You can run, but you can’t hide: Taxation of collective investment schemes up for further discussion

Collective investment schemes (CISs) essentially pool funds together for the purpose of operating as a type of investment vehicle for investors. CISs have a special taxation regime in that for income tax purposes, distributions (that are not of a capital nature) from a CIS to unit holders within 12 months after that income is accrued (or in the case of interest is received by a CIS) follow the flow-through principle and are deemed to accrue to the unit holders on the date of distribution and subject to tax in the hands of the unit holders. This is in accordance with the well-established conduit pipe principle in South African law.

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Notably, the conduit principle only applies for income tax purposes, whereas in the event a CIS realises a capital gain or loss, then such gain or loss is disregarded for capital gains tax purposes under para 61(3) of the Eighth Schedule to the Income Tax Act 58 of 1962.

Determining whether a receipt is capital or revenue in nature is one of the most debated topics in South African tax law and has made its way to court on countless occasions. This is because the distinction is not explicitly stated in the Act and reliance is based on facts and circumstances as well as the principles developed in case law.

2018 proposals

During 2018, the Government identified that some CISs are in effect generating profits from the active frequent trading of shares and other financial instruments. These CISs, however, were of the view that the profits were of a capital nature (and thus exempt from capital gains tax) on the basis of the intention of long-term investors in the CIS.

In 2018, amendments were thus proposed by the National Treasury to clarify and provide certainty on the tax treatment of trading profits of CISs. The CDH Tax & Exchange Control Department previously discussed this proposal in the Special Budget Day Alert for 2018. It is worth revisiting the 2018 proposals which were as follows:

  • Distributions from the 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.

Public submissions

There was significant public consultation on the proposals with the asset management industry submitting that the proposals should be withdrawn for various reasons. In the Response Document on the 2018 Taxation Laws Amendment Bill, the National Treasury referenced the following submissions made by the industry as to why the amendments should be withdrawn:

  • The proposed amendment 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.

Given the above, the 2018 proposals were put on hold to give Government and the asset management industry more time to investigate and find solutions that would have a less negative impact on the industry and holders of participatory interests. Since 2018, there have been numerous discussions and workshops regarding the proposed changes to the taxation of CISs with various concerns being raised by the industry.

Government now proposes that a discussion document dealing with the tax treatment of amounts received by or accrued to CISs be published for public comment before any amendments are proposed to the tax legislation. CISs and asset managers should thus ensure they keep an eye out for the discussion document as it will most certainly have a potential impact on the way in which CISs will be taxed.

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