There has been a debate raging for a while now, involving National Treasury and the asset management industry, about the taxation of collective investment schemes (CISs), which include unit trust funds, exchange traded funds (ETFs), and, in recent years, hedge funds.
Treasury has made clear that it raised the issue not with the intention of receiving more tax revenue, but to ensure legal clarity on the different forms of taxation within CISs. However, proposals from Treasury to settle the matter, if implemented, could directly impact investors, by either increasing their tax burden or adversely affecting their returns.
Thankfully, after feedback from the investment industry, its more radical proposals appear to have been shelved.
What is the issue?
At the heart of the debate is the question of which tax applies when you sell an asset for a profit. Is it taxed as revenue (income from sales) or as a capital gain? The rule of thumb is that if buying and selling assets is core to your business, then your profits are revenue, but if you have invested long-term in an asset, your profit when you sell it is a capital gain. Deciding factors are the frequency of sales and your intent.
CISs, governed by the Collective Investment Schemes Control Act, have enjoyed special treatment from SARS. Capital gains in the CIS are exempt from tax – the liability is passed down to investors, in a similar way that, through the conduit principle, tax liability in a trust may be transferred to its beneficiaries. However, it is only when the investor sells units that capital gains tax (CGT) is triggered and the tax becomes payable in the hands of the investor, deferring the benefit for SARS.
This “deferred-CGT” arrangement continued happily for years until around 2018, a few years after retail hedge funds were brought under the Cisca umbrella. The trading activity in these funds, which is speculative and involves derivatives, led Treasury to question the nature of the returns – were they revenue or capital gains? They also began looking at traditional unit trust funds and asking the same question where fund managers traded assets over shorter periods.
Treasury’s proposals
In a discussion document released by Treasury in December last year, Treasury considered a few options:
1. Treat all income in the CIS as revenue in nature, placing the tax liability on the CIS rather than the investor.
2. Make CISs fully tax transparent. This system is used in the United States and Australia, among other countries. The discussion document notes: “Investors will be treated as if they earned the amounts and incurred the expenditure directly and are taxed accordingly, even if the CISs do not distribute the income. The CIS will not be a taxable entity in its own right, but merely a conduit. The revenue or capital nature of amounts will be determined from the perspective of the portfolio and activities of a CIS.” This would require daily valuations and detailed records of disposals.
3. Introduce a threshold or “safe harbour”. A threshold, such as a certain turnover ratio of the fund – would determine the tax treatment of the portfolio. Below the threshold, proceeds would be classified as capital gains. Above it, a “facts and circumstances” approach would be applied to distinguish between capital and revenue.
4: Remove hedge funds from the special CIS dispensation.
Industry kick-back
In a subsequent workshop with Treasury, representatives of the banking and investment industry, including the Association for Savings and Investment South Africa (Asisa), fought back against any proposal that would unnecessarily complicate the administration of CISs or place a further tax burden on investors or the industry. They were strongly opposed to the idea that CISs were profit-making schemes in their own right.
“The notion or possibility that a regulated CIS portfolio, after being offered to the public as a scheme approved for investment, could somehow be re-characterised as a scheme for profit making is untenable,” said Dr Stephen Smith, consulting senior policy adviser at Asisa, in articulating Asisa’s position at a recent media briefing. “We would prefer the avoidance of special conventions which disturb the natural portfolio management function. 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.”
Government backs down
Last week’s Budget proposals by Finance Minister Enoch Godongwana indicate that the government has heeded the concerns raised by the industry and backed down on the two most radical options: taxing all returns as revenue within the CIS or making CISs fully tax-transparent. Future discussions are likely to centre on the treatment of hedge funds.
