Tax treatment of non-resident investors in South African hedge funds
05 June 2011
Posted by: Gary Vogelman and Andrea minnaar (ENS)
South African hedge funds are generally housed in either a debenture structure or an en commandite partnership. From a tax perspective, these structures are aimed at ensuring no tax is triggered in the structure and any taxes are levied on the ultimate investor based on the investor’s tax status.
This is particularly important for (exempt) pension funds and non-resident investors.In a debenture structure investors obtain their return either qua beneficiary by way of a distribution from a trust, or in some instances as interest on the debentures. In South Africa, trusts are supposed to be treated as conduits to the extent their gains are vested in the beneficiaries, and the beneficiaries are taxed on the gains.
As South Africa taxes non-residents only to the extent they derive income from a South African source, non-resident investors may be subject to income tax on the distributions from the trust in so far as such income is from a South African source. Broadly speaking, where the income is generated in respect of capital which is employed in South Africa and the investment decisions are made by persons in South Africa, which is generally the case with investments into a South African hedge fund, such income may be sourced in South Africa.Foreign investment in hedge funds is not often facilitated by debenture structures, as South African exchange control approval is required, and en commandite partnerships are more common in this context. Investment into the partnership is facilitated via a foreign feeder vehicle.
Partnerships are transparent entities for South African tax purposes. Each of the partners are deemed to be carrying on the business of the partnership, and the partnership profits are taxed in the hands of the non-resident investors to the extent they are derived from a South African source, as discussed.Where the foreign investor is a resident in a treaty jurisdiction, the treaty will generally provide that South African sourced income will only be subject to South African income tax in the hands of the foreign investor if the foreign investor carries on business through a permanent establishment in South Africa.
Where the managing partner of the en commandite partnership is a South African resident, this will likely create a permanent establishment for the foreign investor in South Africa and the foreign investor may be subject to South African income tax on its share of the partnership income (less expenditure attributable to the permanent establishment).Amendments to the South African income tax legislation have been introduced in terms of which the definition of permanent establishment has been amended to provide, broadly speaking, that in respect of members in a partnership or beneficiaries of a trust whose liability to the creditors of the partnership or trust is limited to their contributions, any act of that partnership or trust in respect of any financial instrument must not be ascribed to the qualifying investors.The reason for the amendments, as set out to the Explanatory Memorandum to the Taxation Laws Amendment Bill, 2010, is to facilitate foreign investment into South Africa as the possibility of creating a taxable South African permanent establishment makes South Africa unattractive to foreign investors seeking to utilise domestic partnerships or trusts, with the result that foreign investors often invest into Africa through another jurisdiction.
It is not clear, however, how the amendment of the definition of permanent establishment in the South African domestic tax law will provide relief where the investors will look towards the application of the relevant treaty to determine whether South Africa will be allowed to tax South African sourced income. The treaties contain their own definition of permanent establishment which, on the face of it, is not affected by the amendment to the South African domestic law definition thereof.
The principle in relation to treaties is that they should not impose tax beyond that which is imposed under the domestic tax laws. However, there is a disconnect between the domestic law and the treaties and foreign investors should take appropriate advice before relying on the proposed legislative amendment.