Section 9D(2)(a)(i) provides that there shall be included in the income for the year of assessment of any resident who holds any participation rights in a controlled foreign company:
,...where that foreign company was a controlled foreign company for the entire foreign tax year, the proportional amount of the net income of that controlled foreign company determined for that foreign tax year, which bears to the total net income of that company during that foreign tax year, the same ratio as the percentage of the participation rights of that resident in relation to that company bears to the total participation rights in relation to that company on that last day... '
However, a resident referred to in section 9D(2) will be excluded from its operation in tenns of section 9D (2)(A):81
'where such resident (together with any connected person in relation to such resident)
(i) at the end of the last day of the foreign tax year of the controlled foreign company; or (ii) in the case where that foreign company ceased to be a controlled foreign company during
the relevant foreign tax year, immediately before that foreign company so ceased to be a controlled foreign company,
in aggregate holds less than 10 percent of the participation rights in that controlled foreign company'.
According to National Treasury'sDetailed Explanation to Section 9D of the Tax Act(June 2002)82 the lO percent threshold prevents section 9D from applying to minority owners who have no practical say over the company's affairs.83
79 As discussed earlier, this is not a requirement in terms of South African CFC legislation.
80 Sandler Controlled Foreign Company Legislation (1996) (OECD) 38.
8\ Section 9D(2A) proviso.
82 National Treasury's Detailed Explanation to Section 9D ofthe Tax Act (June 2002) 5.
83 The 10 percent rule is in essence a minimum ownership requirement for the imputation of income in terms of section 90.
The above 10 percent rule is illustratedinthe following example:
South African Company A (incorporated in the Republic) holds 48 percent of the shares in a Foreign CompanyB. Mr C, a South African resident owns a further 7 percent of the shares. Foreign Company B will meet the definition of a CFC, as it is being controlled by South African residents to the extent of holding more than 50 percent of the participation rights (being South African Company A and Mr C). However, income earned from the CFC can be imputed to company A in terms of section 9D, but not to Mr C because he holds less than 10 percent of the participation rights.84
It appears from the wording in the legislation regarding the 10 percent rule that it is possible for a foreign company to satisfy the requirements of being a controlled foreign company but at the same time not have any of its income imputed to South African residents. Consider the following example of the National Treasury:85
Example Facts: Foreign Company X has issued 100 shares, each of which is owned by a separate South African resident, none of whom are connected to one another.
Result: Even though Foreign Company X qualifies as a CFC and is controlled by South African residents, none of these shareholders satisfy the 10 percent threshold.
I submit that the above 10 percent threshold can be manipulated in an instance in which, for example, six South African residents who are connected persons each hold 9 percent of a foreign company. This will result in the foreign company being a CFC but no income imputed to the residents. The fact that they are connected persons is irrelevant in terms of section 9D. Macheli86 is of the same view and comments that in order for a minimum threshold limit to be effective, it must be supported by indirect and constructive ownership rules to prevent anti-avoidance through the splitting of ownership interests among related persons. As discussed earlier, there are no constructive ownership rules in South Africa and it appears that the legislation in the use of the term 'indirect' refers only to holdings through another company. Thus, the 10 percent minimum threshold rule as it stands is vulnerable for the reasons discussed above.
84 Jooste 'The Imputation of Income of Controlled Foreign Entities (2001) 118 South African Law Journal 478. It should also be noted that if Foreign Company B is a listed company or scheme or arrangement as contemplated in paragraph (e)(ii) of the definition of 'company' in section I of the Act and Mr C holds less than 5 percent of the participation rights (for example, 3 percent), then Mr C together with Company A hold more than 50 percent of the participation rights, but Mr C will not deemed to be a resident in terms of s 9D(I) sv 'controlled foreign company' and hence the foreign company will not be deemed to be a controlled foreign company.
Also see National Treasury's Detailed Explanation to Section 9D of the Tax Act (June 2002), 9, for a similar example.
8S National Treasury'sDetailed Explanation to Section 9D ofthe Tax Act (June 2002) 5.
86 MacheliA Critical Legal Analysis ofthe Regime for the Taxation of Controlled Foreign Entities in terms ofSection 9D of the Income Tax Act No. 58 of /962 (Unpublished PhD dissertation, University of Natal, Pietermaritzburg) (2000) 220.
In determining whether the above 10 percent rule is applicable to a particular resident, it should be borne in mind that only direct holdings of participation rights by the resident and connected persons in relation to such resident are to be taken into account.
Another important aspect with regard to the 10 percent rule is that it applies to the shareholding on the last day of the financial year.87 Once again, this opens this proviso to manipulation, as it appears to lend itself to investors entering into agreements to dispose of part of their interest shortly before the CFC's year-end and re-acquiring it shortly after the year-end in order to avoid the application of s 9D. Itremains to be seen if this aspect of the legislation regarding the 10 percent threshold will be changed to include provisions similar to those ofs 9D(2)(a)(ii) and s 9D(2)(b).
As new CFC legislation was enacted into South Africa, businessmen and entrepreneurs who had already set up structures earlier now began to look closely at the legislation.
Some of the possible methods of avoiding section 9D included:
• not to control the foreign company as defmed by this section;88
• structuring your foreign operations so as to legally meet one. of the exemption criteria in terms of section 9D(9); or
• not holding greater than 10 percent of the participation rights if you are aware that South African residents collectively hold greater than 50 percent of the participation rights in that foreign company and thus control it.
The above appear to be three simple escape methods in order to avoid the application of section 9D. However, they are much more difficult to achieve than they initially appear especially when it comes down to the loss of control of the foreign company, restructuring of operations and so on. Furthermore, the requirements that need to be satisfied in order for the exemptions to be met are onerous. These exemptions are dealt with in detail in the next chapter.
87 Section 9D (2A) (i) and (ii).
88 This will normally apply where there are a few shareholders from different countries holding large portions of the participation rights in a foreign company. However, the option of controlling the company, in more cases than not
will outweigh the application of section 9D. '
CHAPTER 4
EXEMPTIONS IN TERMS OF SECTION 9D(9)