OCTOBER 2016 ISSUE 205

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1 1 OCTOBER 2016 ISSUE 205 COMPANIES Valuation of trading stock Amalgamation transactions FRINGE BENEFITS Employer-provided accommodation INTERNATIONAL TAX Interpreting double tax agreements Controlled foreign companies TAX ADMINISTRATION Electronic and digital signatures SARS s approach to the interpretation of legislation VALUE-ADDED TAX Private equity transactions SARS NEWS Interpretation notes, media releases and other documents COMPANIES Valuation of trading stock In terms of International Financial Reporting Standards (IFRS) (IAS 2), inventory is required to be disclosed at the lower of cost or net realisable value. In terms of section 22(1) of the Income Tax Act, (the Act), trading stock (other than financial instruments) must be accounted for at the cost price less such amount as the Commissioner may think just and reasonable as representing the amount by which the value of such trading stock has been diminished by reason

2 2 of damage, deterioration, change of fashion, decrease in market value, or any other reason satisfactory to the Commissioner. In both instances, a two-step approach is required: 1. Establish the cost of the trading stock. 2. Determine whether the value has diminished (i.e. whether the value of the trading stock is lower than the cost). Establishing the cost As regards establishing the cost, IAS 2 and the Act are aligned, with the exception of foreign currency hedging arrangements. IAS 2 specifies that costs will include the cost of acquiring the trading stock and such further costs as may be incurred in getting that stock into the condition and position it is in as at the accounting date. Section 22(3)(a)(i) provides that the cost price of trading stock shall include the acquisition price of the stock plus such further costs incurred in terms of IFRS (in the case of a company) as may be incurred in getting that stock into the condition and position it is in as at the end of the year of assessment Diminution in value IAS 2 and section 22(1)(a) both recognise that there may be factors that cause the value of the inventory to be less than its cost price (diminution in value). The language that they use is, however, very different. IFRS In the case of IAS 2, the concept of net realisable value is established in a particular context. One must look at the company concerned and its inventory, and identify the net cash flow that is expected to accrue to the company as a result of disposing of that inventory in the normal course of business.

3 3 IAS 2 contains the following definition: Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. The basis of recording stock at the lower of cost or net realisable value is justified in paragraph 28, where it is stated: The practice of writing inventories down below cost to net realisable value is consistent with the view that assets should not be carried in excess of amounts expected to be realised from their sale or use. In effect, the commercial world has identified that one cannot ascribe a value to an asset that is greater than the net cash flow it is expected to generate for the business. This recognises that it is not only the selling price that establishes value; costs related to securing the sale will also affect the value of the inventory. The following example supports the conceptual soundness of the proposition: X imports a product. The cost of the product is 100. X can sell the product for 150 if X delivers the product to the customer and warrants the product free of defects for 12 months. To deliver the product, X must incur transport and insurance costs of 20. In addition, the experience of X over the past five years has shown that expenditure on remediating warranty claims averages 10% of the sales turnover of the prior year. Applying IAS 2, the net realisable value would be 115, that is, 150 from proceeds on sale in the ordinary course of business, less the estimated costs of delivery and of meeting anticipated obligations under the warranty.

4 4 X would therefore reflect the inventory at cost of 100 in the financial accounts. If there were to be an adverse currency fluctuation and the cost of the imported product increased to 120, and X could not command a higher price for the product in the market, the net realisable value of the items imported at the higher rate of exchange would be lower than the cost and X would reflect the inventory at 115. When considering what a purchaser would pay for the product, the same principles apply, but in reverse. The customer (Y) will pay 150 for a product delivered with a 12-month warranty. What would Y be prepared to pay if the product had to be collected from X s factory? Logic suggests Y would seek a discount equal to the cost of transporting the product and insuring it in transit. Assume further that X is not prepared to give a warranty against defects. In such a case, it would be logical to assume that Y would demand a further discount to address the risk of encountering repair costs within that period. On the assumption that X s estimates are reasonable and verifiable by reference to trading experience, the price finally agreed is likely to approximate 115. This illustrates that net realisable value is a concept that has a sound logical foundation and that its adoption for the purpose of IFRS may be universally accepted as sound. It takes account of the context, and estimates the fair market value, of particular inventory items between a willing seller and a willing buyer who both have full knowledge of the circumstances. It establishes what a person would pay for that inventory if it were to be sold subject to the same conditions. Income Tax Act Section 22(1)(a) specifies reasons for diminution in value. These are:

5 5 damage, deterioration, change of fashion, decrease in market value or for any other reason satisfactory to the Commissioner. Comparison Section 22(1)(a) and IFRS are, in general, not inconsistent in relation to the stated reasons for diminution in value. IAS 2, at paragraph 28, begins with the following statement: The cost of inventories may not be recoverable if those inventories are damaged, if they have become wholly or partially obsolete, or if their selling prices have declined. These different words convey the same conceptual appreciation damage, deterioration, change of fashion, and decrease in market value are reasons for which the value may be diminished, as is stated in section 22(1)(a). IAS 2, paragraph 28 sets out further reasons that the commercial world accepts for recognising a diminution in value: The cost of inventories may also not be recoverable if the estimated costs of completion or the estimated costs to be incurred to make the sale have increased. In other words, the reasons acceptable to the commercial world are codified in IAS 2: the net return and, by implication, the value of the inventory may be diminished by the fact that there are costs that must be incurred in getting the inventory to the point of saleability and closing the sale at a particular price. Section 22(1)(a) goes a different route. It avoids using the universally acceptable commercial practice and instead gives the Commissioner discretion to approve which factors may reasonably contribute to a diminution in value. The partial reliance on IFRS as the basis for establishing cost, and partial rejection of the IFRS principles as the basis for determining whether the

6 6 inventory has a realisable value that is lower than cost, smacks of running with the hares and hunting with the hounds. It may be conceded that section 22(1)(a) was conceived before there were international accounting standards, and the determination of the value of inventory was not universally settled. This in itself does not justify a reluctance to move with the times and align tax practice with internationally accepted accounting principles. Is there worse to come? An amendment to section 22(1)(a) was enacted in the Taxation Laws Amendment Act, 2015 (TLAA). The amendment will come into effect from a date determined by the Minister of Finance by notice in the Gazette. The essence of the amendment is that the phrase any other reason satisfactory to the Commissioner is to be replaced by any other reason listed in a public notice issued by the Commissioner. This must be regarded as a step backwards. If section 22(1)(a) required amendment, it would have been expected that SARS would have sought to align the valuation of inventory by reference to the amount determined under IFRS. It would have been simple to state that the amount to be taken into account in respect of trading stock held and not disposed of at the end of the year of assessment shall be the net realisable value thereof, as determined under IFRS. Such a move would have been consistent with the fact that IFRS is already an element of the Act, not only in section 22. The term is defined in section 1 and is used in sections 23L, 24JB, 25BB, 28 and 29A. Reference to and reliance on IFRS on a wider basis would suggest that National Treasury considers the principles of IFRS, in relation to the matters addressed in the relevant sections, to be reasonable.

7 7 Treasury s reluctance to move with the times means that trading stock valuation will continue to be an issue for taxpayers who report their financial results under IFRS. PwC IAS 2 ITA: Sections 22, 23L, 24JB, 25BB, 28 and 29A Taxation Laws Amendment Act, Amalgamation transactions In this article, we discuss Binding Private Ruling 232 (Ruling), which dealt with section 44 of the Income Tax Act, 1962 (the Act). Section 44 states that parties to an amalgamation transaction will qualify for roll-over relief, whereby certain tax liabilities that would arise in the normal course are deferred, provided that the requirements of section 44 are met. Facts The Applicant in this Ruling is a company incorporated in and a resident of South Africa (SA). There are three Co-Applicants in this ruling, namely the amalgamated companies (ACs), which are SA resident companies that will be wound-up as part of the amalgamation transaction, the shareholders of the ACs, which are all SA resident companies and the resultant company (RC), which is also an SA resident company that will remain in existence after the amalgamation transaction. Description and nature of the proposed transaction The Applicant and the Co-Applicants decided to rationalise the administration of their businesses, which have an identical underlying nature, by amalgamating

8 8 the businesses in a single entity and terminating the existence of the existing companies. The Applicant and the Co-Applicants have significant interests in investments in fixed properties, which they hold individually or jointly. The nature of the investments is in each case similar, comprising shares in companies that own fixed property which is let to derive rental income. The amalgamation will result in the transfer of the assets and liabilities of the ACs to the RC, in exchange for shares in its corporate structure. Those shares will be issued on behalf of the ACs, after which the ACs will be wound up. The RC will issue shares of different classes. Each class of shares will be linked to a designated property investment. The holders of these shares will each be entitled to a distribution of income and capital, attributable to the income and capital generated by the designated property. The distributions will not be limited to specified amounts. In the event of a winding-up, if there is any surplus remaining after satisfying the interests of the shareholders of each class, each shareholder shall be entitled to share equally in the surplus. The rights of each class of shareholder will be documented in the memorandum of incorporation. The relevant legal provisions The provisions in the Act that are relevant for this Ruling are sections 44(1) and 1(1). Section 44(1)(a) defines an amalgamation transaction as a transaction where: 1. any resident company disposes of all of its assets (other than assets it elects to use to settle any debts incurred by it in the ordinary course of its trade and other than assets required to satisfy any reasonably anticipated liabilities to any sphere of government of any country and costs of administration relating to the liquidation or winding-up) to another resident company by means of an amalgamation, conversion or merger; and

9 9 2. as a result of which the existence of that amalgamated company will be terminated. Section 1(1) defines an equity share as any share in a company, excluding any share that, neither as respects dividends nor as respects returns of capital, carries any right to participate beyond a specified amount in a distribution. Ruling SARS ruled that the disposal by the ACs of their businesses to the RC will meet the requirements of an amalgamation transaction as defined in section 44(1). The shares of the different classes to be issued by the RC will each constitute an equity share as defined in section 1(1). Comment There are two interesting observations to make with regard to this Ruling. Firstly, the definition of an amalgamation transaction in section 44(1)(a) refers to the disposal of assets by a company which is a resident. Whereas this phrase in the definition might have suggested that there may only be one amalgamated company to qualify for the roll-over relief, this Ruling could provide support for the argument that the assets of more than one amalgamated company may be transferred to a resultant company. In other words, the Ruling could suggest that under certain circumstances, it might not be necessary for each amalgamated company to conclude a separate amalgamation transaction with the resultant company, to qualify for the rollover relief in terms of section 44. Secondly, the Ruling regarding the shares of different classes issued by the RC is important, in the context of section 44(2) and section 44(4). Section 44(2) states, inter alia, that any capital gain that would have occurred had the property

10 10 been disposed of in the normal course, will not trigger the payment of capital gains tax (CGT) and is deferred until the RC disposes of the property. However, section 44(4)(a) states that this roll-over relief will not apply to the extent that such asset is so disposed of in exchange for consideration other than an equity share or shares in the resultant company It is therefore crucial that the shares issued by the RC constitute equity shares as defined. In terms of the Explanatory Memorandum on the Taxation Laws Amendment Bill, 2010 (EM 2010), the definition of equity share was originally drafted to ensure that preference shares with limited dividend rights fall outside the definition and so that, inter alia, the benefits of section 44 only apply where equity shares are issued as consideration for the capital asset received. The Ruling seems to confirm that this was the intention. Although the distribution of the income and capital received by the shareholder of a certain class of shares is dependent on the property investment to which the class of shares is linked, such shares still constitute equity shares, as defined, provided the distributions are not limited to specific amounts. Taxpayers should still keep in mind that this Ruling is only binding on the parties to the transaction and that SARS will not necessarily adopt this approach in all similar instances. Cliffe Dekker Hofmeyr ITA: Section 1 definition of equity share and section 44 Explanatory Memorandum on the Taxation Laws Amendment Bill, 2010 Editorial Comment: Published SARS rulings are necessarily redacted summaries of the facts and circumstances. Consequently, they and articles discussing them should be treated with care and not simply relied on as they appear.

11 11 FRINGE BENEFITS Employer-provided accommodation On 14 April 2016, the South African Revenue Service (SARS) issued Binding Private Ruling 229 (Ruling), which dealt with provisions in the Seventh Schedule to the Income Tax Act, 1962 (the Act). The Seventh Schedule sets out the tax treatment of employee fringe benefits, referred to as taxable benefits. The Ruling dealt specifically with the provision of accommodation by an employer to its employees. The legal framework Paragraph 2(a) of the Seventh Schedule provides that an employee is deemed to have received a taxable benefit from his employer, if he acquires any asset consisting of property of any nature from the employer either for no consideration or for a consideration less than the value of such asset, as determined under paragraph 5(2) of the Seventh Schedule. The employee will be taxed on the cash equivalent of the fringe benefit, which forms part of a person s gross income in terms of paragraph (i) of the gross income definition in section 1(1) of the Act. Paragraph 5(2) states that the value to be placed on the asset acquired is the market value of the asset, when it is acquired by the employee. In terms of paragraph 5(1), the value of the taxable benefit will be the difference between the consideration paid by the employee and the market value of the asset. There are a number of exceptions to this general rule, one of which is contained in paragraph 5(3A), which states that no value shall be placed on immovable property acquired in terms of paragraph 2(a), provided that none of the following conditions are present:

12 12 the remuneration proxy of the employee exceeds R250,000 in the year of assessment when the immovable property is acquired; the market value of the immovable property exceeds R450,000 on the date of acquisition; or the employee is a connected person in relation to the employer. The term remuneration proxy is defined in section 1(1) of the Act and refers to the remuneration that the employee will be deemed to have received in the preceding year of assessment, where such employee was only employed by the current employer for a portion of or not at all during the preceding year of assessment. The facts pertaining to the Ruling The applicant is a mining company, whose activities are regulated by, inter alia, the Mineral and Petroleum Resources Development Act, 2008 (the MPRDA) and the Broad-Based Socio-Economic Empowerment Charter for the South African Mining and Minerals Industry (Mining Charter). Under certain provisions of the MPRDA and the Mining Charter, the applicant is obliged to improve the housing standards of its employees. To comply with these obligations, the applicant intends selling vacant stands to certain of its employees (qualifying employees). One of the terms of these sale agreements, is that qualifying employees will be obliged to erect a house on the stand at the employee s own cost within a specified time period. The purchase price of each stand will be less than its market value. SARS decision Based on the facts and legal position set out above, SARS ruled that the stands constitute immovable property as envisaged in paragraph 5(3A), but that the tax relief under this paragraph will only apply if the employee s remuneration proxy is below R250,000, the market value of the immovable property is below

13 13 R450,000 and the employee and employer are not connected persons, as indicated above. Comment Paragraph 5(3A) of the Seventh Schedule came into effect on 1 March According to the Explanatory Memorandum on the Taxation Laws Amendment Bill, 2013 (Explanatory Memorandum), one of the reasons for the introduction of this provision, was to assist employers in industries where employerprovided housing is customary, such as employers in the mining sector, who are compelled to provide accommodation to their employees in terms of the Mining Charter. The Explanatory Memorandum acknowledges that in industries where employer-provided housing is customary, such housing is often sold at below market value, but that the potential tax levied on the fringe benefit that could arise from this below-market value transfer effectively hinders the viability of these schemes. The relief provided by this provision was further aimed to encourage employer-assisted housing as part of Government s anti-poverty objectives Considering the challenges and uncertainty currently faced by the South African mining industry, the Ruling should be seen in a positive light. Furthermore, as there is currently no Interpretation Note setting out SARS position regarding paragraph 5(3A) of the Seventh Schedule, the Ruling is helpful and provides some indication of the kinds of employer-provided housing schemes, which will qualify for the relief that paragraph 5(3A) intends to provide. Cliffe Dekker Hofmeyr BPR 229

14 14 ITA: Section 1 definition of gross income and paragraph 2 and 5 of the Seventh Schedule Explanatory Memorandum on the Taxation Laws Amendment Bill, 2013 Mineral and Petroleum Resources Development Act Broad-Based Socio-Economic Empowerment Charter for the South African Mining and Minerals Industry Binding Private Ruling 229 Editorial Comment: Published SARS rulings are necessarily redacted summaries of the facts and circumstances. Consequently, they and articles discussing them should be treated with care and not simply relied on as they appear. INTERNATIONAL TAX Interpreting double tax agreements A double taxation agreement (DTA) regulates how a contracting state will impose tax on income derived by residents of the other state. However, uncertainty about taxation is not entirely resolved simply because there is a DTA in place. One of the burning issues is that the language used in a DTA is typically borrowed from a template prepared by an international agency, such as the Organisation for Economic Co-operation and Development (OECD). As the domestic law of each state uses language and principles which have been crafted by its law officers, any differences in interpretation need to be reconciled. The international templates recognise this difficulty. They provide guidance by including an article relating to interpretation, in which:

15 15 certain terms are defined specifically; and a reference point is given in terms of which each contracting state may interpret an undefined term in the manner applied under its domestic law. An example is Article 3 of the Model Tax Convention on Income and on Capital, issued by the OECD. A recent decision from the Tax Tribunal in the United Kingdom has provided an illuminating example of applying these principles of interpretation to a DTA. That this matter involved the DTA between SA and the UK adds to its relevance. The diver s dilemma In the matter of MF Fowler v HMRC [2016] UKFTT 234 (TC), the UK sought to impose tax on the revenue derived by Mr Fowler, an SA resident person who was employed as a qualified diver to undertake diving work on the UK Continental Shelf, North Sea section. The issue determined by the Tribunal was a preliminary matter, concerned with identifying which Article of the DTA between SA and the UK was determinative of the dispute. HMRC had assessed Fowler for tax on the basis that he had derived income from employment, alleging that it was entitled to do so by virtue of Article 14 of the DTA. Fowler argued that the revenue he had derived was not classifiable as income from employment but as business profits, as set out in Article 7 of the DTA. Therefore, it was not taxable in the UK. The principles

16 16 Under the relevant UK statute, the provisions of a DTA apply for (among other things) taxing the income of non-uk-resident persons that arises from sources in the UK despite anything in any enactment. The term employment is not defined in Article 3(1) of the DTA, and the Tribunal was therefore required to apply the principles set out in Article 3(2) of the DTA. This provides: As regards the application of the provisions of this Convention at any time by a Contracting State, any term not defined therein shall, unless the context otherwise requires, have the meaning that it has at that time under the law of that State for the purposes of the taxes to which this Convention applies, any meaning under the applicable tax laws of that State prevailing over a meaning given to the term under other laws of that State. The Tribunal also noted that a DTA must be interpreted in accordance with Articles 31 and 32 of the Vienna Convention on the Law of Treaties, 1969, quoting the summary of Lord Reed in Anson v Commissioners for HM Revenue & Customs [2015] UKSC 44, at 56: Put shortly, the aim of interpretation of a treaty is therefore to establish, by objective and rational means, the common intention which can be ascribed to the parties. That intention is ascertained by considering the ordinary meaning of the terms of the treaty in their context and in the light of the treaty's object and purpose. Subsequent agreement as to the interpretation of the treaty, and subsequent practice which establishes agreement between the parties, are also to be taken into account, together with any relevant rules of international law which apply in the relations between the parties. Recourse may also be had to a broader range of references in order to confirm the meaning arrived at on that approach, or if that approach leaves the

17 17 meaning ambiguous or obscure, or leads to a result which is manifestly absurd or unreasonable. The issue At the heart of the issue is section 15 of the Income Tax (Trading and Other Income) Act of the UK: 15. Divers and diving supervisors (1) This section applies if (b) a person performs the duties of employment as a diver or diving supervisor in the United Kingdom or in any area designated by Order in Council under section 1(7) of the Continental Shelf Act 1964 (c. 29), (c) the duties consist wholly or mainly of seabed diving activities, and (d) any employment income from the employment would otherwise be chargeable to tax under Part 2 of ITEPA* (2) The performance of the duties of employment is instead treated for income tax purposes as the carrying on of a trade in the United Kingdom. Fowler contended that he was employed as a diver as contemplated in this section and that the remuneration paid to him should be taxed as business profits under the DTA, not as income from employment. He relied on the interpretation placed on the nature of his activities under the tax law of the UK. This stated that his income was not regarded as employment income for income tax purposes. Brannan J was astute in pointing out that the deeming provision under which Fowler based his argument was not an isolated one and that a number of similar provisions could be found in the statute relied upon by HMRC.

18 18 HMRC asserted that the term income from employment fell to be interpreted under common usage and not by reference to the deeming provision in the domestic law. In this regard, the word shall used in Article 3(2) was not to be regarded as mandatory, but merely as an aid to interpretation. The decision The initial decision related to the application of Article 3(2) of the DTA. Brannan J noted (paragraph 99 of the decision): Article 3(2) of the Treaty mandates that any term not defined in the Treaty shall have the meaning that it has [applicable under] the tax laws of the Contracting State applying the Treaty (i.e. the UK). The meaning shall be that for the purposes of the taxes to which the Treaty applies. Parties to a DTA are required to apply the terms of the DTA in good faith, having regard to the object and purpose of the DTA. A distinction is found in the DTA between the use of the words shall and may, and the importance of the distinction was emphasised in paragraph 101, where Brannan J noted: Throughout the Treaty the words shall and may are used deliberately to indicate mandatory and permissive provisions. After providing an illustration of the different effect of these words used in the DTA in the context of dividend income and employment income, Brannan J observed (paragraph 101): The essential point is that those drafting the Treaty (and the OECD Model Convention on which the Treaty is based) were careful to use the word shall when a mandatory provision was intended The use of the word shall in Article 3(2) indicates that recourse must be had to the relevant provisions of domestic tax law in priority to any other meaning, unless the context otherwise requires.

19 19 Brannan J then examined whether the DTA contained an acceptable definition of the terms enterprise, business and salaries, wages and other similar remuneration derived in respect of an employment, and concluded that these terms were not defined, which meant that the domestic law would have to apply in defining them. Brannan J emphasised the difficulty of assimilating treaty terms with the language in domestic law, stating (paragraph 108): The terms that are at issue in this appeal, are, of course, derived from the OECD Model Convention. The OECD Model Convention is intended to apply in a standardised form to a very large number of different countries and tax codes. Its language is, therefore, in many cases conceptual rather than precise. The language of the Treaty must, for this reason, be interpreted as expressing concepts which broadly correspond to the detailed provisions of domestic tax codes. In relation to the term profits of an enterprise found in Article 7 of the DTA, the broadly corresponding term in the relevant UK legislation is profits of a trade, vocation or profession. The question then became whether the term trade in the domestic law applied in its normal usage or in terms of the extended meaning assigned in respect of the activities of a deep sea diver. Brannan J found that the term salaries, wages and other similar remuneration derived in respect of an employment for purposes of Article 14 of the DTA related to items that are regarded as taxable under the relevant provisions of the UK statute as remuneration and not as income from trade. He further justified his decision by pointing to the fact that the classification of income from diving operations as income from trade was already enacted under the UK tax law when the DTA was concluded, and provided the necessary context for his deliberations.

20 20 It was therefore decided that the income derived by Fowler was income from trade, to be dealt with under Article 7 of the DTA and not Article 14. * ITEPA: Income Tax (Earnings and Pensions) Act 2003 PwC OECD Model Tax Convention: Article 3 South Africa United Kingdom Double Tax Agreement: Articles 3, 7 and 14 Vienna Convention on the Law of Treaties, 1969: Articles 31 and Controlled foreign companies Background A South African resident with an interest in a controlled foreign company (CFC) may be taxed on the net income of that CFC, subject to certain exclusions and exemptions. A CFC is defined as a foreign company in which more than 50% of the participation rights or voting rights are (directly or indirectly) held by SA residents. An amount equal to the net income of the CFC will be included in the SA resident s income in the proportion of such resident s participation rights to the total participation rights in the CFC. There are several exemptions in section 9D, and one of the most commonly applicable exemptions is the so-called foreign business establishment (FBE) exemption in terms of section 9D(9)(b) of the Income Tax Act (the Act). FBE exemption explained The net income of a CFC that is attributable to an FBE of that CFC is exempt, provided that the exemption is not denied under specific anti-diversionary rules and passive income rules found in section 9D(9A). Thus, when determining whether the FBE exemption applies, three critical questions to ask are:

21 21 (i) (ii) (iii) does the CFC have an FBE; what income is attributable to the FBE; and do any anti-diversionary or passive income exceptions apply? The critical issue is therefore whether the CFC derives income through an FBE. Substantial economic presence The general requirement of the FBE definition is directed to ensuring that the CFC should have a substantial presence in a country in which it operates. In this regard, the CFC must have a 'fixed place of business' that comprises the necessary physical infrastructure - in the form of 'suitable' premises, staff, equipment and facilities - to perform the primary operations of that business. There are specific inclusions in the FBE definition for mining, construction, farming, shipping and other specialised businesses, but these are not relevant to the present discussion. Shared resources It may happen that a CFC does not itself meet the substance requirements, for example by not renting premises in its own name, or not itself having full-time employees. However, it is able to carry on its business because it can occupy premises of another CFC and utilise the facilities and employees of that other company. In these circumstances, a proviso to the FBE definition allows the first-mentioned CFC to qualify for the FBE exemption. This 'shared substance' proviso has three conditions: The two CFCs must both form part of the same 'group of companies'. This 'group' concept is defined in section 1(1) of the Act - the main requirement being that there is a 70% direct or indirect interest in the equity share capital by a common shareholder or that one of the companies holds 70% of the equity share capital of the other.

22 22 The infrastructure and employees of a CFC that are being used to provide substance for a second CFC must be situated in the same country as the FBE of the second CFC. The CFC whose infrastructure and employees are being shared must be 'subject to tax by virtue of residence, place of effective management or other criteria of a similar nature' in the same country where the other CFC s FBE is located. It is this third requirement that is the cause of confusion in many instances. The particular issue is whether the CFC in question is 'subject to tax' in the same country in which the other CFC s FBE is located. Subject to tax The words used in the proviso are (arguably) unfortunate. The term 'subject to tax' is common in international tax and appears frequently in double tax conventions. Consistent language is applied in double tax conventions and a distinction may be drawn between the terms 'liable to tax' and 'subject to tax'. Both of these terms may be found in the same double tax agreement (DTA), and courts have been quick to identify that they are conceptually different and should be interpreted and applied differently. In the context of a DTA, a person will be regarded as a resident of a contracting state if that person 'is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature'. On the other hand, a resident of one of the states may be exempt from tax in the other state in respect of a certain income item (e.g. a royalty payment) if that person is 'subject to tax' in the other state in respect of that income item. Precedent on the term 'subject to tax' is concerned with identifying whether a person must pay tax in his state of residence on a specific item of income derived within the other state. The United Kingdom decision of Paul Weiser v

23 23 HMRC (TC02178) was concerned with a claim by an Israeli resident that he was entitled to relief from tax in the UK on a pension from a UK pension fund under a DTA between the two states. The DTA provided that the income would not be taxable in the UK, if the recipient was subject to tax on that income in Israel. It was found that the pension was exempt from tax in respect of that income under Israeli law and therefore Mr Weiser was not subject to tax in Israel on the pension amount and the UK could tax the amount. Berner J pointed out that there is a distinction between being subject to tax and being liable to tax in the context of a DTA, and examined decisions and commentary on the meaning of the terms. Ultimately, Berner J accepted the principles put forward by counsel for HMRC, namely: liable to tax is understood to require only an abstract liability to taxation on income in the sense that a contracting state may exercise its right to tax the income in question (whether or not the exercise of that right actually results in an amount of tax becoming payable). 'Subject to tax', on the other hand, requires income actually to be within the charge to tax in the sense that a contracting state must include the income in question in the computation of the individual s taxable income with the result that tax will ordinarily be payable subject to deductions for allowances or reliefs The term 'liable to tax', as used in a DTA, is contextualised by the words that follow it, namely 'by reason of his domicile, residence, place of management or any other criterion of a similar nature'. The Commentary on Article 4 of the OECD Model Tax Convention on Income and on Capital clarifies the concept thus: As criteria for the taxation as a resident the definition mentions: domicile, residence, place of management or any other criterion of a similar nature. As far as individuals are concerned, the definition aims at covering the various

24 24 forms of personal attachment to a State which, in the domestic taxation laws, form the basis of a comprehensive taxation (full liability to tax). Liability to tax has therefore been understood to refer to a requirement to submit to the tax laws of a particular country by reason that the person in question fulfils the requirements by which a person may be regarded as being tax resident. This may be compared with a person who may be required to pay tax in a particular state on income derived from that state because the income is derived from a source within that state, and not because that person is tax resident in that state. The proviso uses the same criteria as the Model Tax Convention The same context for liability to tax under a DTA is found in the wording of the shared substance requirements in the FBE definition. For the shared substance provision to be recognised, the CFC providing the substance must be subject to tax in the country in which the FBE of the other CFC is situated 'by virtue of residence, place of effective management or other criteria of a similar nature'. The context is clearly identifiable, and it may be safely interpreted that the term 'subject to tax' in that particular context is the same as the concept of 'liable to tax' in the language of a DTA. For the shared substance provisions to be applied, it is not enough that the CFC providing the substance may be required to pay tax in the country where the other CFC has an FBE. The basis for that liability to taxation must be something akin to residence (e.g. incorporation or having a place of effective management in that country). Put differently, if the CFC providing substance is taxable in that state simply on the basis of 'source' or 'permanent establishment' (or something similar), this requirement would not be fulfilled. On this point, the OECD s Commentary clarifies that the use of criteria relevant to tax residence is intentional, as it excludes circumstances in which a person ' is subject only

25 25 to a taxation limited to the income from sources in that State or to capital situated in that State'. As to the interpretation of the phrase 'other criteria of a similar nature', the reference to 'similar nature' must be seen as a direct link to the concepts of residence and place of effective management. Furthermore, the ejusdem generis legal principle means that the more general term (other criteria) following a list of more specific terms (e.g. residence) must be interpreted narrowly as being descriptive of criteria similar to the preceding specific terms. How should this apply in practice? The practical application of the 'subject to tax' requirement for shared substance may best be illustrated by way of two examples. The first of these relates to the application of the criteria: CFC 1 is resident in Country X and has a branch in Country Y. The Y branch constitutes a permanent establishment (PE) in Country Y, and CFC 1 is subject to tax in Country Y only in respect of the income sourced in Country Y and attributable to the PE in that country. CFC 2, a resident of country Y, does not have its own FBE premises or staff. The Y branch facilities and employees of CFC 1 are shared by CFC 2 in Country Y. CFC 2 would NOT be able to rely on the substance of CFC 1 s Y branch, as the liability of CFC 1 for tax in Country Y only arises because CFC 1 derives income from a source within Country Y and not by reason of 'residence, place of effective management or other criteria of a similar nature'. Furthermore, the CFC providing substance must be subject to tax in the same country as that in which the fixed place of business of the other CFC is located. This might not be the country in which the other CFC is tax-resident: CFC 1 is resident in Country X and has a branch in Country Y, which is a fixed place of business suitably staffed and equipped to carry on the principal

26 26 business of the branch. CFC 2 is also resident in Country X and also has a branch in Country Y but does not employ its own resources to operate the branch. If CFC 2 utilises CFC 1 s infrastructure in Country Y, that infrastructure may NOT be taken into account to determine whether CFC 2 has an FBE in Country Y, because CFC 1 is not subject to tax in Country Y by virtue of CFC 1 s residence in Country Y, but by reason that it derives income from a source within Country Y. The fact that both CFC 1 and CFC 2 are subject to tax in Country X is of no assistance. PwC ITA: Section 1 definition of group of companies and section 9D Commentary on the OECD Model Tax Convention: Article 4 TAX ADMINISTRATION Electronic and digital signatures With tax litigation becoming more prevalent in recent years, taxpayers are now faced with new issues. One such issue is: when and to what extent will documents bearing an electronic signature be acceptable under the relevant tax legislation? In this regard, section 255(2) of the Tax Administration Act, 2011 (TAA) provides that the South African Revenue Service (SARS) may, in the case of a return or other document submitted in electronic format, accept an electronic or digital signature of a person as a valid signature for purposes of a tax Act if a

27 27 signature is required. Section 255(3) of the TAA then continues to state that if, in any proceedings under a tax Act, the question arises whether an electronic or digital signature of such person was used with the authority of such person, it must be assumed, in the absence of proof to the contrary, that the signature was so used. The terms electronic signature and digital signature are not defined in the TAA. However, these terms are defined in the Rules for electronic communication (Rules) which were promulgated under section 255(1) of the TAA in terms of GG 37940, Notice 644, on 25 August A digital signature is defined in Rule 1 to have the meaning assigned to an electronic signature. Electronic signature is, in turn defined through ascribing a meaning thereto in relation to a registered user and an electronic communicator. On page 36 of the SARS Electronic Communications Guide (SARS Guide), the TAA mentions both electronic and digital signatures, but because these terms are not necessarily interchangeable in terms of the Rules, when the TAA refers to a digital signature, it is specifically in the context of identification. In addition, the SARS Guide provides on page 13 that the concept of a digital signature is often used to denote encryption, rather than a signature for identification purposes. The meaning of electronic signature in relation to registered users In this context electronic signature means the user ID and access code of the user and the date and time that the electronic filing transaction was received by the information system of SARS. A user ID is the unique identification created in compliance with the requirements of Rule 6 and used by a registered user in order to access the user s electronic filing page. Further, an access

28 28 code means a series of numeric characters, alphabetic characters, symbols or a combination thereof, associated with an individual user ID. The meaning of electronic signature in relation to electronic communicators In this context, electronic signature refers to data attached to, incorporated in, or logically associated with other data which is intended by the electronic communicator to serve as a signature. An electronic communicator is a person that is obliged to or has elected to communicate with SARS in electronic form or is a person who is a registered user, for example, a registered tax practitioner registered under Rule 5. Rule 7 specifically deals with electronic signatures and states that, other than the use of a user ID and access code for the signing of electronic filing transactions, if a provision of a tax Act requires a document to be signed by or on behalf of an electronic communicator, that signing may be effected by means of an electronic signature if the electronic signature is: uniquely linked to the signatory; capable of identifying the signatory and indicating the signatory s approval of the information communicated; capable of being accepted by the computers or equipment forming part of the information system of SARS; and reliable and appropriate for the purpose for which the information was communicated. Rule 7 of the Rules further states that when considering the use of an electronic signature, an electronic communicator must specifically consider the level of confidentiality, authenticity, evidential weight and data integrity afforded by the signature.

29 29 According to the SARS Guide at page 36, because an electronic signature can be an electronic image of a signature, a symbol or even a typed name at the bottom of an , the simple act of signing on the dotted line may be slightly more challenging within the electronic environment. The challenge, of course, is that of confidentiality and security, including authenticity, evidential weight and data integrity. In light of the above, in our view, it may be argued that the information contained at the bottom of an meets the requirements set out in Rule 7 of the Rules and if the sender of an is someone who has elected to communicate with SARS in electronic form, an unsigned document attached to the would constitute data attached to other data which is intended by the electronic communicator to serve as a signature. ENSafrica TAA: Section 255 Rules for electronic communication promulgated under section 255(1) Notice 644 in Government Gazette 37940, 25 August 2014 SARS Electronic Communications Guide SARS s approach to the interpretation of legislation (Refer to Article 2547 in September 2016 Issue) On 29 April 2016 the High Court of South Africa (Gauteng Division, Pretoria) handed down judgment in an application brought by Julius Malema (Applicant) against the Commissioner for the South African Revenue Service (SARS). The matter concerned a compromise agreement concluded between them in terms of section 205 of the Tax Administration Act, 2011 (TAA).

30 30 This case is of great importance for the following reasons: the issues which emerged from the case are relevant to matters which extend beyond the mere application or interpretation of section 205 of the TAA; the arguments made by SARS point to a disregard by SARS for the circumstances of the taxpayer when interpreting legislation; and the judgment provides some indication as to the judiciary s view on SARS s approach. One of the important issues discussed in the judgment is the interpretation of the word material in the context of section 205 of the TAA. In terms of the compromise agreement, SARS would not be bound by the agreement if the Applicant, among other things, failed to make a full, verifiable and complete disclosure of all material facts to which the compromise relates or if he supplied materially incorrect information to which the compromise relates. Section 205(a) and (b) of the TAA states that SARS is not bound by a compromise if: (a) the debtor fails to disclose a material fact to which the compromise relates; or (b) the debtor supplies materially incorrect information to which the compromise relates. The TAA itself does not define the word material. Nor is there mention in section 205 of the words full, verifiable and complete disclosure and this simply appears to have been a contractual term. From the judgment it appears that SARS argued that the word material within the context of section 205 meant that anything not disclosed by the Applicant would be material. Therefore, any misstatement or failure to make a disclosure would automatically be material. In the court s view, if SARS s argument was followed to its logical conclusion, the word material \would have no effect as

31 31 any form of non-compliance with a compromise agreement, no matter how insignificant, would result in a breach of that agreement. It is then not clear why the word material is necessary or used in section 205. This is irrespective of whether or not an omission or misrepresentation actually caused SARS to enter into the compromise agreement. According to the court, the word material properly construed within section 205 appears to state that the misrepresentation or omission must, to a significant extent, induce SARS to enter into the compromise agreement or reject it. The court referred to the judgment of O Connell v Flischman (1948) 4 SA 191 (T) where it was stated that, whether a term is material to a contract may be assessed by how vital the term is. In this case SARS appears to have argued for absolute liability, regardless of the circumstances. But what happens in a case where the taxpayer is unaware of certain facts and the taxpayer or SARS only ascertains them after conclusion of the compromise agreement? What happens if there was no intention by a taxpayer to misrepresent or omit the facts, or the misrepresentation or omission was not caused by negligence on the part of the taxpayer? These are issues that the court grappled with. In the court s view, logic would dictate that any noncompliance with the terms of the compromise agreement is not necessarily material as it would depend on the facts upon which the compromise agreement was entered into. The matter was unfortunately referred to trial and no final judgment was therefore delivered on these aspects. However, we have come across many similar issues, in particular with regard to the interpretation of section 227 of the TAA. Section 227 of the TAA contains a similar provision to the disclosure requirement in section 205, only in section 227 the disclosure relates to the requirements for a valid voluntary disclosure in terms of the Voluntary Disclosure Programme (VDP). The requirements for a valid voluntary