Amendments to CFC diversionary income rules

On July 22 2015, National Treasury released for comment the Draft Taxation Laws Amendment Bill, 2015 (DTLAB 2015), the Draft Tax Administration Laws Amendment Bill, 2015 (DTALAB 2015), and related Explanatory Memoranda.

Section 9D currently provides for diversionary income rules which seek to impute into the income of South African residents, service income derived from the performance of services by a Controlled Foreign Company (CFC) to a connected South African resident, and certain sales income derived by CFCs in relation to those residents, from the sales of goods that were sourced by the CFCs from connected parties in South Africa (so-called “CFC inbound sales”). The inbound sales rule does not apply where the CFC is located in a high-tax jurisdiction, or the income from the sale of goods is attributable to the activities of a permanent establishment of the CFC.

Prior to April 1 2012, however, the exemptions to the diversionary income rules in relation to CFC inbound sales were substantially broader, in that an exemption existed if:

• the CFC purchased those goods from an unconnected person in the same country of residence of the CFC; or
• the CFC was engaged in the creation, extraction, production, assembly, repair or improvement of goods that involved more than minor assembly or adjustment, packaging, repackaging and labelling; or
• the CFC sold a significant quantity of goods of the same or similar nature to unconnected persons at comparable prices, after taking into account whether the sales were wholesale or retail, volume discounts and costs of delivery; or
• similar goods were purchased by the CFC mainly within the CFC’s country of residence from unconnected persons in relation to that CFC.

Furthermore, prior to April 1 2012, section 9D also contained diversionary income rules in relation to the sale of goods by a CFC to a foreign resident or to unconnected South African residents where those goods were initially purchased from connected South African residents (so-called “CFC outbound sales”), unless:

• those goods purchased by the CFC from a connected South African resident amounted to an insignificant portion of the total goods; or
• the CFC was engaged in the creation, extraction, production, assembly, repair or improvement of goods that involved more than minor assembly or adjustment, packaging, repacking, and labelling; or
• the products were sold by the CFC to unconnected persons for physical delivery to customers’ premises situated in the CFC’s country of residence; or
• the same or similar products were sold by the CFC mainly to unconnected persons for physical delivery to customers’ premises in the CFC’s country of residence.

The diversionary rules relating to CFC outbound sales, however, were abolished with effect from April 1 2012 as it was felt that the transfer pricing rules could be applied as an effective alternative taxing method in this regard.

The DTLAB, 2015 proposes that both the diversionary rules in respect of CFC outbound sales and CFC inbound sales be reinstated in their pre-1 April 2012 form with effect from January 1 2016 (and will apply in respect of foreign tax years of CFCs ending during years of assessment commencing on or after January 1 2016). According to the EM, the removal of the diversionary rules in respect of CFC outbound sales resulted in the CFC rules being less effective in immediately addressing profit shifting by South African-resident companies. Transfer pricing auditing processes by their nature often take years to finalise and therefore relying solely on transfer pricing leaves the South African tax base vulnerable to profit shifting. In addition, the narrowing of the diversionary rules in respect of the CFC inbound sale of goods limited the scope of effective application of these rules.

Treasury acknowledged in the past that the previous rules were “overly mechanical” in their application, and accordingly we were anticipating that changes may have been made to the new rules to address this concern. However, this has not happened, as the rules have simply been reinstated in their previous form.