The National Treasury's discussion document on the tax treatment of collective investment schemes (CIS), released on Wednesday, underscores future regulatory shifts anticipated under the draft Conduct of Financial Institutions (COFI) Bill.
The bill proposes a comprehensive framework for managing pooled investment vehicles, which are growing rapidly as CIS assets under management reached R3.36 trillion by the second quarter of 2023—a 3% rise from the first quarter. Over the year leading up to June, the industry saw a 13% increase, primarily due to stock market gains, with R16 billion in net inflows resulting from substantial reinvestments.
In the niche hedge fund sector, assets grew to R120bn at the end of June 2023 from R113.01bn at the close of 2022, marking a steady net inflow of R4.27bn and a slight increase in fund numbers.
The COFI Bill will introduce licensing for "alternative investment portfolios" to address the unique risks associated with diversified pooled investments, including hedge funds. This expansion of regulatory oversight aims to differentiate between traditional CIS products and alternative investments, aligning the framework with the specific risks and operational strategies that vary across investment types.
Hedge funds, which permit dynamic strategies like leveraging and shorting, could experience nuanced regulatory adjustments that reflect their particular risk profiles.
Replacing the Collective Investment Schemes Control Act (CISCA), the COFI Bill’s objective is to create an updated framework that encourages industry growth while ensuring investor protection, especially in the hedge fund domain. As these funds continue to stimulate new investments, the regulatory changes seek to promote responsible industry growth and align investor safeguards with market diversity.
Taxation Proposals: Transparent Model and Safe Harbour
Treasury’s discussion document outlines several tax model proposals for CISs. One option is a "fully transparent" tax model that treats CISs as conduits, attributing income and expenditure directly to investors daily. This approach would tax investors as if they earned the income directly, even if the CIS does not distribute it. In this model, the CIS would not be a taxable entity but would only serve as a vehicle for investor income allocation. Each investor would receive a return indicating the income and expenses to be accounted for in their taxable income for the year. The revenue or capital nature of earnings would be determined by the portfolio's activities.
Another proposal involves using a "turnover ratio" to establish a tax-safe harbour, which would classify gains based on a CIS’s trading volume relative to its portfolio size over a year. If the turnover ratio stays below a set threshold, gains would be treated as capital, allowing the CIS to avoid tax under current rules. However, portfolios exceeding the turnover limit would revert to current rules, where gains are classified based on specific circumstances.
Treasury notes that most CIS portfolios have a turnover ratio under 1, allowing a realistic threshold to be set to target only high-activity portfolios. This model would afford CISs greater flexibility to manage risk and cash flows within reasonable limits.
Hedge Funds’ Tax Exemption Considered
The Treasury also proposes removing hedge funds from the CIS regulatory regime, effectively excluding them from the CIS tax treatment. This exclusion would eliminate the need to apply the revenue-versus-capital distinction, which is particularly challenging in the context of hedge funds' often complex strategies.
The Treasury’s document says, as a niche but significant industry, hedge funds would benefit from tailored regulatory and tax treatment, to foster sector growth while ensuring stability and safeguarding investors.
Addressing Tax Avoidance in Corporate Transactions
Treasury also highlighted concerns about tax-neutral share transfers to CISs, which it says some corporations exploit to avoid substantial tax liabilities in restructuring processes. The current tax exemption on unrealised gains for shares transferred to CISs enables significant tax avoidance. Treasury has proposed amendments to the definitions of “company” and “equity share” to prevent CISs from being involved in such asset-for-share transactions, which would close this loophole and preserve revenue for the fiscus.
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