CONTROLLED FOREIGN COMPANY (CFC) RESTRUCTURING

[Clauses 68(1)(a-d) and (f), 69(1)(a) and (k), 71(1)(a-b) and (d) and 72(1)(a-e) and (h-i);

Applicable Provisions: Sections 42, 44, 46 and 47 of the Income Tax Act and paragraph 64B(2)(b) of the Eighth Schedule to the Income Tax Act]

I. Background

Resident companies can restructure their affairs through various transactions falling within the reorganisation rollover rules. Rollover relief means that the transactions themselves are exempt, but any gain is deferred until a later disposal. These rollover transactions can take the form of asset-for-share transactions, amalgamations, intra-group transfers, unbundlings and liquidations.

This relief is premised on the fact that the parties at issue have merely transformed their interests in the underlying assets as opposed to a cash-out of underlying risks. These relief measures are not available to the restructuring of foreign operations (except in very limited circumstances).

A simpler and narrower set of parallel relief provisions exist for offshore restructurings, known as the capital gains participation exemption. Under this exemption, gain is wholly exempt (not simply deferred) when residents and CFCs dispose of equity shares in a 20 per cent held foreign company. However, this exemption is generally available only if the foreign shares are transferred to a totally independent foreign resident or to a CFC under the same South African group of companies (without any intention of resale to South African residents). The restructuring of CFC assets can also qualify for tax relief if disposed of within the confines of the foreign business establishment exemption or if the disposal occurs within a high-taxed country.

II. Reasons for change

Many South African multinationals seek to restructure their offshore operations. These restructurings often occur when multinationals acquire foreign companies with inconveniently located subsidiaries and seek to move these foreign subsidiaries into more efficient locations within the group. In light of the current economic downturn, these restructurings have accelerated in order to realise economies of scale and to increase internal efficiency, thereby keeping South African multinationals globally competitive.

The current participation exemption applicable to offshore restructurings has a number of shortcomings. On the one hand, the regime is too narrow – allowing some restructurings while inadvertently excluding others (e.g. certain transactions lacking an actual disposal of shares or certain transfers to South African companies within the same group). On the other hand, the breadth of the exemption poses a risk to the tax base with some taxpayers seeking an internal restructuring solely to elevate the base cost of their shares, followed by a taxable sale with artificially reduced gain (due to the elevated base cost). A balance must therefore be struck between facilitating restructurings and preventing tax avoidance.

III. Proposal A. Overview

In view of the above, the domestic corporate restructuring rollover rules will be extended to include the restructuring of offshore companies that remain under the control of the same South

111

African group of companies. More specifically, the asset-for-share, amalgamation, unbundling and liquidation rules will be revised to cover offshore restructurings within this framework.

It should be noted that the extension of the reorganisation rollover rules to cover foreign restructurings was always intended, but this extension was delayed until many issues involving offshore CFCs could be resolved and simplified. For instance, the initial system of indirect credits has been dropped and a simplified exclusion exists for high-taxed foreign country income.

B. Extension of the reorganisation rollover regime 1. Asset- for-share transactions

Asset-for-share relief is mainly limited to the transfer of assets between residents. This relief will now be extended to cover the transfer of foreign company equity shares to CFCs (thereby allowing intra-group foreign share-for-share transactions). This extended asset-for-share relief is premised on the fact that reorganisation rollovers should not result in the tax-free externalisation of corporate value outside the South African group.

In particular, this extended rollover relief will allow for the transfer of foreign equity shares (in addition to other pre-existing requirements for asset-for-share transfers) if:

(i) the transferor holds a qualifying interest (i.e. 20 per cent equity shares and voting rights) in the transferee; and

(ii) the transferee constitutes a controlled foreign company in relation to the transferee or any group company.

Foreign asset-for-share rollovers will also be subject to a charge if the qualifying criteria is not maintained for a period of 18 months after the transaction. More specifically, the transferee must remain a CFC remain within the group, and the transferor must maintain a qualifying interest in the transferee for at least 18 months, Failure to comply with these requirements will trigger a gain for the transferor.

Example

Facts: Foreign Parent owns all the shares of South African Holding Company. South African Holding Company owns all the shares of CFC and 45 per cent of the shares of Foreign Company (FC). CFC owns the other 55 per cent of the shares of CFC. South African Holding Company transfers all of its shares in FC to CFC.

Result:

The foreign share-for-share rollover relief will apply because FC became a controlled foreign company immediately after the disposal, and FC remains part of the same group. However, gain will be triggered if CFC status or group status is lost within 18 months (or qualifying interest status is lost).

112

2. Amalgamation transaction:

Current amalgamation rollover relief is only available if the resultant company is a resident. Thus, a resident company can be merged into another resident company or a foreign company can be merged inbound into a resident company. This rule will be extended to cover the amalgamation, merger or conversion of a foreign company into certain resultant foreign companies. As in the current rules, the amalgamated foreign company must transfer all of its assets (other than assets used to settle debts incurred in the ordinary course of business).

This extended rollover relief for foreign amalgamations applies (in addition to other pre-existing requirements for asset-for-share transfers) if:

(i) the amalgamated company and the resultant company form part of the same group of companies,

(ii) the resultant company constitutes a CFC in relation to resident group company, and

As discussed elsewhere in this explanatory memorandum, the resultant company need not issue shares in exchange for the assets of the amalgamated company (note: many connected party foreign amalgamations do not involve any transfer of shares).

Example

Facts: South African Parent company owns all the shares of CFC 1, which in turn owns all the shares of CFC 2 and CFC 3. CFC 2 transfers all its assets to CFC 3. Following the transfer, CFC2‟s existence is terminated in terms of foreign law. CFC 3 does not issue any shares to CFC 2 (because CFC 1 already owns all of the CFC 3 shares).

Result: The amalgamation of CFC2 into CFC3 will qualify for rollover relief.

3. Unbundling transactions

The current unbundling rules already allow for the unbundling of foreign companies. This relief, however, is limited to situations involving 95 per cent ownership.

The unbundling of foreign companies will be aligned to the newly revised rules. More specifically, this extended rollover relief will allow for the unbundling of foreign holding companies to other foreign companies if:

(i) the unbundled company constitutes a controlled foreign company, and (ii) the unbundling company and its shareholders form part of the same group

of companies (with foreign companies viewed as part of the group for this purpose despite their foreign status).

113

(iii) The unbundling company must hold at least 50 per cent of the equity shares of the unbundled company before the transaction

Example:

Facts: South Africa Company owns all the equity shares of CFC1. CFC1 owns 80 per cent of the shares of CFC 2. A foreign company owns the remaining 20 per cent of the equity shares of CFC 2. In turn, CFC 2 owns all the shares of CFC3. In order to create a flatter structure, CFC 2 distributes all the equity shares held in CFC 3 to CFC1 and the Foreign Company in accordance with their effective shareholding in CFC2. CFC 1 and CFC2 do not elect out of the unbundling provisions.

Results: The distribution of the CFC3 shares to CFC 1 (and Foreign Company) will qualify for rollover relief as an unbundling transaction.

4. Liquidation transaction

Current liquidation rollover relief covers the liquidation of companies into domestic holding companies. The liquidation rollover rules will additionally allow for liquidation into group CFCs revised rules. More specifically, this extended rollover relief will allow for the liquidation into foreign holding companies if:

(i) the liquidating company and the holding company form part of the same group of companies (with foreign companies viewed as part of the group for this purpose despite their foreign status), and

(ii) the holding company constitutes a controlled foreign company in relation to group company that is a resident.

5. Note on participation exemption

The capital gains tax participation exemption for the transfer of equity shares to totally independent foreign residents will temporarily remain. The participation exemption will be re-examined in 2012 when the offshore reoganisation rules are refined.

IV. Effective date

The proposed amendments will generally apply in respect of transactions entered into on or after 1 January 2012.

______________________________