Interpretation Note 75 (Issue 3) – Exclusion of certain companies and shares from a "group of companies" as defined in section 41(1)

Interpretation Note 75 (Issue 3) – Exclusion of certain companies and shares from a "group of companies" as defined in section 41(1)

• 11 February 2020
• Corporate Tax
• SARS

Important:

This article is based on tax law for the tax year ending 28 February 2020.

Background

Under specified circumstances the corporate rules provide relief from income tax when assets are disposed of between companies forming part of the same “group of companies” as defined in section 41(1). Generally these relief measures defer the income tax on income and capital gains until the asset is disposed of to a third party or until a degrouping occurs. The Act contains a global definition of “group of companies” in section 1(1) and a narrower definition of the same term in section 41(1). The narrower definition generally applies for the purposes of the corporate rules but is also used elsewhere in the Act.

The definition in section 41(1) starts with the definition in section 1(1) and then proceeds to exclude specified companies and shares by way of a proviso. This Note is concerned with the application and effect of that proviso.

The law

The definitions in the Act, which are used in this Note, are reproduced in the Annexure.

Application of the law

Interpretation of the proviso

The term “group of companies” as defined in section 1(1) means two or more companies in which one company (the controlling group company) directly or indirectly holds shares in at least one other company (the controlled group company), to the extent that –

• at least 70% of the equity shares in each controlled group company are directly held by the controlling group company, one or more other controlled group companies or any combination thereof; and
• the controlling group company directly holds at least 70% of the equity shares in at least one controlled group company.

The definition of “group of companies” in section 41(1) defines a group of a companies as “a group of companies as defined in section 1(1)” but in applying that definition specifically excludes, through paragraphs (i) and (ii) of the proviso, certain companies and shares from consideration. See the definition of “group of companies” in section 41(1) in the Annexure for detail on the companies and shares that are excluded in the proviso.

At issue is whether, after excluding the companies and shares listed in the proviso, the remaining companies meet the requirements of the definition of “group of companies” in section 1(1) and comprise a group of companies under the definition of “group of companies” in section 41(1). If not, the corporate rules may not apply to a transaction conducted between those remaining companies.

Craies, Statute Law states the following on the effect of a limiting proviso: 

“ ‘[T]he effect of an excepting or qualifying proviso, according to the ordinary rules of construction, is to except out of the preceding portion of the enactment, or to qualify something enacted therein, which but for the proviso would be within it;…’.”

In Jennings & another v Kelly Viscount Maugham cited the following extract from Kent’s Commentaries on American Law with approval:  

“ ‘The true principle undoubtedly is, that the sound interpretation and meaning of the statute, on a view of the enacting clause, saving clause, and proviso, taken and construed together, is to prevail.’ ”

The effect of applying the proviso to the main enacting clause, namely, the definition of “group of companies” in section 1(1), is to exclude from consideration any company listed in paragraph (i) of the proviso and any shares disqualified as equity shares by paragraph (ii) of the proviso. After excluding the said companies and shares from consideration, it is necessary to assess whether the remaining companies and shares meet the requirements of the definition of “group of companies” in section 1(1).

Apparent from the definition of “group of companies” in section 1(1), for a group of companies to exist it must have a “controlling group company” and one or more “controlled group companies”. A group that does not have a “controlling group company” after applying the proviso cannot comprise a “group of companies” for the purposes of the definition of that term in section 41(1). Likewise, a company whose equity shares are deemed not to be equity shares by paragraph (ii) of the proviso cannot have a controlling group company and will accordingly be excluded from forming part of a “group of companies” as defined in section 41(1).

Tax discrimination under tax treaties

Article 24(5) of the OECD Model Tax Convention on Income and on Capital provides as follows:

“5. Enterprises of a Contracting State, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first-mentioned State to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which other similar enterprises of the first- mentioned State are or may be subjected.”

In HM Revenue and Customs v FCE Bank Plc a company resident in the United States of America (USA) owned and controlled two companies resident in the United Kingdom (UK). Under the UK’s group taxation provisions the one subsidiary wished to “surrender” its assessed loss to the other subsidiary. The Commissioners for Her Majesty’s Revenue and Customs (HMRC) refused to permit the transfer of the assessed loss on the grounds that the two subsidiaries did not form part of a group of companies because of the exclusion of their USA parent company from the group for group taxation purposes. The court held that HMRC’s refusal to allow the transfer of the assessed loss amounted to discrimination under Article 24(5) of the Double Taxation Convention between the UK and the USA and dismissed HMRC’s appeal. The court’s reasoning was that had the two subsidiaries had a resident parent company they would have been entitled to transfer the assessed loss and accordingly there was discrimination.

The question arises whether this judgment could find application under the corporate rules, for example, when a foreign incorporated parent company, which is not effectively managed in South Africa, holds shares in two resident subsidiaries and the subsidiaries are denied roll-over relief on a transfer of assets between them under section 45 because of the operation of the proviso. The parent company in this example would be a non-resident for income tax purposes. 

In deciding this question it is necessary to determine whether two resident subsidiaries of a resident parent company which are in a similar position would be denied group relief.

The proviso does not discriminate against resident companies because they are wholly or partially owned or controlled, directly or indirectly, by one or more non-resident parent companies. Rather it does so because the parent companies are not liable to taxation in South Africa except on South African-source income and capital gains on South African immovable property and assets of a permanent establishment in South Africa. The relief is also denied to resident subsidiaries of a resident parent company when the parent company is exempt or partially exempt from normal tax. For example, subsidiaries of the following resident companies are excluded from a group of companies under paragraph (i) of the proviso:

• A co-operative [paragraph (i)(aa)].
• An association formed in South Africa to serve a specified purpose, beneficial to the public or a section of the public [paragraph (i)(aa)].
• A portfolio of a collective investment scheme in property that qualifies as a “REIT” as defined in the listing requirements of an exchange approved in consultation with the Minister of Finance and published by the “Prudential Authority”, as defined in section 1 of the Financial Markets Act 19 of 2012, under section 11 of that Act [paragraph (i)(aa)].
• A “non-profit company” as defined in section 1 of the Companies Act 71 of 2008 [paragraph (i)(bb)].
• A company whose receipts or accruals of whatever nature would be exempt from normal tax under section 10 [paragraph (i)(cc)].
• A company that is a public benefit organisation or recreational club that has been approved by the Commissioner under section 30 or 30A [paragraph (i)(dd)].

As a result, Article 24(5) will not apply when paragraph (i) of the proviso excludes a non-resident controlling company from a group of companies because resident companies who are similarly exempt from South African income tax are also excluded from relief under the corporate rules.

Conclusion

It is impermissible to interpret the proviso as an independent enacting clause and its provisions must be read as if they formed part of the opening words of the definition of “group of companies” in section 41(1). The exclusion by the proviso of, for example, a controlling company from a group of companies will accordingly impact on whether its controlled companies remain part of a group of companies under the corporate rules. The exclusion of non-resident companies by the proviso does not constitute discrimination under South Africa’s tax treaties.

This article first appeared on cliffedekkerhofmeyr.com.

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