Tax-free conversions of hedge funds: not so simple?
22 January 2016
Posted by: Author: Keith Engel
Author: Keith Engel (SAIT)
Converting hedge funds into collective investment schemes may face tax
those who are unfamiliar with the world of exotic financial instruments, a hedge
fund is a pooled security investment vehicle administered by a professional
investment management firm. In South Africa, these funds are typically
structured as en commandite
partnerships or trusts, both of which are flow-through vehicles for tax
terms of underlying activities and instruments, a hedge fund uses any strategy (or
takes any position) that could result in a securities portfolio incurring
losses greater than its aggregate market value. It’s also characterised by the
fact that its strategies or positions include leveraged or net short positions.
typical securities savings funds almost exclusively invest in long-positions
(with minor investments to offset risk) and do not rely on borrowings for
investment, hedge funds rely heavily on
leveraged or short-positions for profit.
recently, hedge funds fell wholly outside the regulatory scope of the Financial
Services Board. Hedge funds have
generally been regarded as complex and exotic investment vehicles that are available
only to high net worth individuals and institutional investors.
hedge fund managers themselves have been regulated (under the Financial Advisory
and Intermediary Services Act,No. 37 of 2002). It seemed that no regulation was required
because these funds were viewed as too sophisticated for the retail investment
2015, this perception changed with the introduction of a new framework that now
allows (or even requires) the regulation of certain hedge funds in accordance
with the Collective Investments Scheme Control Act.
means that many funds are now required (or may simply opt) to be converted into
a collective investment scheme.
Collective investment schemes typically house security funds in the form
of a trust (with company incorporation being a theoretical but impractical
How government wants to ensure tax-free
order to facilitate the conversion process, the draft Taxation Laws Amendment
Bill (Draft TLAB) (formally introduced in the National Assembly on 15 October
2015) amends the definitions of "company” and "equity share” contained under
section 41 of the Income Tax Act. These
amendments expand both definitions so that they include a portfolio of a hedge
fund collective investment scheme and the units thereof.
extending the definitions the legislator has effectively allowed for the
tax-free rollover of unregulated hedge funds into regulated hedge funds. The parties will effectively be seeking to
transfer the assets of the unregulated hedge fund into a regulated fund with
the initial hedge fund unit holders swapping their unregulated units for
regulated units. These transfers may
entail asset-for-share transactions under section 42, or amalgamations under
section 44. The parties swapping the
hedge fund units need not have started or ended with any set minimum percentage
of units (i.e. starting and ending percentages can fall below 10 per cent).
So what’s the problem?
big issue is the potential capital versus ordinary nature of the securities
contained within the hedge fund. As soon
as the tax character changes, for example trading stock is converted into capital
assets, the transaction or amalgamation will fall outside the rollover
treatment. This is true, even if all other requirements of sections 42 and 44
character of hedge fund securities has remained
a vexing tax question for many years.
The question is how to classify the nature of these instruments under
South African judicial principles when no authorities specifically exist on
point. As a result, there are several
different views that have come about based on common practice:
- Some revenue officials take the informal
position that all securities derivatives should be viewed as ordinary. The
finite nature of these instruments is said to mean that a disposal has always
been intended at the outset with all gain being viewed ordinary.
- A common industry view is that all
derivatives that are hedging long instruments must be viewed as hhttp://www.thesait.org.za/surveys/?id=Tax_free_conversions_of_hedge_fundsaving the
capital or ordinary character of the matching long position.
- Some practitioners hold the view that all
collective investment scheme assets have a capital character based on an
informal SARS ruling in the 1990’s because of the long-term nature of the
investment vehicle. Some believe that
this applies regardless of whether the investment vehicle is regulated while
others view regulation as a precondition.
differing nature of these views means that the conversion of unregulated funds
into regulated funds could mean that the conversion inadvertently triggers a
character switch which would violate section 42 or section 44 (whichever is otherwise
applicable). If this happens, the
transfer of assets into a regulated fund triggers significant tax gains and it
will be to the detriment of the investors participating in the conversion.
And the solution?
first sight, there is no reason to believe that the character of underlying
hedge fund instruments will change simply because a fund goes from an
unregulated to a regulated status, especially if the hedge fund activities /
positions remain the same.
On the other hand, the character issue is so confused that
any outcome is possible. For instance,
if one views all assets held by a regulated collective investment to be capital,
do otherwise ordinary assets then switch to capital upon conversion?
said, it is hard to suggest that the issue of character can be solved by
legislation. Perhaps, a SARS ruling is
in order. This ruling could simply state
that the character of the hedge fund assets remain as before as long as the
underlying positions / activities of the fund remain the same. Given the potential high tax price of an
error, hedge fund investors may need some form of assurance.
commandite partnerships: This is a specific type of partnership where one
partner (dubbed the limited partner) gives over money, is then silent as to how
it is managed, and then earns a return on whatever profit was made using his
investment. The partnership also creates limited liability for the co-partners.
In other words, if business goes pear shaped, their investments are safe from
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This article first appeared on the January/February 2016 edition on Tax Talk.