A memorable solstice day indeed—on 21 June 2024, the South African (“SA”) Constitutional Court delivered its much-anticipated verdict on the Coronation case. Before diving into this judgement and its implications for controlled foreign companies (“CFCs”), let’s recap the facts.
Recap of the Facts
The CFC legislation is outlined in section 9D of the SA Income Tax Act (“The Act”). While various exemptions apply to CFCs, this case focuses specifically on the Foreign Business Establishment (“FBE”) exemption. According to the National Treasury’s explanation of section 9D, the FBE exemption aims to ensure that the foreign company has economic substance and a legitimate business purpose for operating abroad rather than in SA.
The FBE exemption, though detailed and complex, essentially requires that the CFC operate as a genuine business capable of conducting its primary operations. This includes having a fixed place of business that is adequately equipped and staffed with both managerial and operational employees. If these conditions are met, the net income from that business is not subject to SA taxation.
This case involved a dispute between the South African Revenue Services (“SARS”) and Coronation Investment Management SA (Pty) Ltd (“Coronation SA”). Coronation SA was the sole shareholder of Coronation Global Fund Management, an Irish subsidiary (Coronation Ireland) a CFC as defined under section 9D of The Act.
For its 2011, 2012 and 2013 assessment year, Coronation SA applied the foreign business establishment (“FBE”) exemption and as a result did not impute the net income of Coronation Ireland. Essentially, this meant that Coronation SA did not include any of the net income generated by Coronation Ireland in its tax return for that year.
This led the South African Revenue Services (“SARS”) to issue an additional assessment of roughly R 800 million for Coronation SA, arguing that Coronation SA should have included Coronation Ireland’s net income in the 2011, 2012 and 2013 tax return, as they believed that Coronation Ireland did not meet the FBE exemption requirements.
Under Irish law, Coronation Ireland’s license limited it to fund management operations, prohibiting direct investment trading activities. To comply with Irish regulations, Coronation Ireland outsourced its investment trading activities to Coronation Asset Management (Pty) Ltd (“CAM”), a SA tax resident company, and Coronation International Limited (“CIL”), a UK tax resident.
This business model became the focal point of SARS’s dispute, as they viewed it as outsourcing primary operations, thereby disqualifying Coronation Ireland from the FBE exemption and cementing the beginning of what has become a landmark CFC case for SA.
Recap of the Tax Court Decision
Coronation SA objected to SARS’ additional assessment, leading to the case being heard by the Western Cape Tax Court on 21 September 2021. The Tax Court distinguished between fund management and investment management, concluding that Coronation Ireland primarily operated as a fund manager and merely outsourced its investment activities. This outsourcing did not affect Coronation Ireland’s primary operations. The court ruled that Coronation Ireland had genuine economic substance and qualified for the FBE exemption. Of course, SARS was unhappy with this decision and appealed.
Recap of the Supreme Court of Appeal (“SCA”) Decision
On 7 February 2023, the SCA adopted a different perspective, determining that Coronation Ireland’s primary operations were investment management. By outsourcing its investment management trading activities, Coronation Ireland was not adequately equipped in Ireland to perform these primary operations. This led to an unfavourable outcome for Coronation, with the SCA ruling in favour of SARS and overturning the previous decision.
Judgement by the Constitutional Court
In the new judgement, the Constitutional Court ruled that both SARS and the SCA did not make an adequate distinction between fund management and investment management. The Court emphasised that when interpreting “primary operations” in accordance with the FBE definition, it is crucial to determine “what the business of the CFC is”, and then to identify the “primary operations of that business.” This approach focuses on the “actual business” rather than a “notional business interpretation.”
The Constitutional Court supported Coronation SA’s view that Coronation Ireland was a fund manager, and not an investment manager. Thus, its primary operations were fund management, not investment management trading. The outsourcing of investment management trading activities was due to license limitations, which prohibited Coronation Ireland from performing these activities directly. As a result, the Court ruled that Coronation Ireland had economic substance in Ireland and met all the requirements of the FBE exemption. Consequently, its net income should have been exempted from tax for Coronation SA’s 2011, 2012 and 2013 year of assessment.
The Takeaway
The most critical principle emerging from this case is the two-step approach to determining primary operations: first, understanding the actual business of the CFC, and then identifying the primary operations of that business.
For now, all eyes are on SARS as we anticipate possible changes to the CFC legislation. If you are a CFC shareholder, it is crucial to understand the complexities of operating a CFC before you are faced with any costly surprises! Contact us today with any questions regarding CFCs and compliance matters.
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