South Africa: A Hospitable Habitat

Last Updated: 29 July 2011
Article by Shayne Krige

At the time of writing, South Africa's Treasury was finalising its Tax Amendment Bill which it is hoped will make vital improvements to the country's tax treatment of foreign funds. With high-return investments in emerging markets in the East and South America proving increasingly scarce, Africa is becoming a popular destination for international capital. The continent remains dark for many foreign investors and perhaps moreso than in any other region, investors need expert investment managers to assist them in deploying their cash.

Given the dominance of the South African economy, the country is the most likely destination for African capital. Also, with South Africans having proven adept at managing investments elsewhere in Africa, local skills are sought after by investors targeting the rest of Africa.

This is good news for South Africa. An expanding investment management industry creates jobs at all skill levels and attracts highly paid individuals who pay taxes on the money they earn and the cash they spend locally.

Unfortunately, this potential is currently difficult to tap because hiring a South African investment manager is an extremely bad idea for a foreign fund as it results in two major tax consequences.

First, any income that is deemed to have a South African source is taxable in South Africa which, because of the way the law is interpreted, may well be the case if the local manager has discretion to contract on behalf of the foreign fund. This is a risk that is easier to manage in other jurisdictions and it makes it very difficult for a South African manager to fulfil a truly discretionary mandate.

The second and more serious issue relates to tax residency. A fund that has its "place of effective management" will be deemed to be South African tax resident. Internationally, this is the place where the fund's high-level strategic decisions are taken. The South African Revenue Service's (SARS) interpretation differs such that a fund will be effectively managed where the investment decisions are implemented rather than the place where the investment objectives, policy and restrictions are set.

This is a uniquely South African problem and although the note setting out SARS' interpretation is not law and is widely held to be incorrect, it nevertheless has a chilling effect on the allocation of investment mandates to South African managers who are under pressure to move their operations to places like London, Geneva or Mauritius.

The UK is a one of many countries that have created an investment management exemption in terms of which only the investment management fees paid to a UK-based manager are taxable. The management activities neither create a local source of profits nor do they result in the fund becoming UK tax-resident. London remains the de facto financial capital of Europe and the global investment management hub despite the high cost of living and relatively high (and rising) personal tax liability UK managers face.

In May 2010, the Treasury proposed changes to the Income Tax Act which focused on creating a "regional investment fund regime". I believe the demand for an African investment fund structure is small. Investment funds with a multi-jurisdictional focus are mobile entities and generally set up shop in jurisdictions that have low tax and low regulation.

A panoply of jurisdictions offers attractive regimes for investment funds. Despite Mauritius' attempts at attracting this business, the bulk of investment funds targeting Africa are still set up in the Caribbean or Europe. It would be enormously difficult for South Africa to attract the actual fund business. On the other hand, the investment managers who manage these funds are less mobile and in fact more interesting in terms of the taxable revenues they generate.

The proposal document does recognisethat "the possibility of creating a taxable South African permanent establishment makes South Africa unattractive to foreign investors seeking to utilise [structures] with a portfolio manager within South Africa," and proposes tax relief to remedy this situation. The actual implementation has to date fallen somewhat short of achieving the stated aims. Although the amendment has been widely welcomed as a positive step in the right direction, it has been criticised for:

  • focusing on the fund structure rather than the relationship between the fund manager and the fund prompting the question as to why contractual investment management mandates are not covered;
  • being limited to funds set up as partnerships and trusts, excluding funds set up as corporate entities and essentially focusing on foreign private equity funds; and
  • dealing exclusively with the permanent establishment issues that funds and their investors currently have and not extending to the issue of a fund's tax residence being in South Africa by virtue of the discretionary actions of its South African managers.

In the 2011 Budget speech, Pravin Gordhan, South Africa's finance minister, indicated that further amendments are in the pipeline. The country's competitive advantage lies in its infrastructure and skills. These play to its ability to provide investment management services rather than offer a competitive fund regime. The government would be well advised to play to South Africa's strengths by attracting investment managers rather than focusing on investment funds.

What the country needs is a regime that allows investment managers to conduct discretionary activities, whether under a contractual mandate or through a particular structured participation, without creating any tax risk for a foreign fund. It is important that the law is unequivocal in relation to South Africa's taxing rights so that investors (be they individuals or funds) are left in no doubt as to the consequences for them of using a local manager.

When it comes to investment management activity, it is not far-fetched to imagine Cape Town or Johannesburg as the African equivalent of the City of London. If South Africa does not react soon, this business will establish itself elsewhere and it remains to be seen whether the changes that are due in 2012 will, by creating a true investment management exemption, give the country the tools it needs to capitalise on this opportunity.

Draft tax changes fail to satisfy foreign funds

The South African Treasury's Draft Tax Laws Amendment Bill published on 2 June has provided some good news for foreign funds looking to invest in South Africa, but has not addressed all the challenges posed by the current tax environment, according to industry sources.

"The draft is a step in the right direction but only appears to address half the issue," said one offshore hedge fund service provider, referring to the proposed abolition of 'deemed sources'. Currently, income that is deemed to have a South African source is taxable in South Africa, which may be the case if the local manager has discretion to contract on behalf of the foreign fund.

"This important amendment would go a long way to addressing the source issue facing investment funds," said Shane Krige, director of Cape Town law firm Werksmans Attorneys. "However, the amendments do not appear to address the residency issue."

Krige was referring to the part of the tax law that treats foreign funds as residents of South Africa if they use a local fund to make investment decisions – which has not been altered in the draft. At present, South Africa's tax environment is considered relatively inhospitable for foreign funds hiring domestic managers, with many preferring to use the tax-friendly offshore centre Mauritius as a route into South Africa.

"The draft seems to offer a different kind of investment management exemption that has a similar effect to the provision in the UK but the changes are not material," added the offshore service provider. However, Krige said, "there has already been some discussion about proposals contained in the draft and it is likely the final version will be substantially different".

Footnotes

1 The articles in this legal brief were first published in African Fund Manager, June 2011.

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.

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