider concept of a financial services business.
Section 1(1) of the Financial Advisory and Intermediary Service, 2002, defines a financial service provider for purposes of such legislation as any person, other than a representative, who as a regular feature of the business of such person furnishes advice and/or renders an intermediary service. The term “provider” is defined in a business dictionary as “a person, organisation or business that offers a good or a service”.
The issue therefore arises whether a “financial service provider” is an intermediary as opposed to a principal in respect of financial service transactions.
The eiusdem-generis rule of interpretation applies to the interpretation of provisions made up of a phrase of general application preceded by a class of words of a limited or particular meaning. The general phrase is then restricted to the narrower, generic meaning of the preceding words.
In terms of the eiusdem-generis rule the words “bank” and “insurer” include entities that raise capital in the form of borrowings or issuance of policies and invest such capital with the aim of providing a return to the funders/policyholders. Arguably the term “financial service provider” should therefore have the same common features.
In addition, in order for the foreign business establishment exemption to apply, the bank, financial service provider or insurer must also not constitute the activities of a “treasury operation” or “captive insurer”. It must therefore be possible for a financial service provider to constitute a “treasury operation”. As set out below a “treasury operation” is an entity that borrows and on-lends funds.
Therefore, it is arguable that the term “financial service provider” includes an entity which acts as a principal, that is, raises capital and re-invests such capital.
A further requirement in order for the foreign business establishment exemption to apply in respect of amounts arising from financial instruments is that the relevant principal trading activities of the CFC do not constitute the activities of a treasury operation.
The issue arises what is envisaged by a “treasury operation”. In this regard various deeming provisions set out circumstances where a treasury operation is deemed to exist. In essence a treasury operation is deemed to exist where a company provides finance to other group entities.
On the basis that a CFC’S operations are not deemed to be a “treasury operation” it is then necessary to determine whether these constitute a treasury operation in terms of the ordinary meaning of that term.
The deeming provisions are useful in this regard since they provide insight and context to the concept of a “treasury operation”. As mentioned above, the deeming provisions refer to the provision of credit to related parties.
Therefore, it is arguable that the concept of a “treasury operation” refers to an entity within a group of companies conducting treasury operations for the group and does not apply to an entity which conducts business with or extends credit to third parties.
Amendments applying to CFCS are contained in the Taxation Laws Amendment Act 2011.
When determining whether the foreign business establishment exemption will apply to CFCS in respect of amounts arising from financial instruments it is now necessary to consider whether the CFC carries out principal trading activities which constitute, amongst other things, the activities of a financial service provider and also do not constitute the activities of a treasury operation.
Peter Dachs and Bernard du Plessis are tax directors in the tax division at ENS.