Professor Emil Brincker | The tax treatment of collective investment schemes

National Treasury released a discussion document on 13 November 2024 dealing with the tax treatment of portfolios of a CIS, including the tax treatment of the holders of the participatory interests in these portfolios (Units).

Amendments were proposed to the ITA in 2018 to provide certainty on the income tax treatment of profits earned by CISs. The proposal was to the effect that profits would be on capital account to the extent that a specific counter has been held for a period of longer than 12 months. However, after reviewing the public comments that were made at the time, it was decided to withdraw the proposals to allow more time to work with industry to find solutions that would not negatively affect the relevant stakeholders. 

The discussion document came as somewhat of a surprise in circumstances where the impression was created that certain amendments would be proposed in the Budget. During a workshop that was held on 17 January 2025, National Treasury indicated, however, that decisions will not be made overhastily and that the interests of all stakeholders will be considered. 

The relevant items that were highlighted in the discussion document were the following:

• the treatment of CISs themselves;
• the treatment of hedge funds;
• whether CISs should be allowed to participate in asset-for-share transactions in terms of section 42 of the ITA and to facilitate rollover relief; and
• the treatment of capital distributions by CISs.

The proposals dealing with the tax treatment of CISs

In terms of section 25BA of the ITA, CISs enjoy a flowthrough tax treatment insofar as income is concerned. This means that the holder of Units would be taxed on interest and/or dividends, as the case may be, as opposed to the CIS itself. A CIS would only be taxed to the extent that income/revenue is not distributed to investors within a period of 12 months after accrual/receipt thereof.

In making the proposals, National Treasury indicated that:

• not all returns are automatically taxed as capital, hence the current uncertainty in the market;
• the relevant proposals were made in addition to the common law principles dealing with whether receipts are on capital account;
• the relevant proposals are not aimed to tax all returns as revenue;
• the proposals are not aimed at raising more revenue;
• it will impact negatively upon returns by not allowing for tax deferrals; and
• not all hedge funds operate in a similar manner.

Two proposals were made in relation to the tax treatment of CISs insofar as it relates to capital receipts. Neither of these proposals is really practical and they present a number of concerns.

The first proposal entails the CIS being treated as fully tax transparent. Capital gains and losses would be allocated to Unit holders on a daily basis and reported to them on an annual basis. This would result in CISs not being subject to tax at all in respect of capital gains. This should be compared to paragraph 61 of the Eighth Schedule to the ITA which currently provides that:

• any capital gain or capital loss in respect of the disposal of an asset by a CIS must be disregarded; and
• a Unit holder must determine a capital gain or a capital loss in respect of a Unit only upon the disposal thereof.

The treatment of a CIS as fully transparent, however, would not be practical. Even though taxation only occurs at the investor level, there would be substantial reporting complexities. In addition, some Unit holders would be prejudiced in circumstances where the timing of the investment in the CIS and the timing of the disposal of an asset by a CIS did not coincide. New investors would thus be subject to capital gains in respect of profits enjoyed by earlier investors and vice versa. This would make CISs less attractive as saving vehicles. The problem is that fund compositions change daily due to investor flows and fund managers’ intercessions. Even with accurate attribution, the subjective classification methods would remain vulnerable to SARS’ challenges as intention is very difficult to verify. In addition, investors would be unfairly taxed in view of fund managers’ decisions rather than their own investment activities. In addition, it may also result in some foreign investors not paying tax at all.

The second proposal entails a safe harbour rule in the sense that disposals within a certain pre-determined ratio would be deemed to be on capital account. This ratio is set between portfolio trading turnover and portfolio size. A percentage of 33% was proposed by National Treasury. Even though this proposal obtained more support, it was indicated that its conceptual design and application still need careful consideration. Some commentators indicated that the safe harbour rule should not apply to closely held CISs. However, generally a 33% threshold is too low and restrictive. Turnover in a portfolio is only measured to determine if a fund is speculating or not. Thus frequency of trading in itself cannot be a test to determine whether proceeds are on capital account. It was also indicated that fund managers may retain underperforming or overvalued assets to avoid exceeding turnover limits. In other words, managers may avoid re-balancing portfolios merely to stay within the threshold.

Even though the safe harbour rule is thus more palatable than the transparent entity proposal, it still does not specifically cater for the requirements of CISs. 

Hedge funds

One of the proposals was to exclude hedge funds from any deemed capital treatment. However, commentators argue that, if a hedge fund is treated as a CIS, it should get the same tax treatment. In addition, it is argued that there is no distinction between long only and other hedge funds. It would also create uncertainty about how hedge funds will otherwise be taxed.

Another proposal was to the effect that closely held funds should be excluded. However, the number of investors should not in itself impact upon the treatment of proceeds. Another objective criterion should be found.

There is a line of thinking that, to the extent that CISs in securities which generally focus on the actual acquisition of counters and are therefore “long only”, it should potentially result in a separate treatment for these types of funds compared to hedge funds, or more particularly, qualifying investor hedge funds. This is especially the case to the extent that the investment framework for hedge funds is potentially different from CISs in securities.

Disqualification of CISs from corporate rollover relief

In terms of this proposal CISs could not participate in corporate rollover relief transactions. This is especially the case given the potential abuse in circumstances where:

• an investor needs to realise a specific investment because of corporate action, which will result in capital gains tax for the investor;
• the relevant counter is transferred by the investor to the CIS in terms of section 42 of the ITA dealing with asset-for-share transactions in return for the issue by the CIS of additional Units to the investor;
• the CIS thereafter realises the counter on the basis that paragraph 61 of the Eighth Schedule provides that the proceeds are exempt; and
• the investor continues to hold the relevant investment in the CIS even though the base cost of the Units is equal to the base cost of the counter that was transferred to the CIS.

Some of the proposals indicated that the exclusion of CISs from corporate rollover relief may harm legitimate transactions. One should rather apply the General Anti-Avoidance Rule, alternatively distinguish between publicly traded and widely held CISs to closely held CISs.

In terms of the Budget it was indicated that this proposal will be implemented. It seems that there was too much perceived abuse in this area where investors obtained relief by transferring their shares to a CIS.

Capital distributions by a CIS

There is currently a school of thought that capital distributions by a CIS will result in no tax whatsoever on the basis that:

• a CIS is exempt from capital gains; and
• there is no part disposal by a Unit holder to the extent that it receives a capital distribution from a CIS.

This type of transaction has not enjoyed that much attention given the fact that CISs could not make capital contributions in the past. However, with CISs being able to do so (especially hedge funds), attention has shifted on the basis that it seems to be accepted that:

• the base cost of the Unit holder should be reduced by the capital distribution on the basis that the CIS itself will not pay any tax; and
• to the extent that the Unit holder does not have any base cost in the Unit, a capital gain arises.

This proposal will also be implemented in terms of the Budget. In the interim it does seem that there was a flurry of capital distributions and the question arises of whether SARS will attack same or whether the amendment will be retrospective.

*Professor Emil Brincker, Director and Head: Tax & Exchange Control practice at Cliffe Dekker Hofmyer, Corporate Tax.