As part of the 2011 Budget, SARS conceded that the current South African controlled foreign company ("CFC") legislation contained in section 9D of the Income Tax Act, 58 of 1962 ("the Act") is overly complex. According to National Treasury's Tax Proposal document for Budget 2011, certain provisions can interfere with normal business conduct whilst others create unintended loopholes. National Treasury has, therefore, proposed that the CFC rules are further refined to focus the legislation without compromising its purpose.
It's not the first time that National Treasury has proposed simplifying the CFC legislation. In 2009, the ruling system contained in the then section 9D(10) was partially replaced with a high-taxed net income ‘exemption'. The ‘exemption' is contained in the proviso to section 9D(2A) and applies where the income of the CFC is subject to a minimum level of tax. The purpose of the ‘exemption' is to disregard CFC income if little or no South African tax is at stake once South African foreign tax credits in section 6quat of the Act are taken into account. At first sight the proviso seems simple to apply; if the CFC is subject to a minimum level of tax, there is no CFC income. However, a deeper examination of the proviso reveals that its application is very complex and gives rise to a number of unanswered questions.
Generally, in terms of the CFC rules where a South African or South Africans jointly hold more than 50% of the participation rights in a foreign company, the company is a CFC. Unless an exemption or exclusion applies an amount equal to the net income of a CFC is included in each South African resident's income in the proportion of the participation rights of the South African resident in the CFC to the total participation rights in the CFC.
Section 9D contains complex rules as to how the net income of the CFC is calculated and the circumstances in which amounts are included or excluded from the net income calculation. The proviso to section 9D(2A) provides that the net income of a CFC will be nil if the amount of foreign tax payable by the CFC is equal to or greater than 75% of the South African income tax that would have been payable by the CFC for the foreign tax year of the CFC had the CFC been a South African tax resident. In determining the foreign tax payable by the CFC, tax payable to all spheres of government, the provisions of any applicable double tax agreement and any credit, rebate or right of recovery of the foreign tax must be taken into account. Any tax losses of the CFC and any tax losses of any other company (if the CFC is in a jurisdiction which applies group tax) must not be taken into account.
Therefore, in determining whether the CFC qualifies for the exclusion, taxpayers cannot assume that if the corporate income tax rate of the CFC is at least 21% (75% of 28%) the proviso will apply.
Determining whether the proviso applies requires a detailed calculation of the CFC's taxable income as if the CFC was a South African tax resident. This means that the South African resident holding participation rights in the CFC will need detailed financial information for the CFC in order to prepare a South African taxable income calculation for the CFC. If the actual foreign tax payable by the CFC is at least 75% of the South African income tax that would be payable based on the South African taxable income calculation for the CFC, the CFC's net income is deemed to be nil.
Some of the difficulties with the South African taxable income calculation which must be performed in order to determine whether the proviso applies are evident from the following examples:
- The proviso was included by the Taxation Laws Amendment Act, 17 of 2009 which was only promulgated on 30 September 2009 but applies retrospectively to any foreign tax year of a CFC ending during years of assessment ending after 1 January 2008. It is therefore possible that a taxpayer completing his income tax return for the 2008 year of assessment during 2009 could have included in his CFC income for the 2008 year amounts which should have been excluded in terms of the proviso. There appears to be no mechanism in the legislation or income tax returns to correct this.
- Although income tax is an annual event, certain capital allowances such the section 12C allowances are deductible when plant or equipment are brought into use for the first time by the taxpayer. If a CFC uses plant or equipment which would in principle qualify for the section 12C allowance, it is not clear in applying the proviso whether the provisions of section 12C can be used because the equipment may not have been brought into use for the first time by the CFC in the 2008 year of assessment when the proviso is first applied. If the section 12C allowance cannot be used it is possible that the 75% test would not be met if the CFC is entitled to a similar allowance under the rules of the jurisdiction where it operates.
- An income tax deduction is allowed for bad debts in terms of section 11(i) of the Act but only if, inter alia, the amount was included in the taxpayer's income in the current or a prior year of assessment. On a strict reading of section 11(i), amounts which accrued to a CFC before the effective date of the proviso but which become bad after the effective date of the proviso cannot be deducted in determining whether the proviso applies.
There are countless other examples of provisions in the Act which will be difficult to apply in calculating a CFC's taxable income for purposes of determining whether the proviso applies.
We submit that these and other difficulties in applying the provisions of section 9D should be addressed in a SARS Interpretation Note on the application of section 9D. We contend further that any further refinements to the CFC legislation should consider the effort required by taxpayers to comply with the rules in relation to the additional tax which is collected by SARS.