It has been over two months since the Constitutional Court ruled in favour of Coronation Investment Management SA in its long-running battle with the South African Revenue Service (SARS).  The Constitutional Court ruled that the Coronation group had properly established an exempt foreign business establishment under section 9D of the Income Tax Act via its Irish investment fund subsidiary.  Many had expected National Treasury to overturn the Court’s decision in its latest tax bills released on 1 August 2024, but these tax bills omit any consideration of the Constitutional Coronation decision.

It is doubtful that this silence will last for long.  While the current tax bills are silent, it is most likely that an immediate legislative response to Coronation was viewed as outside the scope of the National Treasury legislative mandate set on Budget Day on 21 February 2024.  Tax planners should probably not count on this silence lasting for Budget Day 2025.

Factual background

For those unfamiliar with the facts, precisely at issue was the nature of the activities of an Irish investment fund subsidiary of Coronation – i.e. whether the Irish subsidiary’s activities qualified as a fixed place of business that was suitably staffed and equipped for conducting “the primary operations of the business.”  Activities of a foreign subsidiary are exempt from current taxation if actively engaged offshore because these foreign activities must be able to compete with local foreign businesses (which also operates outside the South African tax system).  The key point of the business establishment test is to ensure that businesses of South African owned foreign subsidiaries have sufficient economic substance to justify exemption.

The Coronation parent company had various subsidiaries.  Of note was an Irish subsidiary called Coronation Global Fund Managers (Ireland) Ltd, which was licensed as a fund management company of various investment products.  The Irish subsidiary delegated its investment management trading activities to South African and United Kingdom group subsidiaries.  SARS asserted that the related investment management trading activities were the real primary business that could not be outsourced, meaning that the Irish subsidiary lacked the requisites of a foreign business establishment. Coronation to the contrary position asserting that the primary operations was indeed the fund management business, thereby constituting a legitimate foreign business.  Agreeing with Coronation, the Constitutional Court essentially held that fund management was the real primary business as opposed to investment management trading.

Why was SARS so upset?

There are two problems.  One is generic.  What is the business that requires substance?  Who defines that business – the taxpayer or SARS?  In this case, it appears that the Constitutional Court favoured the taxpayer’s view, perhaps for good reason.  The Irish subsidiary was given a specific license solely to conduct the fund management business as opposed to the investment management trading business.  Proof existed that this fund business operated like other separate businesses in the region.  From an enforcement matter though, SARS may lack the ability to control the business definition when the facts are typically more directly under taxpayer control.

A second issue may have been operating more subtly in the background. While the fund management or investment trading businesses may technically qualify as a business, one should take note that the underlying assets of the business are nothing more than financial instruments.  Although the Irish fund was paid for services rendered, payment was based on a direct percentage of assets under management.

As a general rule, financial instruments are excluded from the business establishment exception.  It should also be noted that foreign collective investment schemes could potentially fall within the controlled foreign company definition.  The only specified relief for foreign collective investments is for certain less than 5 per cent unit holders (paragraph (iii)(bb) of the definition of “controlled foreign company” under section 9D(1)).

Unfortunately for Government, there is a key exception to the financial instrument business establishment disqualification.  Financial instruments can qualify as part of a business establishment if:  (i) those instruments are  “attributable to the subsidiary’s principal trading activities”, (ii) those activities constitute a bank, financial service provider or insurer, and (iii) do not constitute a treasury operation or a captive insurer (section 9D(9A)(iii)(aa)).  Query whether a foreign fund manager is a “financial service provider”.

The term financial service provider is not defined in the Income Tax Act.  However, this term is defined under the Financial Advisory and Intermediary Services Act (FAIS), 2002 (an act that pre-dates the financial service provider language in section 9D of the Income Tax Act).  Under definitions to the FAIS Act, a financial services provider “means any person, other than a representative, who as a regular feature of the business of such person (a) furnishes advice, furnishes advice and renders any intermediary service; or renders any intermediary service.”  Hence, it seems that National Treasury may have specifically (and possibly inadvertently) recognised the trust fund management business given that an intermediary, such as a fund manager, could be viewed technically as a financial service provider.

What about transfer pricing?

It should be noted that SARS may have been motivated to act by the lack of hard substance in the Irish subsidiary.  The subsidiary had only four employees (a managing director, two accountants and a compliance officer) and a correspondingly sized office.  Although a transfer pricing report seems to have been in evidence, query whether that report specifically dealt with the allocation of profits to the Irish subsidiary.

In short, it is not enough for a CFC to have a business establishment.  The exempt income must be attributable to that establishment from a transfer pricing analysis.  This is similar to the permanent establishment analysis, which also required a transfer pricing analysis for determining whether business profits are attributable to a permanent establishment (Article 7(2) of the OECD Model Treaty and paragraph 7.2.11 of the OECD Commentary).

Query how much of the group’s income can be attributable to a four person team?  It is hard to imagine that profits attributable to such a small team could give rise to an R800 million dispute (even after taking into account interest and penalties).

What can or should the Treasury do?

At issue is whether the fund management business was really the type of business Treasury explicitly sought to exempt despite the probable explicit language to the contrary?  If so, the law should remain in place and SARS was misguided in its attempt to collect additional revenue from the taxpayer.

On the other hand, the functions appear to be secondary in terms of value to the overall Coronation group and are also highly mobile (given regulatory framework options of this nature are available globally, especially amongst low tax jurisdictions).  The fund management does not appear to be client-facing nor the value-add of allocating/controlling specific products as would be expected of the investment trading arms.  The subsidiary seemingly had little proportional expense in terms of payroll and tangible assets (see the substance-based income exclusion of Article 5.3 of OECD Pillar Two Inclusive Framework).  If National Treasury indeed agrees that businesses of this nature are problematic, one could reasonably expect a clarification of the term financial service provider to exclude certain forms of financial intermediaries from the term “financial service provider”.

What National Treasury should not do is alter the core definition of foreign business establishment so as to disrupt the foreign subsidiaries of all South African multinationals.  The business facts of Coronation are highly unique and not reflective of the industry as a whole.  If concerns of avoidance exist, more efforts should be made for SARS to enforce the transfer pricing aspects of attributing income to foreign business establishments with minimal employees and physical assets.

Written by South African Institute of Taxation CEO Professor Keith Engel