Kieswetter hooks Coronation: Why this matters for business in SA

It’s what you might describe as a bad day: opening a message from your lawyer and discovering that not only isn’t your tax all sorted as you’d thought, but that your bill may actually be as much as R900m.

Yet on February 7, this is what happened to South Africa’s third-largest investment firm, which manages R602bn on behalf of thousands of clients — many of them pensioners — and does business under the motto “trust is earned”.

Its hard to overstate the gravity of that landmark ruling in the Supreme Court of Appeal, in Coronation Fund Managers’ long-running battle with the SA Revenue Service (Sars) over how it structures its offshore business. 

Until then, pundits had picked Coronation as one of the stocks to buy, licking their lips at the prospect of a juicy dividend, equal to 75% of its pretax earnings. But the ruling meant that not only is the dividend on ice, its future profits may yet be hit further.  

The day after the ruling, as Coronation said, “given the material impact on earnings and cash flows, [it] does not anticipate declaring an interim dividend”, investors scrambled to sell. Stock worth R159m changed hands as the share tumbled 11%.

This might seem like an overreaction, but it was a judgment with deep implications.

It extends beyond simply drawing a line in the sand for how investment companies structure their overseas operations to keep them out of the clutches of the taxman. It also goes to the heart of how pension managers conduct their businesses, and whether they practise what they preach to other firms when it comes to ethical tax compliance.

And it sends a warning shot to other companies that Sars, under pressure to bring in enough tax to keep the badly leaking vessel that is South Africa running, is going to be taking a microscope to their “offshore businesses”. 

The crisp issue was that Coronation had claimed that its Irish business — Coronation Global Fund Managers (Ireland) — was a legitimate offshore business, and should be exempted from its South Africa tax submission.

Initially, there was no cause for alarm. Coronation won the first round in the tax court in September 2021. But on February 7, this was dramatically upended in the supreme court, where judge Caroline Heaton Nicholls, ruling unanimously with a full bench of judges, sided with Sars on what constitutes a “foreign business establishment”.

Without getting too technical, section 9D of the Income Tax Act says a company that claims it is a foreign business (and hence exempt from tax) must meet five criteria. These include that it must be “suitably staffed with on-site managerial and operational employees of that controlled foreign company, who conduct primary operations of that business”.

But in this case, Nicholls ruled, Coronation’s Irish business effectively “outsourced” its main business — managing funds — to its South African head office. 

Nicholls said: “The primary operations of [Coronation’s Irish unit] is that of fund management, which includes investment management. These are not conducted in Ireland. Therefore, [the company] does not meet the requirements for [tax] exemption.”

Many other investment firms that operate foreign subsidiaries in places such as Ireland, Mauritius and Luxembourg, and claim exemption from tax, will have watched this ruling in horror.

“Much has been said that the case is about outsourcing, but the law is fairly clear on the point,” Keith Engel, CEO of the South African Institute of Taxation, tells the FM. “For a foreign subsidiary to be exempt as a foreign business establishment, [it] needs to rely on its own employees, or employees of certain group members.”

Nicholls’s judgment made this clear: where the “key operations of the business have been outsourced” — in this case, investment management — “then the fixed place of business in Ireland lacks the staff and facilities to conduct those operations”. 

And as the main Irish fund management business wasn’t sufficiently independent of Coronation’s head office in Claremont, the Irish unit should rather be seen as a “foreign-controlled business taxable in the hands of the South African owner”.

Given what’s at stake, it’s no surprise that Coronation CEO Anton Pillay is taking the supreme court ruling to the Constitutional Court to settle once and for all what constitutes a “foreign business establishment”.

Derailing the recovery

For Coronation as a company, it’s a big whack. Coronation hasn’t yet said exactly what the bill is — only that it will raise a provision for the backdated tax assessments of between R800m and R900m. 

For a company that clocked up bottom-line profit last year of R1.3bn, it’s a huge number, and it’s little surprise that Pillay’s firm said it wouldn’t pay a half-year dividend. 

This will hurt investors who’d bargained on Coronation’s handsome regular payouts, which were equal to roughly 75% of its after-tax profits.

And yet Coronation’s share price has recovered to R32.45 — higher than the R30.72 at the end of December — which perhaps reflects some belief that the company may yet succeed in the Constitutional Court. 

The unavoidable reality, however, is that its share price is still less than a third of the R112 it hit in 2015, underscoring how, over the past seven years, it’s been a disappointment for those who backed its undeniable investment skills, headed by Karl Leinberger. (Coronation will, however, point out that R100,000 invested in its stock when it listed in 2003 would be worth well north of R3m now, compared with barely R1m had it been invested in the wider JSE.)

The problem for investors is that, as its AGM reveals, Coronation hasn’t exactly been engaging entirely with shareholders about the implications. 

Coronation also refuses to discuss this case with the FM, responding to detailed questions with the one-liner: “We cannot discuss any specifics of the case beyond the media statement.”

So what does this decision mean for other South African fund managers with similar overseas structures? Can they also expect a nasty surprise from Sars boss Edward Kieswetter?

“One might expect that other local fund managers with offshore structures will be sleeping a little less comfortably,” says Graham Molyneux, tax partner, and Greg Boy, senior tax manager at Mazars.

Molyneux and Boy are hesitant to describe this as a “test case” for offshore investment funds, as each company’s structure has to be analysed “on its own specific facts”. 

Engel is less ambiguous on this, and argues that other asset managers should expect a hit. “Additional [tax] assessments can be expected for further South African owners of offshore funds,” he tells the FM.

This puts pressure on other asset managers to “ensure there is substance” at their offshore locations, says Joon Chong, a partner at law firm Webber Wentzel.

And fund managers seem to be acting quickly to do just this. South Africa’s largest fund manager, Ninety One (which was spun out of Investec in 2020), is confident it’ll avoid such a surprise. 

“The rules applied by Sars apply only to subsidiaries of South African tax-resident companies,” spokesperson Kotie Basson tells the FM. “Ninety One’s dual-listed company structure means that the only subsidiaries potentially in scope are those in Botswana and Namibia.”

Ninety One says it has reviewed the position for “both locations and [is] comfortable that there would be no basis for Sars to levy similar tax assessments”. 

Rob Spanjaard, chief investment officer at Rezco Asset Management, also doesn’t foresee surprise tax assessments for his business. 

“I have read the judgment,” he says. “It was not an attack on the [structure of collective investment schemes], but against some tax structuring that Coronation did. The structure they adopted would not be considered aggressive. This is evidenced by the different courts giving different judgments.”

What Nicholls’s judgment did do, however, is muddy the waters.

“While [the judgment] may provide a modicum of comfort to those fund managers who feel their offshore structures are robust, the Coronation judgment has created a great deal of industry uncertainty,” say Molyneux and Boy. This is due to Nicholls’s “blurred” distinction between overall fund management — which includes investment management as one of, but not its primary, functions — and investment management itself.

In reality, the nuanced distinction between “fund management” and overall “investment management” is now murkier than ever and companies are “desperately trying to seek tax clarity on their own specific structures”, Molyneux and Boy say.

The industry body for fund managers, the Association for Savings & Investment South Africa (Asisa), doesn’t want to be drawn into the fray. “As a trade association, Asisa cannot get involved in anything that is member-specific,” it tells the FM.

Treasury clamps down

But does this mean other companies outside the investment business should also expect Sars to come for them, based on this ruling?

Molyneux and Boy are wary of extending it this far.  They say it remains to be seen if the principles laid down in the case could be extrapolated to other industries that routinely employ similar outsourced business models.

Perhaps, but the indication from the government is that companies from outside the fund management industry had also better prepare for some rather intense scrutiny of their overseas arms.

This is because the National Treasury has now proposed tax changes to make it more difficult for local businesses to claim that their offshore units are foreign entities, taxable in the countries where they operate.

In this year’s Budget Review,  the Treasury says: “It has come to government’s attention that some taxpayers are retaining certain management functions, but outsourcing other important functions for which the [foreign company] is also being compensated [for] by its clients.” 

This, it says, runs contrary to the policy rationale around foreign entities. 

“It is proposed that the tax legislation be clarified such that, to qualify as a foreign business establishment, all important functions for which [foreign company] is compensated need to be performed by [that company],” it says. 

Molyneux and Boy expect that tax amendments to this effect will probably come into effect by May or June. “One would expect that offshore fund management operations would require a higher degree of local substance ... to safeguard against [this] risk,” they say.

It means the days of South African fund managers setting up a foreign arm in a low-tax jurisdiction while doing most of the fund management at home and expecting a tax exemption are probably over. 

Of course, there are still grey areas.

Engel says this tax is only likely to apply where the South African owners are large “anchors” for the offshore investment fund, or where they own more than 50% of the fund. 

“The best way to eliminate this problem is for the South African anchor investors to lower their percentage holdings,” he says. But, he adds, this is “probably easier said than done”.

Much, of course, depends on what happens in the Constitutional Court. So which way is it likely to go?  

Pundits are divided on this point.

Chong, for one, says the supreme court decision was “probably correct”. 

Spanjaard thinks otherwise: “These are complicated legal arguments that as a [portfolio manager] I am not really qualified to answer. Personally, I think that Coronation was correct in its interpretation, but there are obviously very strong arguments both ways.”

In the end, if the decision goes against Coronation, shareholders in local fund managers will probably find their investment to be less valuable than they’d thought, as the tax liability will rise. 

And this has implications for clients too, as those who invest in offshore structures through South Africa may find their fees rise, to cover for this extra tax. 

“The new ruling will raise the cost of these offshore investments, thereby lowering returns,” says Engel. “These investors may shift their investments to wholly foreign offshore funds where the costs are lower.”

For Coronation’s shareholders, who already seem likely to miss their half-year dividend,  it’s yet another disappointment in a year in which the fund manager was finally tipped to begin its recovery after a hard seven years.