What startups should know about tax, when setting up an overseas company

No matter how small the world is becoming or how much of a global village we live in, each country’s tax authorities need to be treated fairly and honestly.

It simply means that if genuine value is created in Country A, you need to account to Country A’s tax authority for that value and pay tax in Country A.

These last two short sentences have been the subject of literally millions of lines of legislation and law textbooks, but if you appreciate the principle and comply, you are unlikely to fall afoul of the dreaded revenue services.

This article is the fourth in a series (see links to the other below), intended to guide entrepreneurs on how to grow their SA businesses offshore and create wealth and value as an international group of companies.

When dealing with tax it simply means that when genuine value is created in Country A, you need to account to Country A’s tax authority for that value and pay tax in Country A

So, now that you’ve read the first few articles in this series, you have carefully chosen to create an offshore structure (see this article), set up the legal entities and allocated the commercial functions across the globe (see here) and you’ve created your first international company structure (see here). This, however, is where things start to get challenging.

Taxation of SA shareholders

The first matter that raises its head, is the concept of a “controlled foreign company” or CFC.

SA tax laws provide that where more than 50% of an offshore company is owned by South Africans, then those South Africans will pay tax on their share of the profit of that company even if it is not distributed to them.

This is a pretty powerful tool in the SA Revenue Services’ (Sars) artillery, and frankly, you can understand why they use it.

It is not fair for a group of South Africans to dodge SA tax merely by routing their revenue through another country. Sars’s reasoning is the following: if OffshoreCo is “passive” and earns “mobile” revenue (ie has no substance, and actually doesn’t do anything), then this rule will hit SA shareholders. To me, this makes sense.

However, based on that logic, there is the logical exemption to this rule: if OffshoreCo establishes a genuine “foreign business establishment”, then this rule does not apply.

Simply put, this exception will apply if you can show that OffshoreCo is not a passive “shell company”, and does not earn only revenue that is mobile, but actually has “substance”. Specifically, you need to prove that OffshoreCo has created all the infrastructure and personnel required to run its business offshore, in its country of residence.

So, to genuinely set up a company that is located offshore and where the SA shareholders are not taxed for their “imputed” profit of the OffshoreCo, a genuine offshore business establishment will be required. The term “substance” will run through the remainder of this article.

The requirement for this “substance” is ultimately why offshore companies are so hard to implement in reality — someone needs to be there, running the show, if it is to really be worthwhile.

Taxation of the offshore company

Assuming you are exempt from CFC rules (ie OffshoreCo has all the infrastructure you would expect to see in order to operate its business), SA shareholders will not be taxed on the profit retained by OffshoreCo.

The next question is: where will OffshoreCo itself be a tax resident? The
important point here is that OffshoreCo may not actually be taxed in the country that you set it up in.

Where is the company really based?

This is another question that has been the subject of thousands of pages of discussion, but it really comes down to this one thing: where is the corporate mind based?

Where is the “mind” that takes the crucial decisions relating to opportunities, balances the risks involved in those opportunities, and deploys its capital in order to exploit those opportunities?

In the language of tax law, where is the place of effective management? This looks through the legal structure and also ignores how the cash flows.

This enquiry asks the question of where the company is actually run from. So, the country in which OffshoreCo will actually be taxed will be the country in which its place of effective management (or “POEM”).

Again, the theme of “substance” is all important. As a starting point, one would look to see where the board of directors meet.

The board ultimately controls the company, and therefore involves most of the “brain cells” of the corporate mind.

Secondly, once the board has made the decision, how and where is that decision implemented? For example, a decision to borrow money or to invest money, will be evidenced by a contract — where is the contract drafted, negotiated, and signed?

A real risk in the SA case, is that all the directors and senior management are based in sunny South Africa and so even if all the investment comes from OffshoreCo (and all revenue is earned by it), OffshoreCo could well be taxed in South Africa if its POEM is here.

Importantly, as the complexity of this business grows, this decision-making function would be expected to be supported by more people and more infrastructure. This is crucial for startup companies.

We recognise this, and advise that in the early stages of a startup, it will have little in the way of business activities and so its “substance” requirements will be lower. However, as the business grows, and as the risk of having its tax residence in another country grows, then this is a factor to invest time and effort into.

The matter goes further too – if OffshoreCo does indeed have its POEM in its home country but key employees are based in South Africa, then the offshore company can be regarded as partially taxable in South Africa. In that case, OffshoreCo could have established a “permanent establishment” here.

Simply put, a portion of the profit may be taxed in South Africa, where some of the value of the OffshoreCo is attributable to the person who is based in South Africa.

This is sometimes solved by employing those key people through SACo. SACo would then be separately engaged to deliver services to OffshoreCo through intergroup agreements, fairly priced in terms of transfer pricing.

Transfer pricing

This principle essentially means that profit should be fairly allocated between OffshoreCo and SACo, so that the tax authorities of each company receive their fair tax revenue.

This effectively means that SACo should be fairly compensated for the services which it delivers to OffshoreCo. If not, then in the worst-case scenario the SA tax authorities could recalculate the profits of SACo, taking into account the global revenue earned by OffshoreCo.

You can imagine that this could be disastrous – so all the group companies should prepare in advance to justify their profit allocation.

However, panic aside, the solution to this is simply good governance: well drafted agreements with fairly calculated fees based on solid internal transfer pricing policies.

And that is of course, where corporate attorneys like ourselves come in and add real value.

Read more:How to structure functions and operations across your international group
Read more:Here’s how SA startups can legally create an offshore company
Read more: The ins and outs of taking your startup offshore

Adrian Dommisse has extensive experience in corporate and financial transactions across Africa, Europe, Eastern Europe, and the Middle East. He founded Dommisse Attorneys law firm in 2008, and holds three degrees in economics and law. 

Featured image: jarmoluk via Pixabay