The Constitutional Court (CC), on 21 June 2024, handed down judgment in an application for leave to appeal and an application for leave to cross-appeal against a judgment and order of the Supreme Court of Appeal (SCA) dated 7 February 2023, which had set aside a judgment and order of the Tax Court (TC). The main issue before the SCA was whether the net income of a controlled foreign company (CFC) should be included in the taxable income of its parent company, which is resident in South Africa (SA), in terms of the Income Tax Act, 1962 (the ITA); or whether the CFC is a foreign business establishment (FBE) tax exempt in terms of the ITA. This determination required an interpretation of the terms “the business of that controlled foreign company” and “the primary operations of that business” in the FBE definition.
Coronation Investment Management SA (Pty) Ltd (Coronation) is the applicant in the main application and the respondent in the cross-appeal. Coronation is a private company incorporated and registered in SA and a South African taxpayer. Coronation has various subsidiaries, including Coronation Global Fund Managers (Ireland) Ltd (CGFM) in Ireland, Coronation Asset Management (Pty) Ltd (CAM) in SA and Coronation International Ltd (CIL) in the United Kingdom. CGFM was established as a fund management company and it delegates investment management trading activities to CAM and CIL.
SARS included the net income of CGFM (a CFC) in Coronation’s taxable income and imposed an understatement penalty, an underestimation penalty for provisional tax, and interest. Coronation objected on the basis that the FBE exemption applies to CGFM and that its net income should not be included in Coronation’s taxable income, and the penalties and interest due to SARS do not arise.
On appeal, the TC ruled in favour of Coronation. It distinguished between the functions of fund management and investment management, and understood CGFM’s primary operations to be fund management (which it conducts in Ireland) and not investment management (which it delegates outside of Ireland). The TC held that CGFM meets the requirements of the FBE tax exemption. The TC dismissed SARS’ claims for penalties and interest.
SARS appealed to the SCA which reversed the TC’s decision. It understood CGFM's primary operations to include fund management and investment management (conducted outside of Ireland). The SCA held that CGFM does not meet the requirements of an FBE and Coronation is required to pay tax on CGFM’s net income. The SCA dismissed SARS’ claim for penalties.
Coronation appealed to the CC. Coronation argued that the SCA incorrectly interpreted the term FBE. Coronation argued that the SCA employed a “notional-business interpretation,” under which the business and primary operations of a CFC must be determined by having regard to the operations that the company could perform, and not what it does perform. Coronation maintained that the correct interpretation is the “actual-business interpretation,” under which the business and primary operations of a CFC must be determined with reference to what the company does, and not what it could do. Coronation submitted that it cannot perform operations that are not part of its chosen, or authorised, licensed business and that the FBE definition does not use the word “outsource” and its focus is squarely on economic substance.
SARS submitted that CGFM outsources all its licensed functions as a management company, including its primary function of investment management, to offshore entities – CIL and CAM. SARS argued that the proviso to the FBE definition permits outsourcing of the location permanence and the economic substance of a CFC, provided the requirements of the proviso are met. SARS maintained that CGFM’s delegation of functions to CIL and CAM do not meet the requirements in the proviso and CGFM does not meet the requirements of the FBE definition.
SARS brought a cross-appeal before the CC against the SCA’s penalty findings, which Coronation opposed. SARS argued that Coronation was deliberate in claiming the FBE exemption and, even if the tax position taken by Coronation was in good faith, it was not unintentional and therefore falls outside the scope of “inadvertence”, subjecting Coronation to the understatement penalty. Coronation submitted that SARS failed to engage with the evidence demonstrating that Coronation acted in good faith by relying on a tax expert opinion and did not deliberately misstate its tax liability or act with the intention to deceive. It also argued that SARS’ approach in declaring that “inadvertence” requires only a “slip of the pen” as opposed to a tax position deliberately adopted is flawed.
The CC held that the matter fell in its jurisdiction as the proper interpretation of the business of the CFC and the primary operations of the business as provided for in the ITA for the purposes of applying the FBE exemption is a question of law, as it involves forming a view on the meaning of the relevant section in the ITA. The interests of justice required that leave be granted to attain certainty regarding a matter of significant importance to the SA economy given the diverging conclusions of the TC and the SCA.
The CC held that CGFM met all the requirements of an FBE and that its net income should be exempted from tax. The CC held that SARS misconceived the central issue, the distinction between fund management and investment management. The CC found that the SCA committed the same error leading to its incorrect conclusions. Per its business plan, presented as part of its licence application, CGFM employed a delegated business model through which it could conduct specified fund management functions, and would delegate investment management trading activities (which it is not authorised to do by its licence) to competent third parties, CAM and CIL, while retaining overall supervision of, and responsibility to the regulator for those functions.
CGFM performed a number of core licensed management functions, including the supervision of delegates like CAM and CIL as investment managers. Its day-to-day operations in Dublin in pursuit of these management functions met the “economic substance” requirements of an FBE, namely that the company must have a fixed place of business which is suitably staffed and equipped to conduct the primary operations of its business, namely the provision of fund management in terms of the delegation model. The CC held that the TC was correct that CGFM qualified for tax exemption.
The CC considered the flaws in the reasoning and outcome of the SCA that held that “the regulations indicate that the purpose of delegation is to enhance the efficiency of the company’s business. It does not detract from the business of the company, nor is it possible for delegation to alter that business.” The CC found that in adopting this “notional business” approach (so termed by CIMSA’s counsel), the SCA erred in its holding that CGFM does not meet the requirements of an FBE exemption and, instead, the net income of CGFM is imputable to CIMSA. The CC explained that the SCA should have had regard to CGFM’s business model (the manner in which it elects to do business) and its licensing conditions (what it may lawfully do). The CC also held that the SCA failed to distinguish between investment management in its wide sense and investment management trading, the narrower concept.
The ultimate effect of the SCA’s erroneous “notional business” approach is that CGFM’s primary business is that which it calculatedly chose not to do, did not apply to do and by law was not able to do, namely investment trading. The CC argued that it is inconceivable that the business of a CFC is everything that the CFC can in theory and notionally do in pursuing a commercial endeavour, even if that company does not actually do it. The CC then also had regard to the SCA’s conclusions that “the FBE definition is not aimed solely at advancing international competitiveness for offshore businesses. Nor is the legislation concerned only to prevent diversionary, passive or mobile income eroding the South African tax base. It is also to limit a situation where an exemption is obtained over earnings in a low tax jurisdiction when the primary operations for the business are not conducted there.” The CC found that these statements undermine the objects of the ITA to ensure that offshore companies remain competitive in relation to their foreign rivals. The SCA lost sight of the fact that a SA company is legally constrained to move offshore to service their investor clients who want to take up the opportunities created abroad after the relaxation of foreign exchange controls.
The CC upheld the appeal and ordered that the SCA’s order be set aside with costs (reliance was placed on the Constitutional Court's Media release).