4.2 THE BUSINESS ESTABLISHMENT EXEMPTION
4.2.1 Mobile foreign business income
4.2.1.1 Permanence and independence
Silke19states that this criterion might refer to an enterprise with the qualities of a sound and stand alone or independent existence which is not subordinate to another business.
National Treasury states that 'a business establishment essentially involves a business that has some permanence, some economic substance, and a non-tax business reason for operating abroad rather than at home.,20
A 'business establishment' in relation to a controlled foreign company is defined in section 9D(1)as:21
a) a place of business with an office, shop, factory, warehouse, farm or other structure which is used and will continue to be used by the foreign entity for a period of not less than one year, whereby the business of such company is carried on, and where:
13 Jooste 'The Imputation ofIncome of Controlled Foreign Entities' 118 South African Law Journal 487.
14 See section 90(1) of the Act for the definition of a 'business establishment'.
15 SIR v Downing SATC 249.
16 J
ooste • The Imputation of Income of Controlled Foreign Entities' (200 I) 118 South African Law Journal 487.
17 Sections 9D( I)(a), 90(1 )(a)(ii) and 90( I)(a)(iii).
:: ~eseterms are not used in the Act but describe the fixed locations mentioned in s 90(1)(ii) of the Act.
Sllke South African Income Tax (2002) I §§ 5.40.
~o National Treasury's Detailed Explanation to Section 9D ofthe Tax Act (June 2002) 9.
I Sections 90(1)(a), 90(1)(b) and 90(1)(c).
(i) that place of business is suitably equipped with on-site operational management, employees, equipment and other facilities for the purposes of conducting the primary operations of that business; and
(ii) the place of business is maintained in a country outside South Africa for bona fide business purposes (other than tax avoidance, postponement or reduction);
b) a mine, oil or gas well, a quarry or any other place of extraction of natural resources where the CFC has a right to directly explore those natural resources, or any area where that CFC has the right to carry on prospecting operations preliminary to the establishment of a mine, oil or gas well, quarry or other place of extraction or prospecting operations;
c) a site for the construction or installation of buildings, bridges, roads, pipelines, heavy machinery or other projects of comparable magnitude which lasts for a period of not less than 6 months, where that CFC carries on those exploration, extraction or prospecting operations;
d) agricultural land used forbona fide farming activities directly carried on by that CFC; or e) a vessel or an aircraft solely engaged in transportation within a single country, or a fishing
vessel used for prospecting, exploration or extraction, where that vessel or aircraft is operated directly by that CFC.
Brincker, Honiball and Olivier (2003) comment that the above definition of 'business establishment' broadly resembles the definition of 'permanent establishment' in the OECD and UN Model Tax Convention.22 Itis evident from the above examples given in the Act that if the business is an office, shop, factory, warehouse, farm or other structure, then the one-year criteria must be satisfied. This, I believe, can be done historically (i.e. business already in existence for more than one year), or it can be proved that the business will continue to be used by the CFC for a period of not less than one year (in the case of a newly established business). Inthe case of a construction site or installation of buildings, bridges, roads, pipelines, heavy machinery or other projects of comparable magnitude, the six-month criteria will need to be satisfied.23 According to National Treasury's Detailed Explanation to Section 9D of the Tax Act (June 2002), the six-month requirement is designed simply to ensure that the CFC is providing an activity that amounts to more than a momentary service.24
22 Brincker, Honiball and OlivierInternational Tax: A South African Perspective(2003) 175.
23 Jooste, in his analysis of 'The Imputation of Income of Controlled Foreign Entities', states that due to these periods not being of a substantial length of time, and the fact that in most cases an enquiry will be done long after the date of receipt or accrual, it will therefore be easy for the courts to decide whether the one year or six month period as described here has been satisfied. (Jooste 'The Imputation of Income of Controlled Foreign Entities' (200 I) 118 South African Law Journal 488).
24 National Treasury'sDetailed Explanation to Section 9D ofthe Tax Act(June 2002) 9.
Mines, construction sites, farms and fishing operations are all deemed to be business establishments without having to satisfy the additional economic substance and business purpose test. This is because of the extreme difficulty associated with trying to fabricate operations of these kinds which have a fixed nature. There are also no time limits applicable for mining and fishing operations due to the fact that a one-year period will more than likely always be satisfied with respect to these kinds of operations.25 Brincker, Honiball and Olivier(2003)26 also comment that although a company that operates a vessel or aircraft solely for transport purposes need not have a place of business in the foreign country, it has to operate within a single country. This emphasis on operation within a single country is due to the tax planning opportunities that exist with regard to international transportation.
4.2.1.2 Suitably equipped
The second requirement for the definition of 'business establishment' to be satisfied is that such a place of business must be suitably equipped with on-site operational management, employees, equipment and other facilities for the purposes of conducting the primary
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operatlons0 suc usmess.
The term 'suitably equipped' is not defined in the Act. From its usage in section 9D(9)(b), it seems to qualify 'permanent establishment' and require it to have such physical, human and financial support bases as are sufficiently necessary for conducting the controlled foreign company's principal business.28 In other words, the business must possess the funding, business premises, facilities and suitably qualified and skilled employees as is appropriate for the type of business concerned.29
The 'suitably equipped' criterion attempts to ensure that a business does not qualify as a business establishment purely on the basis of the form that is presented. Businesses involving purely paper-based transactions or a business that is conducting passive income- generating activities which may be disguised as something more substantial are therefore
25 Also see Brincker, Honiball and OlivierInternational Tax: A South African Perspective (2003) 176.
26 Ibid.
27 Section 9D(9)(a) (i) of the Act.
28 MacheliA Critical Legal Analysis ofthe Regimefor the Taxation of Controlled Foreign Entities in Terms of Section 9D of the Income Tax Act No. 58 of 1962 (Unpublished PhD dissertation, University of Natal, Pietennaritzburg) (2000) 294.
29 SilkeSouth African Income Tax Vol I SS 5:40.
excluded.30 There is no objective standard of proving whether a business constitutes a permanent establishment. Once again, the courts will need to rely on the facts of each given case.
Anexample of a business that satisfies both the permanence and independence and suitably equipped criteria would be the following:31
SA Co (a company resident in South Africa) owns all the shares in CFC (X), a company that manufactures a drug in a factory in country Y to sell to other CFCs of SA Co. The factory is leased by CFC (X) in terms of a three-year lease. The manufacturing equipment in the factory is owned by CFC (X) and it employs twenty employees to run the factory and to keep the books. All security, cleaning and other incidental functions are contracted out. In these circumstances, because there is a place of business (the factory) which is to be used by CFC (X) for a period of not less than a year, the 'permanence and independence' criterion is satisfied. The suitably equipped criterion is also satisfied because the business is suitably equipped with on-site operational management, employees and equipment to conduct the primary operations of the business. The functions contracted out are incidental.
An example illustrating the absence of the suitably equipped criterion but satisfying the permanence and independence criterion is the following:32
SA Co (a company resident in South Africa) holds all the shares in CFC (X) located in countryY.
CFC (X) owns a block of flats in country Y. All the day-to-day administration, maintenance and related operations involved in the leasing of the flats are conducted by an independent contractor.
CFC (X) has an office in country Y, which is under a five-year lease. This office is occasionally occupied by an employee of CFC (X) and is where the accounting and bookwork is performed. In these circumstances the 'permanence and independence' criterion is satisfied, but not the 'suitably equipped' criterion. CFC (X) does not have a place of business that is suitably equipped to conduct the primary operations of the business. The primary operations are performed by an independent contractor.
The following example has been extracted from National Treasury's Detailed Explanation to Section 9D ofthe Tax Act(June 2002) and illustrates further the absence of a business establishment:33
30 Jooste 'The Imputation of Income of Controlled Foreign Entities' (200 I) 118 South African Law Journal 488. Also see National Treasury's Detailed Explanation to Section 9D ofthe Tax Act (June 2002) 13.
3\ Jooste op cit 488 (adapted).
32 Jooste op cit 489.
33 National Treasury's Detailed Explanation to Section 9D ofthe Tax Act (June 2002) 10.
Example Facts: South African Company owns all the shares of CFC, a company located in a tax haven. CFC owns a lOO-unit apartment building located in Country X. CFC hires an independent contractor to run all the daily operations of the apartment building, paying the independent contractor a flat annual fee. CFC has two office employees located in a Country X office. The Country X office has been leased for many years; the two office employees occasionally visit the apartment buildings; and all the apartment accounting functions are handled at the Country X office.
National Treasury's response: The CFC does not have a business establishment. The CFC lacks economic substance in running the primary daily operations of the business, all of which are conducted by the independent contactor.
Itshould also be noted that in order for the business establishment exemption to be granted, there should be a direct relationship between income and a controlled foreign company's permanent establishment.34 This effectively means that the volume of financial resources, facilities and employees of the establishment must correspond to the volume of business being conducted. Although to qualify for the business establishment exemption, the establishment needs to satisfy the 'permanence and independence', 'suitably equipped' and utilised outside the Republic for a 'bona fide business purpose' criteria35, the Act does not place any restrictions on the type of business being conducted. For example, it is also possible for the principal business activity to be money lending, in which case the facilities should be adequate for the type and volume of business being conducted.36