The Participation Puzzle: A Guide to Calculating CFC Rights under Section 9D

By Dr Hendri Herbst and Dewald Pieterse

I. Introduction

Section 9D of the South African Income Tax Act 58 of 1962 (‘the ITA‘) stands as a pillar of South Africa’s international tax architecture. Introduced in 1997, it was a targeted anti-avoidance measure that foreshadowed a major policy shift. The country’s pivotal transition from a source-based system of taxation to a comprehensive residence-based framework that taxes South African residents on their worldwide income was formally effected in 2000. At its core, section 9D is an anti-avoidance provision designed to counter the indefinite deferral or outright avoidance of domestic tax on certain types of income, particularly passive income, which has been accumulated in offshore companies situated in low-tax jurisdictions. The legislation achieves this objective through a sophisticated imputation mechanism: it attributes a proportional share of a Controlled Foreign Company’s (CFC’s) ‘net income’ directly to its South African resident shareholders, taxing that income as if it had been repatriated in the year it was earned.

The operation of this complex regime hinges on a critical legislative concept, namely ‘participation rights’. This term underpins every facet of the CFC rules; however, it is often also the source of a profound challenge for taxpayers and their advisors. While the ITA defines ‘participation rights’ in broad, principles-based terms, it conspicuously fails to prescribe a specific mathematical formula for their calculation. This legislative silence is particularly problematic in the context of modern, sophisticated corporate structures, where different classes of shares may carry bifurcated or differentiated rights to a company’s income and its capital. This ambiguity creates a significant ‘calculation conundrum’, as it were – a zone of material uncertainty and compliance risk for South African multinationals.

This article aims to provide a definitive analysis of this legislative ambiguity. It will dissect the foundational role of participation rights within the CFC regime, provide a forensic examination of the statutory definition and its legislative history, and critically evaluate the competing methodologies that have emerged to fill the legislative vacuum. By highlighting the technical superiority and legal defensibility of a substance-over-form approach, this analysis will conclude with a clear and actionable recommendation for practitioners seeking to navigate this complex and high-stakes area of international tax law.

II. The lexicon of section 9D: defining the core concepts

To navigate the complexities of the CFC regime, a precise understanding of its foundational terminology, as defined within the ITA, is essential.

• Controlled Foreign Company (CFC): This is the central entity targeted by the legislation. A foreign company is classified as a CFC if South African residents, in aggregate, directly or indirectly hold more than 50% of either the participation rights or the voting rights in that company. The definition also includes any foreign company whose financial results are consolidated into the financial statements of a resident company.
• Net Income: This is the tax base to which the CFC rules apply. The ‘net income’ of a CFC is defined as an amount equal to the taxable income of that company calculated in accordance with the ITA, as if the CFC had been a South African resident and taxpayer for the year. This calculation is subject to a number of specific adjustments and exemptions.
• Imputation: This is the core mechanism through which section 9D operates. It is the process whereby a proportional amount of the CFC’s ‘net income’ is attributed to and included in the income of its resident shareholders for the relevant tax year. This prevents the deferral of tax by ensuring the offshore income is taxed in South Africa in the year it is earned by the CFC.
• Foreign Business Establishment (FBE): This concept is central to one of the most important exemptions from the imputation rules. An FBE is essentially a fixed place of business in a foreign country that has sufficient economic substance. To qualify, the establishment must, among other criteria, be suitably staffed and equipped to conduct its primary operations and must not have been located there mainly to avoid South African tax. Income attributable to a qualifying FBE is generally excluded from the CFC’s ‘net income’ calculation.

III. The dual-function linchpin: why an accurate calculation is non-negotiable

The determination of a shareholder’s participation rights is far from an academic exercise; it is a calculation with absolute and potentially severe tax consequences. The concept serves as the dual-function linchpin for two critical statutory tests within the CFC regime, making an accurate and defensible calculation a non-negotiable prerequisite for compliance.

Function 1: the control test in defining a CFC

The first and most fundamental role of participation rights is to determine whether a foreign company falls within the CFC net at all. According to the definition in section 9D(1) of the ITA, a foreign company is classified as a CFC if, among other criteria, ‘more than 50 per cent of the total participation rights in that foreign company are directly or indirectly held… by one or more persons that are residents’. This test requires an aggregation of the participation rights held by all South African residents to ascertain whether this control threshold has been crossed.

This 50% threshold creates a ‘cliff-edge’ effect. A marginal difference in the chosen calculation methodology can determine whether the entire, extensive body of CFC rules applies to a foreign entity. For instance, if one methodology results in a 49.9% aggregate holding by residents, the company is not a CFC, and no income is imputed. Conversely, if another methodology results in a 50.1% holding, the company becomes a CFC, and the imputation rules are fully engaged for all qualifying shareholders. The consequences are absolute and not proportional, highlighting the importance of selecting the most defensible calculation method.

Function 2: The imputation test in attributing CFC income

Once a company is classified as a CFC, participation rights serve their second function: to determine the quantum of income to be attributed to each resident shareholder. Section 9D(2) of the ITA mandates that a resident must include in their income a ‘proportional amount of the net income’ of the CFC. The legislation specifies that this proportion is determined by the ratio that ‘the percentage of the participation rights of that resident… bears to the total participation rights’ in the company. This creates a direct arithmetical link between the calculated percentage of a resident’s participation rights and their ultimate South African tax liability on the CFC’s income.

It is important to note that a de minimis threshold exists to prevent an undue administrative burden on minority or portfolio investors. Proviso (A) to section 9D(2) stipulates that the imputation rules do not apply to a resident who, together with any connected persons, holds less than 10% of the participation rights and cannot exercise at least 10% of the voting rights in the CFC. This ensures that the rules are targeted at those residents who have a more significant economic stake in the foreign entity.

IV. Deconstructing the ‘participation rights’ definition

An understanding of the appropriate calculation methodology must begin with an analysis of the statutory definition of ‘participation rights’ itself. The wording of the definition, reinforced by its legislative history, provides a clear mandate for an approach that prioritises economic substance over legal form.

Section 9D(1) of the ITA defines the term as follows:

‘‘participation rights’ in relation to a foreign company means—

(a) the right to participate in all or part of the benefits of the rights (other than voting rights) attaching to a share, or any interest of a similar nature, in that company; or

(b) in the case where no person has any right in that foreign company as contemplated in paragraph (a) or no such rights can be determined for any person, the right to exercise any voting rights in that company’.

Analysis of the primary definition: paragraph (a)

Paragraph (a) contains the primary definition and is unequivocally focused on economic entitlement rather than legal control. Its key phrases reveal a clear legislative intent:

• ‘benefits of the rights’ – This is the conceptual core of the definition. The phrase is deliberately broad, designed to capture the full spectrum of economic value that a shareholder can derive from their interest. It is widely accepted that this phrase encompasses, at a minimum, two fundamental categories of economic rights: income participation rights (the right to profits, typically via dividends) and capital participation rights (the right to net assets, typically on liquidation).
• ‘(other than voting rights)’ – This explicit exclusion reinforces that the primary test for participation is economic in nature. The power to influence company decisions through voting is deliberately carved out and is only considered as a fallback measure under paragraph (b).
• ‘interest of a similar nature’ – This anti-avoidance language ensures the definition is not limited to formally designated shares, extending its scope to other instruments or arrangements that grant economic participation.

The fallback provision and legislative history

Paragraph (b) serves as a secondary definition that applies only in rare circumstances, such as with a foreign company limited by guarantee with no share capital where no person has a determinable right to profits or assets. Its existence as a measure of last resort emphasises that the economic test in paragraph (a) is the default standard.

V. The legislative history: a shift towards substance

An examination of the legislative history of section 9D provides important context and supports an interpretation that favours economic substance over legal form. The evolution of the definition demonstrates a consistent legislative intent to target the underlying economic interest a resident holds in a foreign entity.

The original 1997 definition of ‘participation rights’ was more concrete, referring to the right to participate in ‘capital or profits’. A pivotal amendment in 2010, however, substituted this with the current, more abstract wording: ‘the benefits of the rights’. This linguistic shift was a deliberate legislative amendment to ‘future-proof’ the provision and strengthen its substance-over-form nature. While the original wording could have been interpreted as a closed list, the principles-based language of ‘benefits’ is far more robust from an anti-avoidance perspective. The evolution compels a valuation exercise, as one cannot measure the ‘benefit’ of a right without quantifying its value. This history suggests that any defensible calculation methodology must be rooted in a valuation of the underlying economic entitlements.

VI. The guiding judicial principle: substance over form

Beyond the legislative text, any interpretation of a tax provision must be viewed through the lens of South Africa’s established judicial principles. It is trite that the common law ‘substance over form’ principle empowers courts to look past the labels of a transaction to its true nature. As the court succinctly stated in Kilburn v Estate Kilburn,[i] ‘courts of law will not be deceived by the form of a transaction: it will rend aside the veil in which the transaction is wrapped and examine its true nature and substance’.

This principle does not give the revenue authority license to disregard any transaction it dislikes. The foundational test, articulated in Zandberg v Van Zyl[ii] and reaffirmed in cases like Erf 3183/1 Ladysmith (Pty) Ltd and Another v CIR,[iii] is that a court will only disregard the form of a transaction if it is satisfied that there is a ‘real intention, definitely ascertainable, which differs from the simulated intention’. Taxpayers are entitled to arrange their affairs to minimise tax, and as the court held in Commissioner of Customs and Excise v Randles, Brothers & Hudson Ltd,[iv] if the parties genuinely intend a transaction to have effect according to its terms, it will be interpreted and given effect to as such.

The modern application of this doctrine was clarified by the Supreme Court of Appeal in Sasol Oil Proprietary Limited v CSARS.[v] The court confirmed that while the commercial motivation for a transaction is relevant, the ultimate test is one of genuineness (see also the judgments  of Wallis JA in CSARS v Bosch[vi] and Roshcon (Pty) Ltd v Anchor Auto Body Builders CC[vii] in this regard). The court in Sasol, quoting Bosch and Roshcon with approval, held that ‘once it is established that the parties genuinely intended the agreements to be implemented in accordance with their tenor… the resulting transaction cannot be found to be simulated’.

In a cross-border context, the substance over form principle has also featured prominently in the determination of ‘beneficial ownership’ by foreign courts. The conceptual parallels between ‘beneficial ownership’ and having a ‘benefit of a right’ is clear. Whilst the ‘beneficial owner’ concept has not been the subject of much South African jurisprudence as would be relevant to the interpretation of ‘participation rights’, it is submitted that our courts will likely follow a similar approach to foreign jurisdictions which recognise the substance over form principle in tax contexts. See, for example, the decision of the Swiss Federal Supreme Court in Re Swiss Swaps Case I/A.[viii]

This judicial doctrine strongly suggests that any calculation methodology that relies on a purely mechanical or formalistic approach, while ignoring the underlying economic value and substance of a shareholder’s interest, is inherently vulnerable to being challenged. It is submitted that considering the valuation-based substance of the ‘benefits of the rights’ is not merely preferable, but prudent.

VII. Calculation methodologies: from the simplistic to the sophisticated

The practical application of the definition of ‘participation rights’ varies significantly depending on the complexity of a foreign company’s capital structure.

In a foreign company with only one class of ordinary shares, where each share carries identical rights to income, capital, and voting, the calculation is straightforward. The percentage of participation rights held by a resident is simply the number of shares they hold divided by the total number of issued shares. For example, if a resident holds 600 of a company’s 1,000 issued shares, their participation rights are 60%, making the entity a CFC.

The interpretative challenge arises when a foreign company has a more sophisticated capital structure with multiple classes of shares that carry different economic rights (e.g. ordinary shares and cumulative preference shares). In this scenario, a simple share count is economically meaningless and legally incorrect, necessitating a more sophisticated approach and leading to an evaluation of two competing methodologies.

The legislative ambiguity regarding the calculation of participation rights in complex structures has led to the emergence of two primary competing methodologies in professional and academic discourse. The choice between them is not trivial, as it can materially alter the tax outcome and significantly impact a taxpayer’s compliance risk profile.

The net percentage approach: a superficial and risky shortcut

This method attempts to simplify the calculation by first determining a shareholder’s percentage entitlement to income and their percentage entitlement to capital separately. It then calculates the simple arithmetical average of these two percentages using the following formula:

% Participation Rights = (% Income Rights+% Capital Rights)/2

The fundamental and fatal flaw of the net percentage approach is that it gives equal mathematical weighting to the income and capital rights, irrespective of their actual or relative economic values. This is an economically irrational premise that leads to distorted and indefensible outcomes. Because it is a purely mechanical formula divorced from economic value, it fails to measure the true ‘benefits’ of the rights as required by the ITA and is highly vulnerable to a successful challenge by SARS.

The relative value approach: aligning with legislative intent

The relative value approach determines a shareholder’s participation rights by calculating the fair market value of their specific income and capital entitlements and expressing that aggregate value as a proportion of the total fair market value of all participation rights in the company. This approach is conceptually superior because it focuses on economic reality, which is consistent both with the anti-avoidance purpose of section 9D and the principle of substance over form. It directly measures the value of the ‘benefits’ a shareholder is entitled to receive, thereby giving effect to the precise wording of the ITA.

The application of this method requires robust valuation techniques. This typically involves a two-step process: first, determining the total equity value of the foreign company using standard methodologies (e.g. discounted cash flow); and second, allocating this total value amongst the different share classes according to their respective rights and priorities, often through a ‘waterfall analysis’ that mimics a liquidation or sale scenario.

VIII. From theory to practice: an example of the relative value approach

To translate the theoretical discussion into a practical application, this section presents a comprehensive worked example demonstrating how the relative value approach is applied to a foreign company with a complex capital structure contemplating an exit. This illustrates the methodology’s alignment with economic reality.

Scenario facts

The shareholders in Foreign Company X expect to exit in four years. Three exit scenarios are modelled:

• Downside case: 20% probability of exit value being R300m;
• Base case: 50% probability of exit value being R900m; and
• Upside case: 30% probability of exit value at R2,400m.

SACo (a South African resident company) holds Class P participating preference shares with a 2x liquidation preference on its initial investment of R200m (i.e. R400m) plus a 15% cumulative dividend accruing over four years (R120m). Class P is non‑participating beyond that total of R520m, but its returns are prioritised at exit. All ordinary shares are held by non‑residents and are entitled to receive all residual equity value after satisfying Class P’s claims at liquidation/exit.

Assume a discount rate of 12% p.a. is appropriate.

Application of the relative value approach

The calculation proceeds through a logical, step-by-step valuation and allocation process:

1. Determine Class P’s payoff in each scenario at exit:

• Downside: SACo receives R300m (capped by total equity value)
• Base case: SACo receives R520m
• Upside: SACo receives R520m

2. Determine the ordinary share payouts in each scenario at exit:

• Downside: R300m – R300m = R0m
• Base case: R900m – R520m = R380m
• Upside: R2,400m – R520m = R1,880m

3. Probability-weight the exit payoffs to determine relative values:

• Expected payoff to Class P: (0.2 x R300m) + (0.5 x R520m) + (0.3 x R520m) = R476m
• Expected payoff to ordinary shares: (0.2 x R0m) + (0.5 x R380m) + (0.3 x R1,880m) = R754m

4. Discount expected payoffs to present value at 12% over four years:

• Present value of Class P: circa R302.5m
• Present value of ordinary shares: circa R479.2m

5. Compute participation rights as relative value of shares:

• SACo’s participation rights: (R302,500,000/R781,700,000) x 100 = 38.7%
• Non-residents’ participation rights: (R479,200,000/R781,700,000) x 100 = 61.3%

Conclusion of Example

SACo has 38.7% of the participation rights. Foreign Company X is therefore not a CFC. This outcome accurately reflects the economic reality that SACo’s participation is capped, while the majority of the company’s value and all of its upside potential reside with the ordinary shareholders. This reflects the substance‑over‑form, valuation‑anchored outcome contemplated by section 9D’s language focusing on the ‘benefits of the rights’.

IX. Conclusion

The determination of ‘participation rights’ is a pivotal exercise in the application of South Africa’s CFC rules under section 9D. While the ITA is silent on a specific calculation method for complex cases, its overarching anti-avoidance purpose, its precise statutory language, and prevailing judicial approaches to the interpretation of tax statutes provide sufficient guidance to conclude that a methodology that reflects the economic substance of a shareholder’s interest must be preferred over one based on superficial legal form or arbitrary mathematical averaging.

Key recommendations for practitioners

In navigating this complex and high-stakes environment, a robust, valuation-based strategy is not merely a best practice; it is an essential component of prudent tax risk management. The following actionable recommendations are imperative:

• Adopt the relative value approach: For all foreign companies with complex capital structures involving multiple classes of shares, the relative value approach should be adopted as the primary and most defensible methodology. It is the only method that accurately quantifies the ‘benefits of the rights’ as required by the ITA.
• Perform and document a robust valuation: The application of the relative value approach must be supported by a comprehensive and well-documented valuation of the foreign company and the various rights attached to its different share classes. This valuation should be prepared in accordance with accepted principles, ideally by a qualified independent expert.
• Prioritize economic substance over legal form: The choice of methodology should be guided by the fundamental principle of ‘substance over form’, which is consistently applied by SARS and the courts in tax disputes. This demonstrates a commitment to determining tax liability based on economic reality.
• Maintain comprehensive evidentiary records: The valuation report and all supporting analyses must be retained as objective evidence to defend the participation rights calculation declared to SARS. In the event of an audit or dispute, this contemporaneous documentation will be the cornerstone of a successful defence.

Taxpayers and their advisors must move beyond simplistic calculations and embrace a methodology that is technically correct, legally defensible, and aligned with the core principles of South Africa’s anti-avoidance framework.

[i] 1931 AD 501

[ii] 1910 AD 302

[iii] [1997] JOL 213 (A)

[iv] 33 SATC 48

[v] [2019] 1 All SA 106 (SCA)

[vi] [2015] 1 All SA 1 (SCA)

[vii] [2014] 2 All SA 654 (SCA)

[viii] Case 2C_364/2012 (2015)