Discussion document coming on tax treatment of collective investment schemes

National Treasury will publish a discussion document dealing with the tax treatment of collective investment schemes’ trading profits before proposing amendments to the Income Tax Act, the 2022 Budget Review says.

CIS distributions that are not of a capital nature to unit holders within 12 months after that income is accrued (or, in the case of interest, is received by a CIS) are deemed to accrue to unit holders on the date of distribution and are subject to tax in the hands of the unit holders.

This conduit principle applies only for income tax purposes. If a CIS realises a capital gain or loss, it is disregarded for capital gains tax purposes in terms of paragraph 61(3) of the Eighth Schedule to the Income Tax.

However, the Act does not explicitly state the distinction between capital and revenue, and what constitutes a “capital” amount depends on facts and circumstances, as well as the principles developed in case law.

In 2018, the government identified that some CISs are effectively generating profits from the frequent trading of shares and other financial instruments. The CISs were of the view that the profits were of a capital nature (and thus exempt from CGT), based on the intention of long-term investors.

As a result, National Treasury proposed amendments to clarify the tax treatment of trading profits of CISs. According to these amendments:

• Distributions from a CIS to unit holders derived from the disposal of financial instruments within 12 months of their acquisition would be deemed to be income of a revenue nature and be taxable as such in the hands of the unit holders if distributed to them under current tax rules relating to distributions.
• Where a CIS acquired financial instruments at various dates, the CIS would be deemed to have disposed of financial instruments acquired first, thereby using the first in first out method to determine the period the financial instruments were held.
• Deductions and allowances would not flow through to unit holders and amounts deemed to have accrued to unit holders would be limited to amounts of gross income reduced by deductions allowable under section 11.

The asset management industry was not happy with the proposed amendments for the following reasons:

• They would cause unfairness between unit holders within a portfolio when a large unit holder decides to redeem units, thereby triggering the sale of portfolio assets that have been held for less than 12 months, resulting in a tax liability on distribution to all unit holders.
• The proposed time-based rule affected all manner of transactions, including unit holder withdrawals, portfolio rebalancing, index-tracking, hedging and transactions directed at efficient portfolio management (for example, purchasing a derivative to gain economic exposure to a share in lieu of holding the physical share).
• The industry was engaged in a study of the impact of the proposals, which was not completed in time before the effective date of the amendments.

As a result, the proposals were put on hold to give the government and the asset management industry more time to find solutions that would have a less negative impact on the industry and unit holders.

It remains to be seen whether the forthcoming discussion document will provide a solution that satisfies the government and the asset management industry.