Recently, the Constitutional Court delivered a landmark ruling in Coronation Investment Management SA (Pty) Limited v Commissioner for the South African Revenue Service, bringing an end to a protracted legal battle between SARS and a holding company having its tax residence in South Africa. Clarifying the parameters of the foreign business establishment (‘FBE’) exemption, the Court overturned the decision of the Supreme Court of Appeal (‘SCA’), exempting the company’s subsidiary from paying tax on its net income.
Coronation Investment Management SA (‘CIMSA’) is a holding company with its tax residence in South Africa. At all times relevant, CIMSA indirectly held 100% of the shares in an Irish tax resident entity, Coronation Global Fund Managers (Ireland) Limited (‘CGFM’), which operates as a fund management company and allocates investment trading functions to South African and UK companies acting under its supervision.
Ordinarily, South African tax residents are required to pay tax on their worldwide income. Conversely, non-residents are simply taxed on income derived from a South African source. The Income Tax Act (‘the Act’), however, incorporates an anti-avoidance provision to regulate the taxation of, inter alia, income earned abroad by South African-owned foreign entities. Under section 9D of the Act, CGFM is classified as a ‘controlled foreign company’ (‘CFC’) as at least 50% of its shares or voting rights are directly or indirectly held by one or more South African tax residents. CGFM is thus subject to the provisions of South Africa’s tax regime.
In 2012, SARS assessed CIMSA and included in its taxable income CGFM’s entire net income, creating a tax liability of just under R800 million. CIMSA objected to the assessment, arguing that CGFM’s income was exempt from its taxable income. To facilitate international competitiveness, section 9D(9)(b) of the Act enables a holding company to exclude the net income attributable to a CFC which qualifies for a FBE exemption from its taxable income. Under section 9D(1), a FBE is defined in relation to a CFC as a fixed place of business located outside of South Africa that is utilised or will be utilised to, inter alia, conduct the business operations of the CFC for no less than one year, which is ‘suitably staffed…and equipped for conducting the primary operations of that business’. Nevertheless, SARS contended that CGFM did not qualify for FBE exemption as it outsourced various primary business functions.
CIMSA instituted legal proceedings in the Western Cape Tax Court, which ruled in its favour. On appeal, the SCA sided with SARS, finding that CGFM did not meet the minimum requirements to qualify for FBE exemption and that the entity’s net income was therefore imputable to CIMSA for the 2012 tax year. Specifically, the SCA observed that CGFM’s primary business was investment trading, which it outsourced. Accordingly, it did not conduct its primary operations beyond South Africa’s borders. In response, CIMSA appealed to the Constitutional Court.
Overturning the SCA’s decision, the Court unanimously ruled that CGFM qualified for FBE exemption. It relied on a two-stage enquiry, namely determining CGFM’s ‘business’ and the ‘primary operations of [its] business’. Critical of the SCA’s misconception of the distinction between fund management and investment trading, the Court found that CGFM conducted the business of fund management – not investment trading – at its fixed place of business in Dublin, Ireland. Whereas fund management involves the administration of funds, management of investments, custodianship, and/or marketing, investment trading entails the professional and strategic allocation of funds invested in collective investment funds.
Noting that CGFM adopted a delegation business model employed by most fund managers in Ireland, the Court found that the entity performed specific management functions from its fixed place of business in Ireland, which was both suitably staffed and equipped to carry out the primary operations of fund management. In line with its selected business model, CGFM delegated – outsourced – investment trading to other entities for commercially and legally sound purposes. To that end, the Court held that CGFM’s daily operations satisfied the ‘economic substance’ requirements underpinning section 9D(1) of the Act. Consequently, the Court ordered SARS to exclude CGFM’s net income from CIMSA’s taxable income for the 2012 year of assessment.
Strongly disagreeing with the SCA’s assessment, the Court reasoned that the definition of a FBE does not constitute an ‘anti-outsourcing’ mechanism. Instead, it ensures that the operations of the offshore entity have economic substance in the particular foreign jurisdiction, enabling it to compete internationally. In this sense, judicial officers are required to objectively consider whether the actual operations of a CFC are commercially sensible – and not simply an ‘illusory business’ – in determining the applicability of the FBE exemption.
