Foreign Business Establishment

An offshore entity would normally be classified as a controlled foreign company (‘cfc’) for South African tax purposes. Even if no income or dividend is repatriated to South Africa (‘sa’), a notional amount of the income of such cfc must be included in the income of a qualifying South African resident, described here for convenience as the ‘resident’s proportional amount’ of a cfc’s ‘net income’.

There are two broad categories within the cfc rules which prevent the attribution of income from a cfc to a South African resident. The first is the so-called high tax exemption. The hypothetical question is asked whether, if the cfc had been a SA tax resident, its theoretical SA income tax payable would have been at least 67.5% of the actual foreign income tax payable.

The second is an exemption for income that is attributable to a foreign business establishment (“FBE”) in the foreign country. The concept of a ‘foreign business establishment’ (fbe) is crucial in determining whether the net income of a cfc qualifies for exclusion from the normal cfc rules, as the main category of income falling outside the ‘tainted’ category is that of amounts attributable to an fbe of the cfc. But the presence of an fbe is only the first requirement that must be met in order for a cfc to rely on the fbe exemption. The second requirement is that the specific amount must be attributable to the fbe of that cfc.

The net income of a cfc is deemed to be zero where ‘all the receipts and accruals’ of the cfc are attributable to an fbe. Where all of a cfc’s receipts and accruals are attributable to an fbe, the net income of the cfc will automatically be deemed to be zero and it would not be necessary to do any calculations in respect of the high-tax exemption.

Paragraph (a) of the definition of ‘foreign business establishment’ contains a broad general description of the term, which brings out the essential characteristics relevant to the exemption. It then goes on to list very specific requirements in sub-paras (i) – (v); and paras (b) to (g) then list specific activities that give rise to an fbe.

The term ‘foreign business establishment’ is defined as follows:

‘ “foreign business establishment”, in relation to a controlled foreign company, means—

(a) a fixed place of business located in a country other than the Republic that is used or will continue to be used for the carrying on of the business of that controlled foreign company for a period of not less than one year, where—

(i) that business is conducted through one or more offices, shops, factories, warehouses or other structures;

(ii) that fixed place of business is suitably staffed with on-site managerial and operational employees of that controlled foreign company who conduct the primary operations of that business;

(iii) that fixed place of business is suitably equipped for conducting the primary operations of that business;

(iv) that fixed place of business has suitable facilities for conducting the primary operations of that business; and

(v) that fixed place of business is located outside the Republic solely or mainly for a purpose other than the postponement or reduction of any tax imposed by any sphere of government in the Republic:

Provided that for the purposes of determining whether there is a fixed place of business as contemplated in this definition, a controlled foreign company may take into account the utilisation of structures as contemplated in subparagraph (i), employees as contemplated in subparagraph (ii), equipment as contemplated in subparagraph (iii), and facilities as contemplated in subparagraph (iv) of any other company—

(aa) if that other company is subject to tax in the country in which the fixed place of business of the controlled foreign company is located by virtue of residence, place of effective management or other criteria of a similar nature;

(bb) if that other company forms part of the same group of companies as the controlled foreign company; and

(cc) to the extent that the structures, employees, equipment and facilities are located in the same country as the fixed place of business of the controlled foreign company;

(b) any place outside the Republic where prospecting or exploration operations for natural resources are carried on, or any place outside the Republic where mining or production operations of natural resources are carried on, where that controlled foreign company carries on those prospecting, exploration, mining or production operations;

(c) a site outside the Republic for the construction or installation of buildings, bridges, roads, pipelines, heavy machinery or other projects of a comparable magnitude which lasts for a period of not less than six months, where that controlled foreign company carries on those construction or installation activities;

(d) agricultural land in any country other than the Republic used for bona fide farming activities directly carried on by that controlled foreign company;

(e) a vessel, vehicle, rolling stock or aircraft used for purposes of transportation or fishing, or prospecting or exploration for natural resources, or mining or production of natural resources, where that vessel, vehicle, rolling stock or aircraft is used solely outside the Republic for such purposes and is operated directly by that controlled foreign company or by any other company that has the same country of residence as that controlled foreign company and that forms part of the same group of companies as that controlled foreign company;

(f) a South African ship as defined in section 12Q engaged in international shipping as defined in that section; or

(g) a ship engaged in international traffic used mainly outside the Republic;’

(Definition of ‘foreign business establishment’ in s 9D(1).)

As indicated in this definition, an fbe must consist of a fixed place of business (an expression not defined) located in a foreign country that is used or will continue to be used for the carrying on of the business of the CFC for a period of not less than one year, in other words, it will not be considered to be ‘fixed’ in a temporal sense unless the business lasts for a minimum of one year (in contradistinction to occasional sales or other intermittent transactions). The one-year test allows for a one-year retrospective or prospective determination.

This general requirement is directed at ensuring that the CFC has a substantial presence in the country in which it operates. In this context, the CFC must have a fixed place of business that comprises the necessary physical infrastructure – in the form of suitable premises, equipment, personnel and facilities – to perform the primary operations of that business. The concept ‘fixed’, it is submitted, extends to include any place of business with a specific situs and a certain degree of permanence. It must be fixed in the sense that a particular building or physical location is used by the CFC for the conduct of its business, and that this building or other physical location is not merely temporary. (There are specific inclusions in the fbe definition for mining, construction, farming, shipping and other specialised businesses, but these are not relevant to this discussion.) The OECD Model, discussed further below, states that the term ‘place of business’ covers any premises, facilities or installations used for carrying on the business of the enterprise whether or not they are used exclusively for that purpose.

In addition, a ‘foreign business establishment’ must satisfy four further criteria. Three of these relate to the nature of the business and the fourth relates to purpose.

In terms of the first three criteria, which relate to the nature of the business, the fixed place must have a minimum specified structure, and employees, equipment and facilities, located in the same country as the fixed place of business. Significantly, the office, shop, factory or warehouse need not be owned by the CFC; rented premises suffice.

Paragraph (a)(i) requires the business to be conducted through one or more offices, shops, factories, warehouses or other structures. This list is illustrative and non-exclusive. Amongst others, the office, shop, or factory, must be the place through which the business is carried on. It is the decisive criterion as to when a company’s activities in a foreign country create a sufficient nexus to subject its business profits to income tax in that country. Presumably the word ‘through’ should be accorded a broad interpretation so as to permit the recognition of such operations.

But a contrary indication arises from double taxation agreements that include the definition of the treaty concept of a ‘permanent establishment’. This concept is primarily used for the purpose of allocating taxing rights where an enterprise of one state derives business profits from another. The definition commences with a basic statement of principle, namely, that ‘for the purposes of this Convention, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on’. The article then lists specific criteria as to what constitutes a PE, which include, amongst others, an office, place of management, factory or warehouse. One of the primary indications of the creation of a PE is the existence of a ‘place of management’ (not necessarily an office),1 but this factor is not explicit in the ‘foreign business establishment’ definition. The implied distinction excludes mere managerial offices that lack internal operational management, such management being one of the major functions, along with supply chains, marketing, finance and human resources. Absent the operational management function, the business would have a tenuous economic nexus with the relevant foreign country.

The requirement for the place of business to be ‘suitably staffed with on-site managerial and operational employees … who conduct the primary operations of that business’ connotes that there must be personnel who, in some way, are dependent on the enterprise and who are required to conduct the business of the enterprise in the State in which the fixed place is situated. The term ‘operational employees’ is not defined, but presumably refers to on-site managerial and operational employees who conduct the primary operations associated with the particular business of the CFC. This requirement may give rise to difficulties of interpretation where management and administration are centralised but operations are decentralised, a situation not catered for in the existing FBE exemption rules.

It could be said that the substance of the FBE exemption has not entirely kept pace with the globalisation of business and technological change that have radically altered the international economic landscape, altering long-standing patterns of productivity and transforming the way in which companies organize production, trade in goods, invest capital, and develop new products and processes.

Few companies function completely independently, and businesses form partnerships with suppliers as well as with outside contractors. Working with outside contractors, or outsourcing, enables companies to conduct their activities more efficiently and effectively. Although it would be contrary to the definition of a FBE for all the activities of a business establishment to be outsourced to third-party suppliers, some outsourcing of activities is possible. To the extent that it is provided by a group company, this is expressly recognised subject to certain conditions, as to which, see below. But which functions may be outsourced to other parties must always depend on the particular facts and, to some extent, may vary according the nature of the industry. Where outsourcing does occur, a manager should possess experience, knowledge and skills in relation to the primary business operations and must also have the authority to dismiss an underperforming outsourcing service provider. Clearly, the personnel, equipment and facilities for the critical ‘primary operations’ of a business, cannot be outsourced; but secondary operations, which are presumably determined in accordance with reference to turnover, profitability or assets employed, need not necessarily require dedicated personnel, equipment and facilities. For example, a car rental business must of course have an office with at least a manager and staff to attend to customers. But the accounting function of the business and tasks such as printing and janitorial services could easily be outsourced and may even leverage the economies of scale that the core business can offer.

The express requirement that the location of the fixed place of business must not have been chosen in order to reduce or postpone South African tax presumably envisages the situation where a decision is made to locate such a business in a low-tax jurisdiction. But the explicit qualification, expressed in the words ‘solely or mainly for a purpose other than …’, makes it clear that the mere fact of the business being located in a low-tax jurisdiction does not suffice – this must have been done with the requisite sole or main purpose. (The criterion of a ‘sole or main purpose’ replaces the previous looser requirement of a ‘bona fide’ place of business.)2 In practice, it would probably be difficult to infer such a sole or main purpose where a business is established from the outset in a low-tax jurisdiction but somewhat easier to infer where a business is relocated from a high tax to a low tax country for no demonstrable commercial reason.

Sub-paragraphs (i) – (v), dealing with the further requirements, use the phrase ‘that business’, ‘that fixed place of business’ or the ‘primary operations of that business’; but no reference is made to the business of the CFC. It would seem that the legislature did not rule out the application of the FBE exemption in respect of a CFC that has more than one fixed place of business, or one that carries on different types of businesses at a particular fixed place. The conclusion that the exemption may be relied on in respect of more than one FBE is, it is submitted, supported by the language of s 9D(9), which provides that, in determining the net income of a cfc (under s 9D(2A)), there must not be taken into account any amount that is attributable to any FBE of the cfc (and specifically not the FBE of that CFC).

Where one of the CFC’s businesses does not meet the requirements for an FBE, this should, in principle, not ‘taint’ other businesses of that CFC that comply with all the requirements of an FBE. Similarly, it may be possible for certain amounts received by a CFC to be attributable to its FBE and thereby qualify for the FBE exemption, while other amounts that are not attributable to the FBE do not qualify for the exemption and must thus be included in the ‘net income’ of the CFC.

It may happen that a CFC fails to meet the substance requirements, for example, by not renting premises in its own name or not itself employing full-time employees. Because many corporate groups separate the activities of a single business into different legal structures, the definition allows for certain activities of controlled foreign companies to be taken into account. In particular, the qualification of a cfc’s fixed place of business as a ‘foreign business establishment’, read together with the words ‘of any other company’ in the proviso to the definition of ‘foreign business establishment’, allows for structures, employees, equipment and facilities of another company in the same group of companies to be taken into account.

This ‘shared substance’ test is posited on the fulfillment of three conditions:

The infrastructure and employees of a CFC that are being used to provide substance for a second CFC must be situated in the same country as the FBE of the second CFC.
The other foreign controlled company (the CFC whose infrastructure and employees are being shared) must be subject to tax either by virtue of residence, place of effective management or other criteria of a similar nature in the same country as the fixed place of business at issue (that is, in the same country where the other CFC’s foreign business establishment is located).
The other company is part of the same s 1 ‘group of companies’ as the cfc at issue. The concept of a ‘group of companies’ is defined in s 1, the main requirement being a 70% direct or indirect interest in the equity share capital by a common shareholder or that one of the companies holds 70% of the equity share capital of the other.

(Provisos to the definition of ‘foreign business establishment’ in s 9D(1)).

The term ‘subject to tax’ in those provisos, although common in the language of international tax, is not defined. Because tax treaties are expressed in more general terms than is typical of domestic legislation, this lack of a definition could be problematic, particular because the various countries that are parties to a tax treaty may attach different interpretations to the term within their domestic framework. The OECD commentary recognises this and acknowledges that, while many jurisdictions treat entities that may be exempted from certain taxes as being ‘liable to tax’, others do not.

Both of these terms may be found in the same double tax agreement, and the courts have consistently held that the phrase ‘subject to tax’ and ‘liable to tax’ are not synonymous.3 In the context of a double tax agreement, a person will be regarded as a resident of a contracting state if he is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature. On the other hand, a resident of one of the states may be exempt from tax in the other state in respect of a certain income (such as royalties) if that person is ‘subject to tax’ in the other state in respect of that income Judicial precedent in regard to the meaning of ‘subject to tax’ focuses on identifying whether a person is liable to tax in his state of residence on a specific item of income derived within the other state. The material facts in Paul Weiser v HMRC4 involved a claim by an Israeli resident that he was entitled to relief from tax in the UK on a pension from a UK pension fund in terms of a DTA between the two states. The DTA provided that the income would not be taxable in the UK if the recipient was ‘subject to tax’ on that income in Israel. It was found that the pension was exempt from tax in respect of that income under Israeli law and therefore that Mr Weiser was not subject to tax in Israel on the pension amount and that the UK was permitted to tax the amount.

Berner J accepted the proposition that there is an internationally recognised distinction that accords the expression ‘liable to tax’ a broader meaning than ‘subject to tax’. Thus, ‘liable to tax’ requires only an abstract liability to tax on income in the sense that a contracting state is entitled to tax the income in question. By contrast, ‘subject to tax’ requires income to be within the charge to tax in the sense that a contracting state is obliged to include the income in question in the computation of the individual’s taxable income, without the possibility of exemption, with the result that tax will ordinarily be payable on that income, subject to deductions for allowances or other similar relief.

Thus, a person is regarded as ‘subject to tax’ if, for example, he or she does not pay tax because his income is so low as to be offset by personal allowances. But a person or entity is not regarded as ‘subject to tax’ if the income in question is exempted from tax in terms of a statutory exemption from tax on such income, for example where the income is that of a tax-exempt charity or a tax-exempt superannuation scheme or pension fund.

The expression ‘liable to tax’, as used in a double tax agreement, is contextualised by the words that follow this phrase, namely ‘by reason of his domicile, residence, place of management or any other criterion of a similar nature’. The Commentary on Article 4 of the OECD Model Tax Convention on Income and on Capital provides the following clarification:

As criteria for the taxation as a resident the definition mentions: domicile, residence, place of management or any other criterion of a similar nature. As far as individuals are concerned, the definition aims at covering the various forms of personal attachment to a State which, in the domestic taxation laws, form the basis of a comprehensive taxation (full liability to tax).

‘Liability to tax’ is thus understood as referring to a requirement to submit to the tax laws of a particular country because the person in question has a ‘personal attachment’ to the state in question in that he fulfils the requirements for being regarded as tax resident. This may be contrasted with the situation where a person is required to pay tax in a particular fiscal jurisdiction on particular income only because that income was derived from a source within that jurisdiction, and not because the person was a tax resident.

Although the definition of ‘foreign business establishment’ in South Africa’s Income Tax Act contains elements of the definition of ‘permanent establishment’ in the OECD and UN Model Tax Treaties, the definitions are not identical. Thus, in the South African legislation there is no need in terms of the definition of ‘foreign business establishment’ to determine whether the place of business is conducted with the necessary degree of permanency, that it falls within one of the excluded categories, or that it is deemed to be a permanent establishment.

Nonetheless, it is likely that the South African courts will have regard to and (save where there is inconsistency with domestic tax legislation) will probably follow, the interpretation that has been assigned to terms such as ‘fixed place of business’ in the context of the OECD Model Tax Treaty.5

Guidance to be derived from the OECD Model

In terms of the OECD Model, the expression ‘fixed place of business’ is regarded as connoting that the business has a specific geographical location (this is sometimes referred to as the location or ‘situs’ test) with a degree of permanence at each such geographical position (referred to as duration test).6

The location or situs test requires that the place of business is permanent or at least fixed at a particular locality. It is no longer regarded as necessary that the place of business be affixed to the soil, and it is now taken to be sufficient that a particular place is available for the performance of a business activity, for example, a market place.

The duration test requires a degree of permanence at the relevant geographical location. The period is taken to commence when activities start at the place of business and to terminate when the business activities cease at that location. There is no rule as regards the minimum period of time required to satisfy the duration test.

The enterprise must carry on its business wholly or partly at the fixed place of business; mere physical presence at that locality does not suffice.

1 The OECD Commentary points out in para 13 that the term ‘place of management’ is mentioned separately because it is not necessarily an office.

2 The previous criterion in this regard was that the place of business be ‘used for bona fide business purposes (other than the avoidance, postponement or reduction of any liability for payment of any tax, duty or levy imposed by this Act or by any other Act administered by the Commissioner’.

3 See, for example, General Electric Pension Trust v Director of Income-tax (International Taxation) Mumbai (2005) 8 ITLR 1053.

4 [2012] UKFTT 501 (TC).

5 The Organisation for Economic Co-operation and Development (‘OECD’) is the legal successor, as from September 1961, to the Organisation for European Economic Co-operation (‘OEEC’) which came into being on 16 April 1948. At its inception the OECD consisted of the European founding countries of the OEEC plus the United States of America and Canada. Since then, the membership of the OECD has expanded considerably. The first draft of the OECD Model Tax Convention was released in 1958 and became the basis of bilateral tax treaties to avoid double taxation (inter alia by regulating the fiscal aspects of cross-border transactions) and to counter tax avoidance. There are currently several thousand such treaties across the world, based on the OECD model. In such treaties, the concept of a ‘permanent establishment’ plays an important role. In terms of the OECD model treaty, where there is a permanent establishment in a particular country, that country has a right to tax profits attributable to that permanent establishment in terms of its domestic law, even if the permanent establishment is not a separate legal entity. In other words, the concept of a ‘permanent establishment’ marks the dividing line between a business that merely trades with a particular country (where some of its income consequently has its source and where such income can thus be taxed on the basis of the source principle), and a business that trades in that country. If an enterprise has a permanent establishment in a particular country, it is regarded as having a sufficiently substantial presence in that country to be regarded as trading in that country.

6 Generally in this regard, see Vogel, Double Taxation Conventions, Kluwer Law and Taxation, London (1997); Baker, Double Taxation Conventions: a Manual on the OECD Model Tax Convention on Income and Capital, Sweet and Maxwell, London (2012); Olivier and Honiball, International Tax – a South African Perspective, SiberInk, Johannesburg (2011).

Reprinted with permission from LexisNexis

Professor Emeritus Alwyn de Koker

Professor Emeritus Bob (RC) Williams

June 2014

de Koker, A P & Williams, R C Silke on South African

Income Tax (Durban: LexisNexis 2014)