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Tax-free conversions of hedge funds: not so simple?

Friday, 22 January 2016   (2 Comments)
Posted by: Author: Keith Engel
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Author: Keith Engel (SAIT)

Converting hedge funds into collective investment schemes may face tax consequences. 

For 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 purposes.  

In 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.  

Whereas 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.

Until 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.  

Only 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 market.

In 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.  

This 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 option).

How government wants to ensure tax-free rollovers

In 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.  

By 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?

The 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 are satisfied.

The 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 h 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.

The 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? 

At 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?

That 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.

En 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 liquidation. 

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This article first appeared on the January/February 2016 edition on Tax Talk.


Rory A. Beddy says...
Posted Wednesday, 19 April 2017
very informative
Rory A. Beddy says...
Posted Sunday, 16 April 2017
very informative



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