The Constitutional Court (CC) recently (21 June 2024) handed down judgment in the case of Coronation Investment Management SA (Pty) Ltd v CSARS (Coronation and SARS)1 clarifying the application of the foreign business establishment (FBE) exemption in relation to controlled foreign companies (CFC) with an outsourcing business model.
The judgment resolved the dispute between Coronation and the SARS regarding whether the FBE exemption applied to the delegation business model applied by CGFM, a CFC in relation to Coronation, and whether CGFM's net income from its offshore operations is taxable in the hands of Coronation in South Africa.
South African tax residents are taxed on their worldwide income, while non-residents are only taxed on their South African source income. Section 9D of the Income Tax Act 58 of 1962 (ITA) - an anti-avoidance mechanism - alters this position. It provides that a proportional part of the income of a foreign company (referred to as its net income) of which more than 50% of the shares or voting rights are directly or indirectly (referred to as participation rights in the ITA) held by South African tax residents, is taxed in the South African residents hands. The income attributable to a FBE in relation to a CFC is however excluded from its net income, which means these amounts are not taxed in the hands of the holders of participation rights in that CFC.
A FBE is broadly defined as a fixed place of business situated outside South Africa that is used or will be used to carry on the business of that CFC for a period of not less than one year, which is inter alia suitably staffed and equipped to conduct the primary operations of that business.
The facts before the Court were as follows. Coronation's foreign subsidiary, CGFM, is a fund management company based in Ireland and a CFC of Coronation. CGFM delegates investment trading activities which it is not authorised to conduct in terms of its relevant licence, to South African and United Kingdom companies who act under the supervision of CGFM. The question before the Court was whether CGFM constitutes a FBE and accordingly whether CGFM's income is exempt from Coronation's taxable income.
The Tax Court ruled that CGFM qualified for the FBE exemption under Section 9D as it carried on activities of fund management at its fixed place of business, in a fixed structure which was suitably staffed. The Supreme Court of Appeal (SCA) however disagreed with the Tax Court and held that CGFM failed to meet the requirements of a FBE in that CGFM's primary business was investment trading which it had outsourced, and it did not therefore conduct its primary operations outside of South Africa.
The CC held that the matter engaged its jurisdiction as the interpretation of 'the business of that controlled foreign company' and 'the primary operations of that business' as contained in section 9D of the ITA is a question of law which is of general public importance.
The CC distinguished between fund management and investment management and held that fund management as carried on by CGFM entails administration of funds, custodianship, management of investments, distributions and marketing. Investment trading on the other hand, which was outsourced by CGFM, includes the expert allocation of the funds invested in a collective investment fund. The delegated business model through which CGFM conducted specific management functions whilst delegating investment management trading, was elected by CGFM for commercial reasons. It was entitled to do so by law and it and complied with the restrictions of its trading licence. This was also in line with prevailing general commercial practice.
The CC agreed with the Tax Court by holding that CGFM's day-to-day operations met the economic substance requirements of the FBE exemption as CGFM had a fixed place of business which was suitably staffed and equipped to conduct the primary operations of its fund management business in accordance with its delegation model. The SARS was accordingly ordered to exclude the amount of CGFM's foreign income from Coronation's South African taxable income.
The CC criticized the SCA's so called 'notional business' approach which equates the business of a CFC to everything that a CFC can in theory do even if it does not actually do it. This, the CC held, leads to insensible and unbusinesslike results which would 'inadvertently discourage legitimate business practices that contribute to the efficiency and competitiveness of South African companies on a global stage'. The SARS and a Court must accordingly rather objectively consider whether the actual operations of the business has commercial rationale and economic substance while determining whether the FBE exemption applies.
The CC emphasised that the FBE definition is not an 'anti-outsourcing' enactment, instead it aims to ensure that an offshore business, irrespective of its chosen model, has economic substance in the relevant foreign country and is not merely an 'illusory or "paper" business'.
The CC's pragmatic and economically minded approach provides clarity as to the requirements for an offshore business to qualify for the FBE exemption. This is a welcome judgment, which will benefit South African companies with offshore structures and ensures that, as the court said, section 9D achieves its objects of ensuring that South African owned offshore companies remain competitive with their foreign rivals.
Although the outcome of the judgment is positive, it must be noted that in the Taxation Laws Amendment Bill, 2023, National Treasury proposed an amendment to the definition of a FBE requiring that a fixed place of business must be suitable staffed, equipped and have facilities for 'performing all the important functions of that business for which the controlled foreign company is compensated' to qualify for the FBE exemption. Following public comment the proposed amendment was withdrawn pending the judgment of the CC. It remains to be seen whether the proposed amendment (or an amended version thereof) will be reintroduced.
Footnote
1. [2024] ZACC 11.
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