Tax can be confusing and scary, and when your smart advisors throw in terms like “controlled foreign company,” it’s easy to feel overwhelmed. Fear not, fellow normal people, we’re here to tell you all you need to know about this behemoth.
Firstly, many developed countries have some sort of controlled foreign company (CFC) regime, essentially trying to extend their tax nexus to include overseas subsidiaries, especially if they seem a bit dodgy, e.g. if they pay low tax, or don’t seem to do very much. So CFC rules are just a type of anti-avoidance provision to extend the tax nexus beyond the country’s boundaries, and they focus on foreign companies which are controlled by residents in that country, hence the name. South Africa (SA) has one of the more complex CFC rules, and today we’ll demystify these and make them, if not fun, at least not too scary.
So what is CFC, anyway?
Imagine you have a South African company making widgets and paying a lot of tax, and your rich uncle suggests setting up a subsidiary in a tax-friendly jurisdiction which buys the widgets at a low price (so low profits in SA) and onsells them at a high price, thus pushing lots of your SA profits offshore to reduce your overall tax bill. Sounds too good to be true? Enter the CFC rules (as well as transfer pricing) – which say that if SA residents (companies or individuals) majority own or control a company outside SA, then SA wants to have a good look at that pie and try to eat a piece.
The CFC rules are designed to prevent South African companies from shifting profits offshore, and where they are in point the rules result in the income earned by those foreign subsidiaries being taxed in the hands of the SA parent. Cripes!
How do CFC rules work?
SA’s CFC rules operate like a giant net to captures the income of foreign subsidiaries owned or controlled by South African companies or persons. Here’s how they work:
- Ownership and Control: The first thing to understand is that SA residents need to have at least 50% of the ownership or control (and the net is very wide, based on participating interest) over the foreign subsidiary. This can be achieved through shareholding, voting rights, or other means of control. The SA residents don’t even need to be connected so this is a very wide test. Now if a CFC exists based on this, anyone who owns more than 10% of the foreign entity is required to disclose this to the SA revenue annually and perform a CFC tax calculation to determine whether any SA tax is due.
- Passive Income Threshold: SA’s tax authorities are generally more interested in passive income generated by the foreign subsidiary, in particular interest, royalties, and rental. If the foreign subsidiary’s passive income exceeds a certain threshold, it can get caught in the CFC net.
- Inclusion of Income: Once the foreign subsidiary is deemed a controlled foreign company, its passive income is added to the SA parent’s taxable income (assuming its operational income is supported by sufficient business substance, the foreign business establishment exemption). This means that the SA resident (individual or company) will be required to pay taxes on that income as if it was earned in SA.
- Exemptions and Calculations: Thankfully, there are exemptions, in particular the foreign business establishment exemption (and painful exclusions to the exemptions) as well as calculations to prevent double taxation and avoid excessive taxation. For example, a good catch-all exemption is that if the foreign subsidiary is subject to an adequate level of taxation in its home country (although this requires a painful calculation), it is generally exempt from SA CFC tax.
It is also important to remember that having a CFC requires annual SA compliance (the dreaded IT10 form), even if an exemption applies so that no SA tax is payable, so it’s important to be aware of your CFCs and any filing and tax obligations that may arise.
There you have it — South Africa’s CFC rules summarised in plain language. These rules are simply designed (but not designed simply) to ensure that South African companies don’t stash away profits in low-tax jurisdictions, protecting the country’s tax base.
This is the broad picture but the actual rules and calculations required are pretty painful, so contact us if you’d like to discuss.
About this author:
Caoilfhionn is an international tax and structuring specialist based in Mauritius who is passionate about making complex tax concepts digestible.
Contact Caoilfhionn Van der Walt at email@example.com