Hedge funds in SA may face more tax uncertainty

The hedge fund industry is still small, but is described as the most innovative financial vehicle in the South African market in the last decade.

However, a recent proposal by National Treasury would create tax uncertainty for investors in these funds and may potentially lead to investments flowing to international hedge funds where there is tax certainty.

Treasury published a discussion document on the tax treatment of collective investment schemes (CIS) at the end of last year. One of the proposals in the document is to take hedge funds out of the CIS tax regime.

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Big debate on future of CIS taxation

This option would automatically remove the current tax treatment and take out many of the funds where the revenue-versus-capital distinction is most at question, Treasury argued.

The South African Revenue Service (Sars) has been auditing hedge funds, reclassifying capital as revenue within the funds and taxing it. Capital is tax exempt in the fund, but revenue is not.

Joon Chong, tax partner at Webber Wentzel, said during a National Treasury workshop that instances where Sars declared capital amounts as revenue during an audit does not mean it was because of trading activities.

She noted that companies would rather settle with Sars than engage in costly and protracted litigation.

South African case law is quite outdated and the chance of being successful in court is slim.

The history

In 2015, the South African government took steps to incorporate hedge funds into the broader regulatory framework for CISs.

Read: Unlocking growth: The rise of hedge funds in SA’s investment landscape

In the discussion document, the hedge fund business model is characterised as “the active trading of underlying assets or positions held for relatively short periods and may well include gearing and the use of derivatives” to ensure the highest possible returns.

“This business model would be indicative, in terms of case law, of a profit-making scheme, the gains of which should be of a revenue nature.”

Treasury also described them as “complex and exotic investment vehicles” that are only available to high-net-worth individuals and institutional investors.

Too simplistic

In their comments, industry specialists said assumptions in the document about hedge funds and how they are managed are oversimplified. There is no distinction between long-only and other hedge funds, or between closely held and widely held hedge funds. It was almost like there was a one-size-fits-all approach.

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Cy Jacobs, co-founder of 36One Asset Management, said the discussion document paints hedge funds in “pretty poor light” and describes them to be risky. In reality the amount of trading, particularly in large hedge funds, is less than the amount that occurs in long-only funds.

This was echoed by Clint du Sautoy, consultant at Dinc Management, who said about 40% of the hedge fund industry, in terms of rands invested, has exposure to very static capital assets.

“In terms of the capital nature of these portfolios, they are as capital as capital can be. They do not churn.”

He also noted that in the UK the revenue authority’s approach is that the active management of an investment portfolio is not considered as trade.

Good fit

Du Sautoy raised concerns that taking hedge funds out of the CIS tax and regulatory regime will set the industry back 10 years.

“The industry is properly regulated and definitely fits under the CIS umbrella. It has given investors a lot of confidence and in some respects, SA is far ahead of the world.”

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Other commentators also warned that removing it from the CIS regime may undermine the role of hedge funds in mitigating market inefficiencies. Investors may prefer international hedge funds, which will shrink the domestic hedge fund market.

Uncertainty about the taxation and regulation of hedge funds will be negative for market sentiment.

Matt Whitelaw, equity analyst at 36One, said the hedge fund industry in SA is around 3% of the market, while it is around 20% in the US and also around 20% in emerging markets such as Brazil.

There are a number of jurisdictions looking to attract hedge funds, notably Abu Dhabi. Several hedge funds are redomiciling there because they have tax certainty. Abu Dhabi is prepared to pay 40% of upfront costs for hedge funds to redomicile there.

“You basically create a death wish for the hedge fund industry [in SA] by not giving it tax certainty,” he added.

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