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Controlled foreign companies – sharing substance

22 June 2016   (0 Comments)
Posted by: Author: PwC South Africa
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Author: PwC South Africa

SARS recently called into question the right of resident companies to claim exemption from imputation of the income derived by a controlled foreign company ('CFC') in relation to a resident through a foreign business establishment ('FBE'). Resident companies that have an interest in one or more CFCs should therefore ensure that they are familiar with the way in which a CFC may establish the existence of an FBE, particularly where the FBE status is reliant on 'shared substance'.


A South African resident with an interest in a CFC may be taxed on the net income of that CFC, subject to certain exclusions and exemptions. A CFC is defined as a foreign company in which more than 50% of the participation rights or voting rights are (directly or indirectly) held by SA residents. An amount equal to the net income of the CFC will be included in the SA resident’s income in the proportion of such resident’s participation rights to the total participation rights in the CFC.

There are several exemptions in s9D, and one of the most commonly applicable exemptions is the so-called 'foreign business establishment exemption' in terms of section 9D(9)(b) of the Income Tax Act.

FBE exemption explained

The net income of a CFC that is attributable to an FBE of that CFC is exempt, provided that the exemption is not denied under specific anti-diversionary rules and passive income rules found in section 9D(9A). Thus, when determining whether the FBE exemption applies, three critical questions to ask are:

(i)  does the CFC have an FBE;

(ii) what income is attributable to the FBE; and

(iii)do any anti-diversionary or passive income exceptions apply?

The critical issue is therefore whether the CFC derives income through a FBE.

Substantial economic presence

The general requirement of the FBE definition is directed to ensuring that the CFC should have a substantial presence in a country in which it operates. In this regard, the CFC must have a 'fixed place of business' that comprises the necessary physical infrastructure — in the form of 'suitable' premises, staff, equipment and facilities — to perform the primary operations of that business. (There are specific inclusions in the FBE definition for mining, construction, farming, shipping and other specialised businesses, but these are not relevant to the present discussion.)

Shared resources

It may happen that a CFC does not itself meet the substance requirements, for example by not renting premises in its own name, or not itself having full-time employees. However, it is able to carry on its business because it can occupy premises of another CFC and utilise the facilities and employees of that other company. In these circumstances, a proviso to the FBE definition allows the first-mentioned CFC to qualify for the FBE exemption.

This 'shared substance' proviso has three conditions:

  • The two CFCs must both form part of the same 'group of companies'. This 'group' concept is defined in section 1 of the Income Tax Act — the main requirement being that there is 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. 
  • 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 CFC whose infrastructure and employees are being shared must be 'subject to tax … by virtue of residence, place of effective management or other criteria of a similar nature' in the same country where the other CFC’s FBE is located.

It is this third requirement that is the cause of confusion in many instances. The particular issue is whether the CFC in question is 'subject to tax' in the same country in which the other CFC’s FBE is located.

Subject to tax

The words used in the proviso are (arguably) unfortunate. The term 'subject to tax' is common in international tax and appears frequently in double tax conventions. Consistent language is applied in double tax conventions and a distinction may be drawn between the terms 'liable to tax' and 'subject to tax'. Both of these terms may be found in the same double tax agreement ('DTA'), and courts have been quick to identify that they are conceptually different and should be interpreted and applied differently.

In the context of a DTA, a person will be regarded as a resident of a contracting state if that person '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 item (e.g. a royalty payment) if that person is 'subject to tax' in the other state in respect of that income item.

Precedent on the term 'subject to tax' is concerned with identifying whether a person must pay tax in his state of residence on a specific item of income derived within the other state. The United Kingdom decision of PaulWeiser v HMRC (TC02178) was concerned witha claim by an Israeli resident that he was entitled to relief from tax in the UK on a pension from a UK pension fund under 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 could tax the amount

Berner J pointed out that there is a distinction between being subject to tax and being liable to tax in the context of a DTA, and examined decisions and commentary on the meaning of the terms. Ultimately, Berner J accepted the principles put forward by counsel for HMRC, namely:

…'liable to tax' is understood to require only an abstract liability to taxation on income in the sense that a contracting state may exercise its right to tax the income in question (whether or not the exercise of that right actually results in an amount of tax becoming payable). 'Subject to tax', on the other hand, requires income actually to be within the charge to tax in the sense that a contracting state must include the income in question in the computation of the individual’s taxable income with the result that tax will ordinarily be payable subject to deductions for allowances or reliefs …

The term 'liable to tax', as used in a DTA, is contextualised by the words that follow it, 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 clarifies the concept thus:

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 has therefore been understood to refer to a requirement to submit to the tax laws of a particular country by reason that the person in question fulfills the requirements by which a person may be regarded as being tax resident. This may be compared with a person who may be required to pay tax in a particular state on income derived from that state because the income is derived from a source within that state, and not because that person is tax resident in that state.

The proviso uses the same criteria as the Model Tax Convention

The same context for liability to tax under a DTA is found in the wording of the shared substance requirements in the FBE definition. For the shared substance provision to be recognised, the CFC providing the substance must be subject to tax in the country in which the FBE of the other CFC is situated 'by virtue of residence, place of effective management or other criteria of a similar nature'. The context is clearly identifiable, and it may be safely interpreted that the term 'subject to tax' in that particular context is the same as the concept of 'liable to tax' in the language of a DTA.

For the shared substance provisions to be applied, it is not enough that the CFC providing the substance may be required to pay tax in the country where the other CFC has a FBE. The basis for that liability to taxation must be something akin to residence (e.g. incorporation or having a place of effective management in that country). Put differently, if the CFC providing substance is taxable in that state simply on the basis of 'source' or 'permanent establishment' (or something similar), this requirement would not be fulfilled. On this point, the OECD’s Commentary clarifies that the use of criteria relevant to tax residence is intentional, as it excludes circumstances in which a person '…is subject only to a taxation limited to the income from sources in that State or to capital situated in that State'.

As to the interpretation of the phrase 'other criteria of a similar nature', the reference to'similar nature' must be seen as a direct link to the concepts of residence and place of effective management. Furthermore, the ejusdem generis legal principle means that the more general term ('other criteria') following a list of more specific terms (e.g. 'residence') must be interpreted narrowly as being descriptive of criteria similar to the preceding specific terms.

How should this apply in practice?

The practical application of the 'subject to tax' requirement for shared substance may best be illustrated by way of two examples. The first of these relates to the application of the criteria:

CFC 1 is resident in Country X and has a branch in Country Y. The Y branch constitutes a permanent establishment ('PE') in Country Y, and CFC 1 is subject to tax in Country Y only in respect of the income sourced in Country Y and attributable to the PE in that country. CFC 2, a resident of country Y, does not have its own FBE premises or staff. The Y branch facilities and employees of CFC 1 are shared by CFC 2 in Country Y.

CFC 2 would NOT be able to rely on the substance of CFC 1’s Y branch, as the liability of CFC 1 for tax in Country Y only arises because CFC 1 derives income from a source within Country Y and not by reason of 'residence, place of effective management or other criteria of a similar nature'.

Furthermore, the CFC providing substance must be subject to tax in the same country as that in which the fixed place of business of the other CFC is located. This might not be the country in which the other CFC is tax-resident:

CFC 1 is resident in Country X and has a branch in Country Y, which is a fixed place of business suitably staffed and equipped to carry on the principal business of the branch. CFC 2 is also resident in Country X and also has a branch in Country Y but does not employ its own resources to operate the branch.

If CFC 2 utilises CFC 1’s infrastructure in Country Y, that infrastructure may NOT be taken into account to determine whether CFC 2 has an FBE in Country Y, because CFC 1 is not subject to tax in Country Y by virtue of CFC 1’s residence in Country Y but by reason that it derives income from a source within Country Y. The fact that both CFC 1 and CFC 2 are subject to tax in Country X is of no assistance.

The takeaway

A CFC can fulfil the substance requirements of the FBE definition by relying on its utilisation of the substance of another entity.

However, that other entity must itself be a CFC and part of the same group of companies (as the CFC).

It is not necessary that the other company should have incurred an obligation to pay tax in that other country in the year of assessment in question. However, the other entity must be tax resident in the country where the CFC’s business is located, and as a result the other state may exercise its right to impose tax on any income derived by that other entity.

Furthermore, the shared resources must also be located in the country in which the CFC’s business is located.

Taxpayers who assert that the FBE exemption applies in respect of a CFC, placing reliance on shared substance, should satisfy themselves that the CFC providing substance may be taxed in the jurisdiction in which the FBE is situated by virtue of residence, place of effective management or other criteria of a similar nature and not by reference to source or attribution to a permanent establishment.

This article first appeared on


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