no tax relief for hedge funds?
With effect from 1 April 2015, the business of a hedge fund has been declared to be a collective investment scheme (“CIS”) in terms of section 63 of the Collective Investment Schemes Control Act 45 of 2000 (“CISCA”). Accordingly, hedge funds are now subject to and regulated by certain prescribed provisions of CISCA.
As a result, a person that conducts the business of a hedge fund must, within 6 months from 1 April 2015, lodge with the registrar of the Financial Services Board an application for registration as a manager to operate a hedge fund in accordance with section 42 of CISCA.
Hedge funds typically constitute en commandite partnerships or trusts and a substantial amount of the investors into such hedge funds constitute tax exempt institutions.
Hedge funds may comply with the CISCA provisions in one of the following ways:
- By transferring their assets to a registered portfolio of a new scheme established by an approved CISCA manager which scheme would constitute a CIS trust arrangement.
- By transferring their assets to a registered portfolio of a new scheme established by an approved CISCA manager which scheme would constitute an en commandite partnership.
- In the case of a hedge fund that is currently constituted as an en commandite partnership by retaining such partnership and appointing an approved CISCA manager and registering the partnership as a new scheme.
Options 1 and 2 above would result in tax implications for the investors into the hedge fund and may also result in tax implications for the hedge fund, depending on the manner in which the hedge fund has been constituted.
In the 2015 budget review, the Government stated that tax amendments will be considered to minimise any inadvertent tax consequences that may arise from the restructuring of regulated hedge funds. The proposed tax amendments were contained in the Draft Taxation Laws Amendment Bill (“Draft TLAB”) which was released on 22 July 2015. In particular, the Draft TLAB contains certain provisions aimed at giving relief for the disposal of assets provided such disposal qualifies as an “asset-for-share transaction” in terms of section 42 of the Income Tax Act (the “Act”).
However, although the Draft TLAB contains proposals for tax relief, in terms of section 42(8A)(b) of the Act the relief will have limited application as tax exempt investors into hedge funds will not be able to rely on the relief and where the hedge fund constitutes a fully distributing trust structure, the trust would not be able to rely on the relief.
Investors that may qualify for the relief will only be able to claim the relief if:
- the market value of the asset transferred to the portfolio of a hedge fund collective investment scheme (“Hedge Fund CIS”) equals or exceeds their base cost or the deductions claimed for income tax purposes;
- the Hedge Fund CIS acquires the assets from such investor as capital assets where the investor held the assets as capital assets (or as trading stock where the investor held the assets as trading stock);
- such assets are disposed of to a resident company. The Hedge Fund CIS is deemed to be a company for this purpose;
- the disposal is in exchange for the issue of an equity share in the company. The participatory interest in the Hedge Fund CIS is deemed to be an equity share for this purpose; and
- the person at the close of the day on which the asset is disposed of holds a “qualifying interest” in the company. The Draft Bill does not deem the participatory interest in the Hedge Fund CIS to be a qualifying interest. However, this oversight should be corrected in the next version of the legislation.
With regard to option 3 above, this should not result in a disposal of assets for tax purposes to the extent that the partners in the partnership and their interest in the underlying assets remain unchanged. However, upon appointment of the manager, the partnership will constitute a “portfolio of a declared collective investment scheme” for purposes of the Act and as a result it would constitute a “person” in terms of the definition in section 1 of the Act.
Therefore, although legally there should not be a disposal of assets by the partners to the partnership in option 3 on the basis set out above, the partnership would become a person for tax purposes as a result of it constituting a portfolio of a collective investment scheme. Section 25BA(2) of the Act which deals with distributions to the partners of a Hedge Fund CIS, does not deal with the impact of the portfolio of a collective investment scheme becoming a person for tax purposes. This raises various questions, such as (1) what is the nature of the partners’ interest in the Hedge Fund CIS? (2) what is the cost of such partners’ interest for tax purposes? (3) when did the Hedge Fund CIS acquire the assets and at what cost?
Furthermore, it is not clear what the applicable tax rate will be to such Hedge Fund CIS, as it would not constitute a company and it is not clear whether such portfolio is a trust. Although the Hedge Fund CIS is exempt from capital gains tax any income or revenue gains that are not distributed within the specified time period will be taxed in the Hedge Fund CIS.
The issues pointed out above in relation to option 3 may be theoretical, as it seems that in practice most hedge funds that are currently constituted as partnerships will opt for a transfer of the assets to a Hedge Fund CIS. This makes it even more important that real tax relief is provided and as noted, although the Draft TLAB contains provisions which are aimed at providing for the transfer of the assets to a portfolio of a hedge fund collective investment scheme, the extent of the application thereof is limited.
ENSafrica have provided detailed comments to treasury and the South African Revenue Service on the Draft Bill, pointing out the various limitations and unintended consequences of the proposed relief.
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