i. INTRODUCTION
In order for a state to impose a tax on a taxpayer, a prescribed nexus is required to exist between the state in question and the taxpayer. Generally understood, a state’s fiscal jurisdiction is premised on a legally relevant connection between the state and the taxpayer.130 The existence of the requisite linking or connecting factor is determined by domestic law and international law in concert. The question of fiscal jurisdiction is both fundamental and complex. As Ketchiman posits, fiscal jurisdiction may be referred to as the ‘legal and factual power of a state to levy taxes over either the taxable person or the taxable object’.131 The two most common linking factors are the residence of the taxpayer and the fact that the income was generated from a source within the state.132 This is the residence basis and the source basis of taxation respectively.
Accordingly, in light of the previous discussion relating to the digitalisation of business models and the concurrent shift in the manner in which business is carried out in the digitalised economy, it is necessary to reconcile this shift with the existing framework for the imposition of tax on the basis of source. In this way, it will elucidate the areas of concern, short-comings and adequacy of the existing rules of taxation on the basis of source. This chapter, accordingly, discusses the existing law regarding source-based taxation at the domestic and international level. Firstly, this chapter discusses the background to source-based taxation in South Africa.
Following this, the theoretical justification for taxation on the basis of source is evaluated in order to construct a normative framework for the ensuing chapters regarding the adequacy of the existing source rules. Finally, this chapter surveys the existing law regarding taxation on the basis of source from a domestic and international perspective.
ii. BACKGROUND TO SOURCE-BASED TAXATION IN SOUTH AFRICA
130 AP de Koker & RC Williams Silke on South African Income Tax (2020) §5.1.
131 Eric P. Ketchemin A Comparative Analysis of the Concept of Fiscal Jurisdiction in Income Tax Law (unpublished Doctor of Laws thesis, University of Cape Town, 2002) at 9.
132 Olivier op cit note 7 at 21.
Prior to 2001, South Africa exclusively levied tax on the basis of source. However, amendments to the Income Tax Act in 2000 lead to the inclusion of residence-based taxation as the primary basis of taxation, while still retaining source-based taxation in a subsidiary role.133 Residents would henceforth be taxed on their worldwide income, whereas non- residents would remain liable to tax on the income that was derived from a source within South Africa as per the definition of ‘gross income’ contained in s1 of the Act. It was noted that the shift from source-based taxation to residence-based taxation would widen the South African tax base, limit opportunities for tax arbitrage and further align the South African framework for taxation with the generally accepted norms of the taxation of international transactions.134
The introduction of residence-based taxation was accompanied by a comprehensive definition of ‘resident’ in s1 of the Act, but as of yet there exists no statutory definition of the term
‘source’. The absence of a comprehensive definition of ‘source’ has led to the court’s reliance on existing jurisprudence regarding the conceptualisation and determination of source.135
Notwithstanding the difficulty in the judicial determination of source, the Katz Commission expressly recommended that a comprehensive codification of general source rules is not desirable.136 Consequently, a dual approach to the identification of source has emerged. The approach is comprised of the judicial approach to the determination of source and the codified or statutory approach. Section 9 of the ITA provides statutory rules for the determination of source. Through this, the legislature has provided codified rules for the determination of source and alleviated the uncertainty in regard to the determination of source for specific types of income received by or accrued to a non-resident taxpayer.137
It is important to draw attention to the interplay between the rules provided for in s9 and the judicial approach to the determination of source. Due to the silence of the Act regarding the definition of ‘source’, resort is first had to s9 of the Act and where s9 itself is silent on the specific income in question, the actual source and the location of the source must be determined by the courts.138
133 Ibid at 20.
134 De Koker & Williams op cit note 130 at §5.1.
135 Clegg & Stretch op cit note 9 at §8.1.
136 Ketchemin op cit note 131 at 207.
137 Clegg & Stretch op cit note 9 at §8.1.
138 Ibid at §8.4.
The historical conceptualisation and determination of source by the courts is in itself contentious. Watermeyer CJ, in the seminal case of Lever Brothers, expressly notes the difficulty and perceived impossibility with regard to the formulation of a definition for the term
‘source’ which would, in turn, provide a universal test for the determination of source.139 Hence, the legislature is cognisant of the role of the judiciary in the determination of source in specific circumstances, despite the partial codification of the source rules contained in s9 of the Act.140 This difficulty in the provision of a definition and a universal test has resulted in the adoption of a casuistic approach by the courts in the determination of source. The facts and circumstances of each case are of paramount importance and as such must be approached with great circumspection.141
iii. THE THEORETICAL JUSTIFICATION FOR THE IMPOSITION OF TAX ON THE BASIS OF THE SOURCE
In preparation for the ensuing discussion regarding the adequacy of the existing source rules of taxation – as applied to the digitalised economy – it is necessary to establish the normative framework through which the adequacy may be discerned. Accordingly, this dissertation constructs a normative framework through the prism of the underlying theoretical justification for taxation on the basis of source.
The right to impose a tax on the basis of the source is justified in terms of the existence of a link between any economic activity and a specific jurisdiction.142 As stated in Kergeulen Sealing and Whaling Co Ltd v CIR,143 the justification rests on the assumption that where a state produces wealth for a taxpayer by virtue of the use of its natural resources or the activities of its inhabitants, that same state ought to be entitled to a share of that wealth.144
The non-resident taxpayer derives great benefit from the ability to compete with residents for the use and enjoyment of income earning opportunities, resources and infrastructure afforded
139 Lever Brothers op cit note 11 at 13.
140 Clegg and Stretch op cit note 9 at §8.4.
141 Ibid.
142 Ketchemin op cit note 131 at 28.
143 Kergeulen Sealing and Whaling Co Ltd v CIR 1939 (10) SATC 363 (AD) at 380.
144 Ketchemin op cit note 131 at 29.
to them by the source state and therefore, duly benefits from the proper organisation of the state. Thus, it is generally contended that such a taxpayer ought to contribute to the state through taxation.145 Vogel further adds that the source concept can only be relied on by a state which in some manner is connected to the derivation of income or to the state where value is added to a good.146
It is apparent from the above discussion that the justification for the imposition of tax on the basis of source is premised on the benefit theory. This theory posits further that the source state is entitled to impose tax on non-residents to reconcile for the costs they impose on the public sector.147 Additionally, it is noted that source-based taxation provides an important tool with regards to the regulation of the commercial activity that takes places within a state’s territorial borders.148 It provides a tool through which the government can incentivise and disincentivise certain multinational corporate conduct.
It is necessary to evaluate other forms of theoretical justifications for taxation on the basis of source. The power theory posits that fiscal jurisdiction rests on the power of the state over the tax subject or object.149 Fiscal jurisdiction is dependent on the extent to which a tax claim can be enforced. The obvious limitation of this theory is that a legitimate tax claim can be defeated by the absence of physical power.150 Green notes that the source state is usually in the best position to enforce a tax on transnational income.151 Perhaps, this is why at the international level the benefit principle justifies the permanent establishment concept, as in the absence of a permanent establishment it is difficult to contend that a multinational entity is likely to benefit significantly from the public resources of a country.152 Where a permanent establishment exists, the source state can closely monitor the permanent establishment and is in a better position to enforce the tax claim.153
Additionally, the contractual theory contends that source-based taxation is justified in terms of the social contract between the state and the taxpayer – through which the taxation operates as
145 Ibid.
146 Ibid at 30.
147 Ibid.
148 Ibid.
149 Ibid at 31.
150 Ibid at 32.
151 Ibid.
152 Ibid.
153 Ibid.
a payment for goods and services provided by the source state.154 Conceptualising the imposition of tax as flowing from a contractual relationship begs the question as to what the underlying and fundamental premise of the contract is. Perhaps through the voluntary activities of the non-resident taxpayer in acquiring property and carrying on income earning activities, the taxpayer tacitly agrees to contribute to the source state through the payment of taxes.155 However, it must be noted that this contract is unilaterally imposed with no consensual deliberations as to the quantum of tax. Moreover, the state is able to vary, abolish and create new taxes without consultation nor negotiation with the non-resident taxpayer.156
Finally, the ethical or retributive theory posits that the justification for source-based taxation rests on an ethical basis as opposed to juridical or political bases.157 Ketchiman notes that there have been considerations of fairness and equity which have influenced the formulation and development of international law with regard to the assignment of rights to tax.158 At the ethical level, this theory posits that source-based taxation is the contribution for the advantages and benefits that accrue to the non-resident taxpayer. Essentially, if one benefits from a community, one ought to contribute to that community. The limitation to this theory is that there is no universal understanding or conception of the principles of fairness and there is no comprehensive and generally accepted standard of fairness in the right to tax. Thus, it is hard to discern the exact parameters of what is just in the determination of the right to impose a tax.159
iv. THE STATUTORY RULES FOR THE DETERMINATION OF SOURCE CONTAINED IN SECTION 9 OF THE INCOME TAX ACT
While the concept of source remains undefined in the ITA, the Act does provide certain statutory rules in s9 which identify the source of certain types or streams of income.160 The decision to provide codified rules regarding the determination of source is a policy decision as the legislature has identified the most important types or stream of income and has
154 Ibid.
155 Ibid.
156 Ibid at 33.
157 Ibid at 34.
158 Ibid.
159 Ibid.
160 Income Tax Act supra note 104 at s9.
deemed it necessary to provide clarity on the determination of their source.161 For the purposes of this dissertation only a select few of the relevant statutory rules in s9 will be discussed.
(a) Interest
In terms of s9(2)(b), an amount accrues from a source within South Africa – provided that it constitutes interest as per s24J(1) – if the debtor is a South African resident or it is received in regard to the utilisation or application in the Republic by any person of any funds or credit obtained in terms of any form of interest-bearing arrangement.162 Where the interest does not amount to interest as per s24J, the decisions in Lever Brothers and other relevant cases are applicable.
(b) Dividends
Section 9(2)(a) states that an amount is from a source within South Africa where the amount constitutes a dividend.163 Therefore, resort must be had to the definition of ‘dividend’ in s1 of the ITA. The rule, restated is that where a dividend is distributed by a resident, the dividend income is from a source within South Africa. Foreign dividends are to be regarded as being from a source outside of South Africa.164
(c) Royalties
Royalties as defined in s9(1) refers to an amount that is received or accrued in respect of the use, right of use or permission to use any intellectual property as defined in s23I.165 The royalty received will be from a South African source where the royalty payment is incurred by a resident or the royalty is received or accrued for the use in South Africa of any intellectual property.166 On the latter point it is noted that where the contract was entered into, where the intellectual property was created or where the payment is to be made is irrelevant for the determination of source in terms of s9(2)(d).167
161 Clegg & Stretch op cit note 9 at §8.5.
162 Income Tax Act supra note 104 at s9(2)(b).
163 Ibid at s9(2)(a).
164 Clegg & Stretch op cit note 9 at §8.5.2.
165 Income Tax Act supra note 104 at s9(1) and s s23I.
166 Ibid at ss9(2)(c) - 9(2)(d).
167 Ibid at s9(2)(d).
Furthermore, s9(2)(e) includes that the source is located in South Africa where the amount is incurred by a resident, in respect of the imparting of or the undertaking to impart any
‘scientific, technical, industrial or commercial knowledge or information’.168 This includes the rendering or undertaking to render any assistance or service in connection with the supplication or utilisation of such knowledge or information.169 A final consideration is s9(2)(f), which relates to information identified in s9(2)(e) above, stating that the source is located in South Africa where the knowledge or information is used in South Africa.170
The previous chapters highlighted the growing importance and reliance on intellectual property and intangible assets in the new digitalised business models. Therefore, the source rules relating to royalties are particularly important in the determination of the source of income derived from various new digitalised business models.
Firstly, it is noted that the words ‘use’ or ‘right of use’ used in s9(1) is understood to mean the right to reproduce, for commercial purposes, either the right itself or the thing the right protects.171 Moreover, another interesting definitional point of order is to give content to the definition of royalty as provided for by s23I, which includes ‘property of a similar nature’.172
It is necessary to discern the nature of the property or knowledge which would fall within the designation of ‘property of a similar nature’. The court considered the phrase ‘property of a similar nature’ in SA Silicone Products (Pty) Ltd,173 where the court held that the property in question must share fundamental characteristics of the property specifically identified.174 In the context of intellectual property the court in ITC 1735, the property rights listed were all rights designed to protect the original intellectual work of the person who had created it.175 Hence, it is submitted that for property to fall within the scope of the phrase ‘property of a similar nature’, the property must relate to the protection of original work which is derived from creative or intellectual efforts.176
168 Income Tax Act supra note 162 at s9(2)(e).
169 Ibid.
170 Ibid at ss9(2)(e)-9(2)(f).
171 Clegg and Stretch op cit note 9 at §8.5.4.
172 Income Tax Act supra note 104 at s23I(f).
173 CSARS v SA Silicone Products (Pty) Ltd (2004)66 SATC 131.
174 Ibid at 139.
175 ITC 1735 (2002) 64 SATC 455.
176 Flynn op cit note 24 at page 31.
(d) Income received from the sale of assets
In terms of s9(2)(j) an amount is regarded as being from a South African source if it is received by or accrued in regard to the disposal of immoveable property or any right or interest in immoveable property, as contemplated in the 8th Schedule, and the immoveable property in question is situated in South Africa.177
Regarding movable property, s9(2)(k) provides that an amount is to be regarded as being from a source within South Africa where the amount is the proceeds from the sale of an asset by a resident, unless the asset is attributable to a permanent establishment of the resident that is located outside of the Republic.178 Alternatively, the amount will be regarded as being from a source within South Africa where it constitutes the proceeds from the sale of the assets by a non-resident and the asset is attributable to a permanent establishment situated in South Africa.179
v. THE JUDICIAL APPROACH TO SOURCE-BASED TAXATION IN SOUTH AFRICA
There is no universal test, definition or understanding of the concept of source, rather different jurisdictions apply varying standards or thresholds in the determination of source.180 This is best illustrated by the judgment of Watermeyer CJ in Lever Brothers. The court was tasked with determining the source of the interest payments made by a South African company on a debt owed to the non-resident Lever Brothers. Watermeyer authoritatively stated that it is likely an impossible task to formulate a definition of source that could be implemented as a universal test in the determination source.181 Watermeyer went on to say;
‘A series of decisions of this Court and of the Judicial Committee of the Privy Council upon our Income Tax Acts and upon similar Acts elsewhere have
177 Income Tax Act supra note 104 at s9(2)(j).
178 Ibid at s9(2)(k).
179 Ibid.
180 Ketchemin op cit note 131 at 203.
181 Lever Brothers supra note 11 at 13.
dealt with the meaning of the word "source" and the inference, which, I think, should be drawn from those decisions is that the source of receipts, received as income, is not the quarter whence they come, but the originating cause of their being received as income and that this originating cause is the work which the taxpayer does to earn them, the quid pro quo which he gives in return for which he receives them. The work which he does may be a business which he carries on, or an enterprise which he undertakes, or an activity in which he engages and it may take the form of personal exertion, mental or physical, or it may take the form of employment of capital either by using it to earn income or by letting its use to someone else.’182
The dissenting judgment – penned by Schreiner – duly acknowledged the relevance of the fundamental principles elucidated in the judgment by Watermeyer.183 The principles formulated in Lever Brothers have become fundamental tenets of the approach adopted by the courts in the determination of source. Still, it is noted that the complexity of the case and other factors ensure than one must remain cautious and circumspect in extracting general legal principles from this case.184 Accordingly, subsequent judgments have found it unnecessary to identify one legal test which finds universal application in all situations in the ascertainment of source.185
Moreover, a comparison of the majority and dissenting judgments reveals that while the court was in agreement that the source of income means the ‘originating cause of the income’, there is still judicial divergence in the ascertainment of the originating cause.
Hence, the courts must be weary and approach the determination of the source of income on a casuistic basis and in accordance with the particular relevant facts.186 This point remains essential in the ensuing discussion of the judicial approach to the ascertainment of source.
In Lever Brothers, Watermeyer proffered the locus classicus of the test for source as illustrated in the passage quoted above. The test can be understood as a two-stage inquiry.
182 Ibid at 8-9.
183 Ibid at 16.
184 Ketchemin op cit note 131 at 205.
185 Ibid at 206.
186 Ibid.