The Association for Savings and Investment South Africa (ASISA) has welcomed National Treasury’s long-awaited discussion document on the tax treatment of collective investment schemes (CIS).
Treasury positions the discussion document, which was released last week, as part of a broader effort to ensure that the tax framework for CIS is comprehensive and equitable. In 2020, Treasury committed to review the income tax treatment of amounts received by CIS portfolios.
One of Treasury proposals is to develop a separate regulatory framework for hedge funds that will allow them to operate outside the traditional CIS framework, providing greater regulatory clarity and tax treatment tailored to their operational model.
Dr Stephen Smith, consulting senior policy adviser at ASISA, said the document invites responses from the public, advisory firms, and the CIS industry primarily on how a simplification rule might be designed to distinguish between income versus capital gains when portfolio assets are bought and sold.
“The document offers several proposals for discussion aimed at implementing a new tax regime for CIS portfolios and achieving tax certainty. This does not mean there will be a new tax liability for the millions of South Africans who save through CIS portfolios.”
Smith said the CIS industry is strictly regulated, and the investment powers of portfolio managers are stipulated in regulation.
“It is therefore somewhat anomalous that explicit tax certainty should not be afforded these portfolios in law. The National Treasury discussion document offers a number of optional proxies to achieve this end. ASISA is appreciative of the fact that the document acknowledges that there may be more than one way of improving income definition.”
Smith said that ideally, the outcome will support the growth of savings as an objective because it is essential to the country’s economic growth and development.
“This requires CIS solutions that continue to be attractive and easily understood by domestic and international investors. CIS portfolios should be of broad appeal and accessible to all; they should not serve the interests of any special groups. They should also encourage a new generation of South African savers who need access to a variety of financial assets to ensure their financial security and the realisation of their long-term financial ambitions.”
COFI is an opportunity
Treasury states that hedge funds, while distinct and smaller within the broader CIS industry, are valuable in terms of economic contribution and diversification of investment options. The document proposes regulatory improvements that balance innovation and risk management, emphasising the hedge fund industry’s potential if supported by clear and effective regulatory measures.
Treasury recognises that hedge funds have a unique position in the financial ecosystem, because they provide investors with exposure to instruments that might otherwise be inaccessible. They can stimulate innovation, promote the growth of unlisted companies, and enhance liquidity through strategies such as short-selling. Their ability to use leverage allows them to take on riskier investments, which can potentially benefit the broader market.
The document highlights that the Conduct of Financial Institutions (COFI) Bill introduces a revised regulatory framework aimed at overseeing investment arrangements that pool public contributions with the goal of generating returns. Under this framework, traditional products such as CIS will be licensed under COFI, while also introducing a new category of pooled investments known as alternative investment portfolios. This distinction will provide tailored regulatory oversight based on the risks these portfolios pose to investors.
The COFI Bill provides an opportunity to reconsider how hedge funds are licensed. The regulatory framework can evolve in a way that supports the growth of the hedge fund industry while maintaining adequate oversight.
Capital vs revenue issue
Treasury outlines the complex issues surrounding the classification of transactions in CIS as either capital or revenue in nature.
The draft 2018 Taxation Laws Amendment Bill (TLAB) proposed changes to the tax policy for CIS. The draft Bill acknowledged that some CIS were generating profits from active trading of shares and financial instruments, but classified those profits as capital, based on the long-term investment intentions of CIS investors. The inconsistency in applying the capital/revenue distinction led to a perception of uneven application of tax laws across different CIS.
The draft TLAB proposed that all gains and losses from disposals of financial instruments within 12 months of acquisition in CIS portfolios be deemed as income (revenue) for tax purposes.
National Treasury, however, recognised the industry’s concerns and made concessions in the revised draft, addressing issues such as portfolio rebalancing, hedging, and transactions aimed at efficient portfolio management. Despite these efforts, the amendment Bill was eventually withdrawn.
Exploring the options
Treasury explores whether there should be any change to the current taxation regime of CIS with respect to the characterisation of the receipts and accruals of a portfolio. It says any recommendations should seek to enhance tax certainty in the South African CIS industry while maintaining the integrity of the tax system.
“CISs offer a liquid, regulated, and diversified savings option to ordinary retail investors. This is important given that South Africa has a low savings rate for both retirement and non-retirement savings,” Treasury says. “Any changes to the CIS taxation regime should be in line with efforts to encourage more savings, while retaining the principles of a fair tax system,” document says.
Characterisation of income within CIS
Some fund managers have argued that CIS investments are typically held with the long-term intent of being capital assets, which could justify treating all receipts and accruals as capital in nature.
National Treasury rejects this approach because it would result in tax avoidance by classifying all returns as capital, regardless of the actual trading activity.
“CIS investors already receive a favourable tax treatment through the deferral of capital gains until their participatory interest is sold, but it is not proposed that a further tax concession be provided for returns that would be of a revenue nature.”
Full transparency in CIS taxation
One recommendation is to adopt a tax model where CIS are treated as fully transparent entities. This means CIS would act as conduits, passing all receipts, accruals, and expenses directly to the investors for taxation purposes. This approach would align the tax treatment of CIS in South Africa with international norms, such as those in Switzerland and Hong Kong.
It would also eliminate the problem that investors may be liable for potential tax payments from trading activities when they did not hold a participatory interest in the CIS.
The uncertainty about the characterisation of income would remain, but in theory any income that is seen as revenue could be attributed to the CIS investor at the time as it is calculated.
This option would eliminate tax concerns for the CIS manager. However, investors would lose the benefit of the deferral of capital gains tax and may face cash flow issues if a tax liability is due on the returns within the CIS, even if they have not sold any of their participatory interests in the CIS.
Turnover ratio as a safe harbour
This proposal introduces a safe-harbour concept, where the tax treatment of a CIS’s gains depends on the portfolio’s turnover ratio. If the turnover is below a specified threshold (for example, 33%), all gains will be treated as capital in nature. If turnover exceeds the limit, the current rules will apply, and gains will be classified based on the facts and circumstances.
Most CIS portfolios have a turnover ratio of below 1, so it may be possible to set a realistic limit that will target only those CIS that are overly aggressive, while also making it more flexible for CIS to manage their portfolio flows and risk within reasonable limits.
However, the potential challenges include managers manipulating turnover ratios and the complexity of applying this rule to derivative instruments.
Exclude hedge funds from the CIS tax definition
Treasury says hedge funds target sophisticated investors who use hedge funds as an active part of a high-risk, high-return investment strategy.
However, the hedge fund sector is significantly smaller than the CIS industry and the returns are low. The CIS sector had R3.36 trillion in assets under management (about 50% of the country’s GDP) in the second quarter of 2023, whereas hedge funds had R120 billion in AUM.
“Of the 69 hedge funds that have been in operation for five years, only five have delivered annualised returns of greater than 15% per annum, while 20 have delivered returns of between 10% and 15%, and 18 have provided returns of between 5% and 10%. There were 18 hedge funds that delivered negative returns, highlighting that these investment vehicles are inherently risky,” Treasury says.
In light of the abovementioned factors, Treasury proposes that hedge funds are excluded from the CIS tax regime.
Treasury and the FSCA can use the COFI regulatory framework to encourage the development of the hedge fund industry, while ensuring stability and the protection of consumers, the document says.
A further reason for treating hedge funds differently from a tax perspective is that “they are not collective investment schemes in essence”.
This option would also exclude many of the funds where the “revenue versus capital distinction” is most at question.
Treasury says it welcomes the industry’s views over whether this amendment alone would be sufficient to address the industry’s concerns about fair tax treatment and tax certainty.
“Going forward, National Treasury will look to implement a targeted and separate regulatory framework for hedge funds brought about through COFI to operate alongside and outside of the framework for traditional CIS in securities. This recognises the unique characteristics of hedge funds and more correctly distinguishes them from collective investment schemes, allowing for greater alignment between the tax and regulatory treatment,” the document says.
Deadline to comment
Treasury invites stakeholders to provide detailed written comments on the proposed options in the discussion document by close of business on 13 December 2024 via email: CIS-Tax@treasury.gov.za
