Investments in foreign tax transparent entities
13 May 2014
Posted by: Author: Werksmans Tax
Author: Werksmans Tax
In this context, the concept of a foreign partnership was introduced into the South African tax law with a view to allowing South African taxpayers to follow the foreign tax analysis applicable to that entity. Essentially, a foreign partnership includes foreign entities (not only partnerships) which are treated as flow-through vehicles for purposes of the tax regime of the country in which the vehicle is formed.
Prior to the introduction of the foreign partnership concept, it was not uncommon for a foreign tax transparent entity to be treated as a foreign company for South African tax purposes. A South African tax resident investing in such an entity often was faced with a situation where, for foreign tax purposes, the investor was regarded as earning the underlying income (say, interest earned by the foreign entity), but for South African tax purposes that amount was categorised as a (foreign) dividend. (As part of the South African reforms, foreign dividends are now also categorised with reference to their foreign classification.)
The developments to synchronise the local tax regime with foreign regimes are commendable. There are, however, some areas where refinement is required.
One such area relates to the South African rule applicable to partnerships (including foreign partnerships), in terms of which a partnership interest is not regarded as a separate asset. The upshot of this rule, as far as currently relevant, is that an investor in a foreign partnership is regarded as disposing of the (relevant percentage of the) underlying partnership assets upon a change in investors or upon exiting the investment vehicle.
Applying this rule in the international investment environment, South African investors in foreign tax transparent entities need to account for tax every time the investor composition changes. Not only is it not commercial or practical to levy tax in a situation like that (as the South African investor is not, commercially, realising an investment or a portion of the investment), it is in most instances not possible to obtain the information required to calculate the tax arising on such a deemed disposal and reacquisition of the underlying assets.
This dilemma often manifests itself in practice in the form of foreign hedge funds, which are often set up as tax transparent entities. Generally, the foreign rules are such that, although the entity is regarded as tax transparent, an investor’s interest is treated as a separate asset which is disposed of only upon the investor actually disposing of an interest. Consequently, during the course of the investment, investment proceeds of the fund will flow through to the investor and will be taxed in the hands of the investor. However, upon the investor disposing of the interest in the hedge fund, the interest is treated as though it is a share in a company. A gain or profit is then determined on such disposal without any reference to the underlying assets, but simply by taking into account the difference between what the investor paid for the interest, and what the disposal proceeds are. That way, there is no need to take a "snapshot” of the value of the hedge fund’s assets at any given time when an investor exits. What is thus required is treatment similar to that adopted in the case of local collective investment schemes, i.e. unit trusts.
It is clear that the foreign classification of the disposal proceeds (being proceeds on the disposal of one asset, being the "share” in the fund which often is regarded as being held on capital account), may very well differ from the South African classification of the proceeds as consisting of proceeds on the part disposal of various underlying assets, some of which may be regarded as trading stock while others may be regarded as capital assets. The different classifications complicate the application of double tax treaties.
What complicates the South African position further are the foreign currency conversion rules. As the South African investor may need to calculate the rand-denominated tax cost and the proceeds with reference to the dates when the hedge fund acquired those assets, the investor will need to get the relevant dates from the fund – often impossible in practice.
These problems have been brought to the attention of the authorities and indications are that solutions may be forthcoming to bring the South African treatment in line with the foreign treatment, so that an interest in a tax transparent entity would no longer be referenced to the underlying assets of that entity. The flow-through rules would then only apply to the investment income and gains earned by the fund, but the investment itself will be treated as a separate asset, similar to a share in a company.
This article first appeared on polity.org.za.