Published in the DealMakers magazine, Q1 2010.
If a company or a trust is “effectively managed” in South Africa, irrespective of where the company is incorporated or where the trust was formed, it can become tax resident in South Africa. This means that the company or trust becomes subject to tax in South Africa on its worldwide income, regardless of where the source of that income is .
So what does “effective management” mean? Most tax authorities today interpret effective management as the place where strategic decisions are made, which would usually equate to the place where the board of directors meets on a regular basis. However, the South African Revenue Service (SARS) prefers a different interpretation. In an Interpretation Note issued on the topic, SARS indicates that the place of effective management would be where the strategic decisions are implemented, not made.
One can think of the management of a company as a pyramid – the apex of the pyramid represents top-level management, which would usually be represented by where the board of directors meets. These meetings and the decisions made there would usually represent where the strategic direction of the company is set. The foundation of the pyramid, in turn, represents the day-to-day management of ongoing operations. “Effective management,” according to SARS’s interpretation, would be somewhere in between these two, where the strategic direction and decisions are implemented.
If one wants to apply this to a practical example, consider a company that manufactures widgets. Top-level management is where the directors decide that the strategy of the company should be to manufacture pink widgets, because there is a much bigger market for pink widgets than for any other colour. Day-to-day management would be where the managers of the factory supervise the daily manufacturing of pink widgets, deals with customers, places orders, etc. But effective management would be where the executive directors or senior managers implement the company’s decision to manufacture pink widgets – for example, where the decisions are made as to where the factory should be situated, what manufacturing process to use, the machinery that should be acquired or replaced, the marketing campaign to be followed, etc.
Of course, the determination of where effective management is located can be quite subjective. Also, in the above example it is fairly easy to distinguish effective management from top-level management or day-to-day management. However, this distinction is not always so unambiguous.
This is particularly true for private equity funds. Applying this line of thought to a private equity fund, one may decide that the strategic direction of the fund is, for example, to acquire investments in a specific industry, such as mining or renewable energy, to make investments within certain agreed parameters, and to have a specific exit strategy. Day-to-day management may be where the performance of portfolio investments is monitored, tracked and reported on, on a regular basis.
Effective management, however, could be argued to be where decisions are made such as whether or not to acquire a particular investment, or whether or not to dispose of a particular investment. In a private equity fund context, it is generally the general partner (GP) of the fund that is responsible for making the ultimate investment and disinvestment decisions on behalf of the partnership. Thus, the place where the GP makes these decisions could be argued to be where the fund itself is effectively managed.
So if the fund is effectively managed by the GP, and the GP is based in South Africa, the fund may be regarded as being a South African tax resident. This should have little consequence for a wholly South African fund with South African investors.
However, there may be unanticipated consequences where the fund is a so-called “dual fund.” A dual fund allows South Africans as well as foreign investors to invest in a fund that holds a portfolio across multiple jurisdictions. A typical dual fund structure involves more than one investment vehicle – one established in South Africa, and one (or more) established offshore, generally in a tax-efficient country such as Guernsey, Jersey, or the Cayman Islands. The two (or more) fund partnerships typically enter into a co-investment agreement in terms of which they agree to invest and disinvest in the same portfolio companies at the same time. There would generally be a GP, therefore, in South Africa (for the South African fund) as well as a GP in the offshore jurisdiction (for the offshore fund).
If the South African GP makes all the investment and disinvestment decisions, and the offshore GP merely “rubber-stamps” them, an argument could be made that the activities of the South African GP also represents the “effective management” of both the offshore GP and the offshore fund in South Africa.
Whether or not there are any South African tax consequences, depends to a large extent on the type of vehicle that was used to form the GP or the fund. For example, partnerships are, from a South African tax perspective, “fiscally transparent.” This means that one “looks through” the partnership to the ultimate partners in order to determine whether a tax liability arises. Where one is dealing with such a fiscally transparent entity, it will be more difficult for SARS to argue that the ultimate investor is effectively managed in South Africa, particularly if the investor’s investment in the fund is only a portion of its overall business activities.
However, for the offshore GP, which is likely to ultimately be a company whose sole business purpose is the making of investment/disinvestment decisions, a successful argument that “effective management” is located in South Africa may result in the GP’s full income becoming subject to tax in South Africa.
It is, therefore, crucially important to carefully evaluate the decisions that are made in South Africa and to ensure that the directors or managers have a good understanding of the potential tax liability that could arise as a result of their activities in South Africa.
¹ If an entity establishes tax residence in South Africa by virtue of effective management, another country may also claim that the entity is tax resident there because the entity is incorporated or established there. In cases where two countries attempt to argue that an entity is tax resident there, one would look to a double tax agreement between the two countries to resolve the issue. Generally, a double tax treaty will award residence to the country where the entity is effectively managed.
² Interpretation Note 6, dated 26 March 2002
³ In this case, however, the offshore investor may end up having a permanent establishment in South Africa. This also has South African tax consequences, albeit not on the same scale as effective management. Refer to the article on this topic titled “To PE or not to PE, that is the question” in Volume 10: No 4.