It follows that South African residents cannot avoid tax on South African income by operating through CFCs located within the South African tax treaty network. This is fair because the income would have been taxed if earned directly by the South African residents. I submit that this exemption prevents the same income actually being taxed twice, and the underlying objective of CFC legislation is to see to it that the income of a CFC which is not subject to any of the exemptions in terms of section 9D(9) is taxed once and does not in its entirety escape the South African tax net.76
The following example IS used to explain the application of the previously taxed exemption:77
Example facts: A CFC, which is resident in country Y, earns royalty income from a South African source.
Response: The royalty income will not be attributed to the South African resident as the CFC will in any event be liable for tax in South Africa as it is South African sourced income received by or accrued to a non-resident. However, should the DTA between South Africa and Country Y provide that South Africa cannot tax the income or that the income may be taxed but only at a lower rate than the rate that would have applied had the CFC been liable for tax directly, the exemption will not apply.
capital gains and twenty-seven percent80 for all other amounts (after taking into account the application of any double tax agreement).81
A designated country is one designated by the Minister of Finance in the Gazette.82
These countries may have an income tax system which is similar to that of South Africa and which has the statutory twenty-seven percent rate referred to by the Minister in compliance with any other requirement he may prescribe by regulation.83 It is worth noting that in order to qualify for designation the foreign country does not necessarily have to have a double tax agreement with South Africa.84
For the exemption to apply, two requirements must be satisfied:
a) the foreign country must have a statutory rate of at least twenty-seven percent, and b) the foreign country must be a designated country.
Itis obvious that for the Minister to designate a country, the minimum statutory rate of that country needs to be twenty-seven percent. However, both of the above need to be satisfied in order to cover a situation in which, the foreign country's tax rate drops to below the required twenty-seven percent after designation. In such a case the country will no longer be considered a designated country.
A provis085
to this exemption was included in relation to jurisdictions that have progressive scales of statutory tax rates. Inthis regard, the highest rate on the scale will be
80 Section 9D(9)(a).
8\ The legislation does not deal with situations where the foreign jurisdiction may have different tax rates for different types of income (e.g. Mozambique) (Casey Deloitte and Touche Tax News 'Residence-Based System of Taxation' 5 (2000) 5).
The legislation refers to a 'statutory' rate because an effective tax rate takes into account special losses and deductions or incentives available in the calculation of the actual tax liability of a company (Mitchell and Mitchell, ABSA Presentation (200
I».
No exemption arises, however, if any person has any right of recovery of the foreign tax other than the right of recovery in terms of an entitlement to carry back losses arising during any year of assessment to any year of assessment prior to such year of assessment (s 9D(9)(a» (Casey Deloitte and Touche Tax News 'Residence-Based System of Taxation' 5 (2000) 5).
For example, in year one a CFC is subject to foreign tax on its receipts and accruals in a designated country. In a subsequent year the CFC incurs a loss which, in terms of the designated country's tax system, can be carried back to year one, resulting in a re-opening of year one's assessment and in less tax being paid in year one. This will not affect the application of the exemption in year one. (Jooste 'The Imputation of Income of Controlled Foreign Entities' (200 I) 118 South African Law Journal 485).
82 The Taxpayer 'Editorial: The Revenue Laws Amendment Act 59 of2000' (2000) 186.
83 Ibid.
84 This was previously a requirement for designation, but was eliminated by the removal of s 9E(8)(a) of the Act by section 11(I)(a) of the Revenue Laws Amendment Act 59 of 2000 with effect from years of assessment commencing on or after I January 200 I.
85 Proviso to section 9E(h)(ii) introduced by section 11 of the Revenue Laws Amendment Act 59 of 2000 with effect from years of assessment commencing on or after I January 200 I.
the statutory rate for the purpose of this section, i.e. the highest tax rate should be at least twenty-seven percent.86
The operation of the designated country exemption IS illustrated by Jooste87 using the following example:
Country X imposes tax on income at a statutory rate of thirty percent on country X source income and is a designated country. Country Y imposes tax on income at a statutory rate of ten percent on income carried by its residents. Mr Z owns all the shares in a foreign company FORCO, which is a CFC resident in country Y. FORCO generates one million rand of receipts and accruals from a source located in country X. In these circumstances, because the one million rand is subject to tax in a designated country (country X) and meets the twenty-seven percent statutory tax rate requirement, the one million rand will not be imputed to Mr Z. The designated country exemption applies. If, however, there was a double tax agreement between country X and country Y, in terms of which the one million rand was not taxed in country X, then the designated country exemption does not apply.
The following example is extracted from the Explanatory Memorandum on the Revenue Laws Amendment Act 59 of 2000 and is used to illustrate the operation of the twenty- seven percent rule:88
A South African resident owns a United States company which earns rental income from letting an office block. The United States is a designated country. The profits of the company are subject to a tax rate of 35% in the US. The profits of the company will not be imputed to the SA resident on a current basis, due to the fact that it complies with a legitimate business establishment test.
Similarly, any foreign dividend declared by the CFC from profits which were not previously imputed to the resident will also be exempt as the underlying profits would have been subject to tax in a designated country (on a similar basis to that of South Africa) at a rate of at least 27 percent.
Jooste89 states that the rationale for the designated country exemption relates to the international law requirements regarding foreign tax credits. The residence-based system of taxation permits South Africa to tax its residents on their worldwide income, including foreign source income earned indirectly through CFCs. Whenever South Africa taxes its residents on their foreign source income, international law requires that the South African tax imposed be reduced by the foreign taxes imposed on that same income.9o International
86 Casey Deloitte and Touche Tax News 'Residence-Based System of Taxation' 5 (2000) 5.
:: Jooste 'The Imputation of Income of Controlled Foreign Entities' (2001) 118 South African Law Journal 485.
SARS, 2000, Explanatory Memorandum on the Revenue Laws Amendment Bill 59 of 2000, 8.
89 Jooste 'The Imputation of Income of Controlled Foreign Entities' (2001) 118 South African Law Journal 485.
90 If this is not the case an unacceptable double counting will arise.
law demands that the country that taxes on a residence-basis must yield its tax to the country imposing tax on a sOUTce-basis.91 In South Africa this is done by way of a foreign tax rebate.92 The net effect of the foreign tax rebate system is that South Africa can only tax foreign source income to the extent that the South African tax rate exceeds the rate imposed by the foreign country in which the foreign income is sOUTced.93
To date the following designated countries have been listed:
Algeria, Australia, Austria, Belgium, Botswana, Canada, Croatia, Cyprus, Czech Republic, Denmark, Egypt, Finland, France, Germany, Granada, Hungary, India, Indonesia, Iran, Ireland, Israel, Italy, Japan, Korea, Lesotho, Luxembourg, Malawi, Malta, Mauritius, Namibia, Netherlands, Norway, Pakistan, People's Republic of China, Republic of China (Taiwan), Poland, Romania, Russian Federation, Sierra Leone, Singapore, Slovak Republic, Swaziland, Sweden, Switzerland, Thailand, Tunisia, Uganda, United Kingdom, United States ofAmerica, Zambia, Zimbabwe.94
Brincker, Honiball and Olivier (2003)95 comment that uncertainty exists as to the meaning of 'subject to tax' in another country. They focus particularly on two questions that arise:
• whether amounts that are exempt from tax still subject to tax; and
• whether amounts against which a deductionmaybe claimed are still subject to tax.
On comparing the meaning of the term 'subject to tax' in the legislation of the United States, the United Kingdom and Australia, Brincker, Honiball and Olivier (2003)96 conclude that for the purposes of South African CFC legislation, income 'subject to tax' means income that falls within a particular country's tax base. This means that for the purposes of section 9D(9)(a) the amount must have been included in the tax base of the foreign country. It is further observed that income exempt under a DTA is regarded as being exempt under the Income Tax Act of South Africa.97
91 Jooste 'The Imputation oflncome of Controlled Foreign Entities' (200 I) 118 South African Law Journal 485.
92 Section 6quat.
93 Jooste op cit 486. This means that if the foreign tax rate is higher than the South African tax rate, no South African tax will result and if it is very much the same, little South African tax will result. The designated country exemption accordingly excludes such similarly taxed income from the operation of s 9D in order to reduce the administration on Revenue.
94 Stack, Cronje and Hammel The Taxation ofIndividuals and Companies (2000) 411. Also see Brincker, Honiball and Olivier International Tax: A South African Perspective (2003) 171. Itwas announced in the 200312004 budget that the designated country list will be repealed.
95 Brincker, Honiball and Olivier International Tax: A South African Perspective (2003) 174.
96 Ibid.
97 Ibid.
4.4.1 The concept of 'cross-crediting'
A further aspect of the reasoning behind the designated country exemption relates to the prevention of what is known as 'cross-crediting'.98 The exemption prevents a taxpayer who has both high-taxed foreign source income and low-taxed foreign source income from manipulating the foreign tax credit system by balancing the one against the other. Such 'cross-crediting' is not possible if the high-taxed foreign income is excluded from the system as a result of the application of the twenty-seven percent rule.