Proposed amendments to the Controlled Foreign Companies ("CFC") rules in section 9D of the Income Tax Act will punish South African companies with loss-making foreign subsidiaries, warns Dan Foster, a tax director at Webber Wentzel.
"This proposal will directly impact the feasibility of foreign expansion by South African firms, and make it more difficult for local companies to compete abroad," Foster predicts. "With the rand in turmoil, it has rarely been more important for SA companies to grow foreign currency earnings".
The effect of the CFC rules is to tax income of a CFC in the hands of its South African shareholders in certain cases, despite the fact that the amounts concerned arise from foreign activities and assets and may never be remitted to South Africa. It is generally accepted that CFC rules operate as a deterrent to tax avoidance (which could take the form of routing income that should arguably have been earned and taxed in South Africa to low tax jurisdictions) and are not primarily aimed at increasing tax collections.
Currently, a foreign subsidiary will not be subject to the harsh CFC regime if it qualifies for the so-called "High Tax Exemption". This exemption is a carve-out designed to protect companies operating in high-tax countries, as opposed to low-tax countries and tax havens. There is a presumption that companies operating abroad in high-tax countries are not seeking to avoid South African tax, whereas companies in tax havens may be avoiding tax, and therefore the CFC rules should apply to the latter but not the former.
The High Tax Exemption operates by comparing the foreign tax payable by the CFC to the notional South African tax that it would have paid if it was a South African tax resident. If the foreign tax payable is at least 75% of the notional South African tax, then the High Tax Exemption will apply and the income of the CFC will not be taxable in the hands of its South African shareholders.
For the purposes of calculating the foreign tax payable, the rules currently provide that a CFC's brought-forward losses are ignored. This is because such losses reduce the amount of tax payable in the foreign country in a particular year, notwithstanding the fact that the company is operating in a high-tax country.
In addition, many foreign countries have a group taxation system whereby tax losses in one group company may be used in another group company. These losses are also currently disregarded in terms of the rules.
The proposed amendment to s 9D of the Income Tax Act will remove the provision which disregards brought-forward losses, and group losses, when calculating the exemption. "This will result in some amounts becoming imputable under the CFC regime, even if the CFC concerned is in fact operating in a high-tax country and has not been set up to avoid tax on foreign earnings", says Foster.
A simple example illustrates the impact if a CFC's own losses brought forward are not disregarded. Assume that the CFC operates in a high tax jurisdiction and its foreign tax payable is R80 and its notional South Africa tax payable if it were a South African resident would be R100. The high tax exemption would be available because the foreign tax payable would be more than 75% of the notional South African tax. However, if that same CFC has losses brought forward, which reduce its foreign cash tax payable to nil, then it would fail to qualify for the high tax exemption because its notional South African tax payable would still be R100 and its foreign tax payable would be 0% of the notional South African tax amount. Therefore, it is logical in terms of the current rules to be able to disregard the losses carried forward in the CFC because it would make the tax payable R80 and thus allow it to qualify for the high tax exemption. The proposed amendments will not allow the carried forward losses to be disregarded and thus the CFC will thus not qualify for the high tax exemption despite it operating in a high-tax jurisdiction.
Elandre Brandt, a tax partner at Webber Wentzel, says: "These proposals are regressive. If there is some mischief that the authorities are trying to address it should be done through a more targeted approach. These amendments could have a wide ranging impact on businesses in high tax foreign jurisdictions because the amendment puts groups at risk of double taxation. Tax will be paid in South Africa in terms of the CFC rules and later again at a high rate on effectively the same amount in the CFC's tax jurisdiction after it uses up its losses."
In addition to the recent re-introduction of the so-called 'diversionary rules', this proposal would seem to be a reaction to perceived base erosion and profit shifting (BEPS). BEPS is high on the agenda at SARS, National Treasury and the Ministry of Finance. "While efforts to curb BEPS are generally supported," notes Foster, "this latest proposal will simply make investing abroad more difficult and costly for SA companies, and would seem to be merely punish firms that make losses in high tax countries".
"South Africa's CFC regime is already one of the most comprehensive in the world", says Foster, "Making it more draconian is like cutting off your nose to spite your face, as the old saying goes. In an effort to collect more tax, these laws will simply discourage future foreign investment, punish existing investment, and result in less hard currency profits for SA firms and less tax collection in the long run."
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