Introduction

• Date: 01 January 2008
• Author: Christoph Jaehne
• DOI: 10.10520/EJC74095
• Pages: 1-2
• Published date: 01 January 2008

*

LLB (Hons) Makerere University, Uganda; HDip Legal Practice LDC, Uganda; LLM,

LLD (Unisa). Associate Professor: Department of Mercantile Law, University of South

Africa.

1

Tax avoidance refers to the use of perfectly legal methods of arranging one’s affairs so

as to pay less tax. Tax avoidance involves utilising loopholes in tax laws and exploiting

them within legal parameters. This is contrasted with tax evasion which is illegal and

usually involves the non disclosure of income, rendering of false returns and the claiming

of unwarranted deductions. See OECD Issues in international taxation no 1 international

tax avoidance and evasion: four related studies(1987) at 1; D Meyerowitz Meyerowitz

on income tax (2006–2007) at 29.1; A de Koker Silke on South African income tax: being

an exposition of the law, practice and incidence of income tax in South Africa vol 3

(2006) in par 19.1.

Resolving the conflict between

‘controlled foreign company’ legislation

and tax treaties: a South African

perspective

Annet Wanyana Oguttu

*

Abstract

In order to prevent the avoidance of taxes that result from investing in

offshore companies, countries often enact “Controlled Foreign

Company” (CFC) legislation which ensures that the undistributed income

of a controlled foreign company is not deferred, but it is taxed to its

domestic shareholders on a current basis. However, the application of

CFC legislation has been questioned on the basis that it contradicts some

of the basic principles of double taxation treaties. In this article the

salient aspects of tax treaties that are considered to be incompatible with

CFC legislation are discussed. The article also analyses how the conflict

between the conflict South Africa’s South Africa’s CFC legislation and

its tax treaties can be resolved.

Introduction

Taxpayers involved in international trade often develop tax avoidance

strategies in order to minimise their global tax exposure.

1

One of the

strategies employed is the deferral of domestic taxes by incorporating a

company in a low tax jurisdiction where its income cannot be subject to

XLII CILSA 200974

2

BJ Arnold & MJ McIntyre International tax primer (2ed 2002) at 87.

3

L Olivier & M Honiball International tax: a South African perspective (3ed 2005) at 357;

B Arnold The taxation of foreign controlled corporations: an international comparison

(1986) at 131; R Jooste ‘The imputation of income of controlled foreign entities’ (2001)

118 The South African Law Journal at 473–474; see also De Koker n 1 above in par 5.

43; Arnold & McIntyre n 2 above at 91; V Thuronyi Comparative tax law (2003) at 297.

4

Arnold n 3 above at 131.

5

D Sandler ‘Tax treaties and controlled foreign company legislation: pushing the

boundaries (2ed 1998) at 112–118.

domestic tax until it is distributed to the domestic shareholders as

dividends.

2

With the growing use of international subsidiary companies, a number of

countries have been prompted to enact specific anti-tax avoidance

legislation to reduce the risk of losing domestic tax revenue from

international investment. An example of such legislation is the controlled

foreign company (CFC) legislation which ensures that the undistributed

income of a controlled foreign company is not deferred, but that it is taxed

to its domestic shareholders on a current basis.

3

Most countries’ CFC

legislation follows the same basic pattern. It essentially ignores the

existence of the foreign company and the resident shareholders of the

foreign company are taxed directly on a pro rata share of the company’s

undistributed income.

4

However, the validity of CFC legislation has been questioned on the basis

that it contradicts some of the basic principles of double taxation treaties

entered into by the countries concerned.

5

The applicability of CFC

legislation in a particular treaty situation has indeed been challenged in a

few court cases notably in the United Kingdom, France and Finland as

discussed below. The question of the compatibility of South Africa’s CFC

legislation with its tax treaties is still a moot point that has received little

attention. In this article the salient aspects of tax treaties that are

considered to be incompatible with CFC legislation are discussed. From a

South African perspective, it is feared that if a solution to this conflict is

not found, South Africa may be faced with a litany of challenges to the

applicability of its CFC legislation in specific treaty situations. The article

also discusses how other countries have addressed this problem and

recommendations for the reform of the South African law are suggested.

‘Controlled foreign company’ legislation and tax treaties 75

6

See par 7 of the Commentary on Article 1 of the OECD Model Convention on Income

and on Capital (2005 condensed version).

7

Arnold & McIntyre n 2 above at 87.

8

T Rosembuj ‘Controlled foreign corporations – critical aspects’ (1998) 26 Intertax at

335.

Aspects of double tax treaties that are considered to be in conflict

with CFC legislation

Tax treaties generally deal with four main issues: the allocation of the

jurisdiction to tax various types of income; the elimination of double

taxation; administrative issues; and non-discrimination.

6

Some of these

issues entail certain fundamental principles of tax treaties that could be in

conflict with CFC legislation.

CFC legislation contradicts the principle that subsidiary companies are

separate legal entities

Bilateral tax treaties based on the OECD Model Tax Convention uphold

the principle that a corporation is treated as a taxpayer separate from its

shareholders. Thus, a foreign corporation is only subject to tax in the

resident country of its shareholders, if it derives income from a source in

that country. Any foreign-source income of the foreign company is

excluded from tax. This principle is clearly illustrated by article 5(7) of

the OECD Model Convention which provides as follows:

The fact that a company that is a resident of a contracting State controls

or is controlled by a company which is a resident of the other contracting

State, or which carries on business in that State (whether through a

permanent establishment or otherwise), shall not of itself constitute either

company a permanent establishment of the other.

In effect, in a cross-border environment a parent corporation and its

wholly owned subsidiary constitute separate legal and taxable entities,

notwithstanding that one may manage the business of the other. Thus, the

profits of a subsidiary company in one treaty country, in which it is

resident, are not subject to tax in the other treaty country. It can only be

taxed in the hands of its shareholders in the other treaty country when

dividends are distributed.

7

It is, however, contended that CFC legislation

ignores this fundamental principle that a foreign company is a legal

person separate from its parent company, as resident shareholders of a

CFC are subject to tax on their pro rata share of the income of the CFC,

when it arises rather than when it is distributed.

8

CFC legislation

effectively consolidates the profits of a parent and its wholly owned