Controlled foreign companies (CFC) are companies where more than 50% of their participation rights or voting rights are held directly or indirectly by South African residents. The CFC regime is one of the measures put in place to tax South African residents that have majority held equity investments offshore. The provisions do this through (absent the qualification of an exemption), the imputation of the net income of the CFC (in essence, the taxable income of the CFC had it been South African resident) to the South African resident shareholders, in proportion to the interest held in the CFC. The Minister has proposed two amendments relating to CFCs as discussed below.
Amendment to the anti-diversionary provisions under the foreign business establishment exemption
Section 9D(9) of the Income Tax Act provides that the net income of a CFC that is attributable to a foreign business establishment (FBE) is exempt from the CFC imputation rules.
A company will qualify as having an FBE if, simplistically, it has a fully-fledged physical business operation in a foreign jurisdiction. Section 9D(9A), however, excludes certain forms of revenue streams from the FBE exemption under the anti-diversionary rules which are aimed at not permitting passive or tainted income between certain transacting parties from qualifying for the FBE exemption. The South African CFC rules currently contain three sets of anti-diversionary rules, namely, CFC inbound sales, CFC outbound sales and CFC connected person services. These CFC anti-diversionary rules are aimed at ensuring that CFC activities are not utilised by South African tax residents to shift taxable income offshore through transfer mispricing.
In 2011, the diversionary rules governing the outbound sale of goods by a CFC were abolished as it was contended by National Treasury that the transfer pricing rules could be applied instead.
In 2016, National Treasury reinstated the diversionary rules for CFC outbound sale of goods due to their effectiveness in preventing base erosion and profit shifting. In its current format, the 2016 diversionary rules for CFC outbound sale of goods now provide for an exemption if similar goods are purchased by the CFC, from unconnected persons to that CFC, mainly within the country in which the CFC is resident.
The Minister has stipulated that certain taxpayers are circumventing these rules by merely entering into a contract of purchase and sale that implies that the purchase of goods took place in the country of residence of the CFC, when this is not the de facto position. In order to address this tax abuse, it has been proposed that the diversionary rules be amended to close this loophole.
Clarification between Participation Exemption and provisions relating to CFC ceasing to be a CFC
Following the relaxation of exchange controls in relation to loop structures in 2020 (being reinvestments made by South African residents into South Africa via an offshore structure), a change was introduced to the capital gains tax Participation Exemption contained in paragraph 64B to the Eighth Schedule of the Income Tax Act in order to curtail aggressive tax planning opportunities of taxpayers. The Participation Exemption, in essence, provides that a South African resident holding a minimum of 10% of the equity shares and voting rights in a foreign company, may disregard a capital gain or capital loss realised on the transfer of shares in the foreign company if the disposal is effected at market value to a foreign person that is not a connected person to the South African resident.
Under the newly inserted paragraph 64B(6), however, a South African resident transferring shares in a CFC where the value of the CFCs assets are attributable to South African assets, is precluded from qualifying for the Participation Exemption.
Separately, section 9H(3)(b) of the Income Tax Act provides for a deemed disposal of all assets of a CFC on the date that the CFC ceases to be a CFC, in the form of an exit charge. This typically results in an imputed capital gain for the South African resident beneficial shareholders, unless one of the CFC exemptions apply. Section 9H(5) of the Income Tax Act, however, excludes from the ambit of these exit charge provisions, the instance where the CFC ceased to be a CFC and the Participation Exemption applied.
To address the interaction between section 9H and paragraph 64B, it is proposed that section 9H be amended so that a partial participation exemption in terms of paragraph 64B(6) would not affect the exclusion under section 9H(5).
Authors: Howmera Parak and Stephan Spamer