It is proposed in the draft Taxation Laws Amendment Bill, released for comment on 4 July, that hedge funds should be included in the tax regime for collective investment schemes (other than collective investment schemes in properties). Certainly, normal tax principles are inadequate to cater for hedge funds and a special tax dispensation will provide certainty as to the tax treatment. The special tax dispensation will only apply to hedge funds that have been declared by the Minister to be a collective investment scheme in terms of the Collective Investment Schemes Control Act. The regulatory framework to deal with hedge funds in terms of the Collective Investment Schemes Control Act is still in the process of being finalised and the tax proposals, intended to take effect 1 January 2014, may be premature.
The tax proposals include changes to the existing tax dispensation for collective investment schemes, following an overhaul of this tax dispensation as recent as 2010. The first welcoming simplification is to completely exempt the investment vehicle and to only levy tax at the investor level. The current tax rules require a distribution of income to investors within 12 months, failing which the investment vehicle must recognise the income for tax purposes. The second proposal will at first glance sacrifice fair treatment for simplicity. It is proposed that all distributions to investors are subjected to income tax (as opposed to the lower capital gains tax rate), except:
- The repurchase of units by the investment vehicle. This will, as in the case of the disposal of units of exchange traded funds in the market, be subject to normal tax principles.
- The distribution of dividends. Local dividends will generally be exempt from income and subject to withholding of Dividends Tax (which is levied at a lower rate than income tax and with the potential of a Dividends Tax exemption applying).
The proposal to subject distributions to income tax potentially increases the tax rate where capital gains realised by an investment vehicle are distributed to investors. However, collective investment schemes in any event do not distribute capital profits, but reinvest. This is not necessarily the case with hedge funds.
In addition to the above, there is a proposal to prevent hedge funds to act as a character converter. What does this mean? The hedge fund will be exempt from tax. The investment growth of an investor that remains invested in the fund for more than three years will be subject to the lower capital gains tax rate. However, if the hedge fund was not exempt from tax, normal tax principles would have applied and revenue profits in the hedge fund will have been subject to the higher income tax rate. Specific mention is made in the Explanatory Memorandum of the greater potential for revenue profits where hedge funds enter into derivatives. Because the hedge fund will be exempt, there could effectively be a 'conversion' of the revenue gains in the hedge fund to capital gains in the hands of the investors. It is proposed that a distinction is drawn between retail hedge funds (open to the public) and restricted hedge funds. Investors disposing of units in restricted hedge funds will always be subjected to income tax. Investors disposing of units in a retail hedge fund can rely on automatic capital gains tax treatment after a 3 year holding period.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.