The South African tax system is a residence based system of taxation. This means that a South African resident is liable for tax on income derived within South Africa and outside South Africa. Therefore determining the residency of a person is of fundamental importance from a tax perspective.
In terms of the Income Tax Act a company is resident in South Africa if it is incorporated, established or formed in South Africa or if it has its place of effective management in South Africa. The Income Tax Act, however, has no definition of the term “place of effective management”.
The Organisation for Economic Co-operation and Development (OECD) has defined the term “place of effective management” in its Model Tax Convention to mean where the key management and commercial decisions necessary for the conduct of its business as a whole are made. The majority of the OECD member states as well as non-member states follow the interpretation of the OECD for purposes of determining a company’s place of effective management (South Africa is not an OECD member state, but it has a working relationship with the OECD and many of South Africa’s double tax treaty provisions are based on the OECD Model Tax Convention). The South African Revenue Service (SARS), however, has taken a different approach to the OECD in interpreting the place of effective management of a company.
Back in 2002 SARS issued Interpretation Note 6 with the purpose of providing guidance on the interpretation and application of the term “place of effective management” when determining the tax residence of a company. In this Interpretation Note, SARS interprets the place of effective management as the place where the day-to-day activities of the business take place, that is, the place where the executive directors and management transact the company’s business (or expressed somewhat differently, where the decisions are implemented). SARS went further to say that, the place of effective management is not the place where the ultimate control of the company is located or the place where the board of directors normally meets to manage and control the company’s operations as a whole, although they may coincide.
The Western Cape High Court took a different approach to SARS in the case of The Oceanic Trust Co. Ltd N.O. v Commissioner for South African Revenue Service, in which the Court was approached by a Mauritian Trust to issue a declaratory order declaring, inter alia, that it was not a resident of South Africa. However the High Court refused to issue the declaratory order on the basis that it only had jurisdiction to hear the matter if the issues to be decided were questions of law and did not require the court to make a finding of fact. It held that the question was not simply a question of law and that the Court was not entitled to enquire into and make findings of fact and held that:
“…even if the facts are sufficiently clear to make a decision, the place where key management and commercial decisions that were necessary for the conduct of SISM’s business, were in substance made, has in my view not been established to be outside South Africa. … Therefore, applying the Smallwood test, the facts to the extent that they have been established, do not, in my view, establish that the place of effective management of SISM was in Mauritius, and not in South Africa."
In light of much criticism and in order to clarify the position, SARS has recently revised its Interpretation Note to align it with the OECD Commentary on the interpretation of “place of effective management”. In draft Interpretation Note 6, SARS provides that:
“a company’s place of effective management is the place where key management and commercial decisions that are necessary for the conduct of its business as a whole are in substance made.”
The draft interpretation note states further that:
“The place of effective management test is one of substance over form. It therefore requires the identification of those persons in a company who actually ‘call the shots’ and exercise ‘realistic positive management’. Otherwise stated, a company’s place of effective management must be determined by ascertaining who makes the key management and commercial decisions for the conduct of the company’s business as a whole. Once this determination has been made, it is necessary to determine where those decisions are in substance actually made”.
SARS goes onto to say that this approach is consistent with the OECD’s commentary on the term “place of effective management” and lists certain key facts and circumstances that establish where key decisions are made.
According to SARS it does not anticipate that the application of draft Interpretation Note 6 will result in many companies, previously held to have their place of effective management outside South Africa, now being held to have it in South Africa, and vice versa.
It is important to note that Interpretation Note 6 is currently in draft form and therefore not yet binding on SARS. It is expected that the final note will be issued shortly.