Against the backdrop of a second Trump presidency, political turbulence in Europe, and the ever-fluctuating Rand, one issue currently dominating conversations within the hedge fund space is the release of the long-awaited discussion document on the tax treatment of collective investment schemes. Image: Pixabay
Marina Kotsopoulos
Against the backdrop of a second Trump presidency, political turbulence in Europe, and the ever-fluctuating Rand, one issue currently dominating conversations within the hedge fund space is the release of the long-awaited discussion document on the tax treatment of collective investment schemes (CIS).
Hedge funds may constitute a small segment of the broader CIS industry in terms of size, but their contribution to the financial sector underscores their importance within the broader financial ecosystem. Despite this, hedge funds still remain widely misunderstood and under-represented in investor portfolios, largely due to misconceptions about their operations and the perceived risks they entail. In reality, hedge funds offer investors access to risk-efficient investing through unique strategies and tools that are otherwise inaccessible to the average investor.
They provide valuable diversification of investment options and outperformance regardless of market direction. Beyond their economic contributions, hedge funds also play a critical role in enhancing liquidity through high-frequency trading, short selling, provision to illiquid assets, and arbitrage strategies—all of which deepen market liquidity on the JSE.
The aim of the new taxation regime is to improve the efficiency, fairness, and competitiveness of the financial industry. It focuses on aligning the tax framework with global best practices, while also ensuring that the tax system remains conducive to economic growth and investment in the country.
However, it can be argued that the options put forward by Treasury may potentially limit the positive contributions that hedge funds have on the financial industry. The proposal is structured around the uncertainty of whether gains are revenue or capital in nature and puts forward four options for regulating the tax status of hedge funds and other CIS entities.
Treating all income within a CIS as revenue in nature
Many CIS managers will argue that CIS investments are used by investors with the long-term intent of being capital assets. This has been rejected by Treasury, with the recommendation to effectively tax investors' gains within a CIS as revenue in nature instead of capital. For hedge funds that trade actively as a means of achieving alpha, this will lead to higher tax costs for investors.
The impact of higher costs may lead to large withdrawals, as investors move their savings offshore to benefit from less severe tax penalties. The knock-on effect of outflows drains liquidity in the market, leads to fewer trades, lower valuations for listed companies, and fewer opportunities for business expansion—negatively impacting growth.
Full Tax Transparency (Flow-Through Taxation)
A new tax model, where the CIS is fully transparent and acts merely as a conduit rather than a taxable entity, passing through tax to investors on a daily basis, has also been proposed. This approach aims to ensure that investors are taxed individually, based on their own tax circumstances, rather than taxing the fund itself. It may eliminate the problem that investors could be liable for potential tax payments from trading activities, when they did not hold a participatory interest in the CIS.
It provides no solution to the uncertainty of whether gains are revenue or capital in nature. This proposal would lessen the burden on the CIS manager, but investors, once again, would be negatively impacted. The benefit of deferred capital gains tax would be lost, making the knock-on effects mentioned above a possibility once again.
Turnover ratio as a safe harbour
Whether a trade is classified as capital in nature depends on activity. Treasury proposes setting a specified turnover ratio and taxing trades accordingly. Simply put, if a CIS has a turnover ratio that is below a particular level, all trades will be treated as capital and not taxed. If turnover is above the specified level, the opposite will apply. While this recommendation does offer some clarity to the argument of characterisation, this option may lead to funds purposely operating below the specified threshold to avoid higher tax costs. This will once again lower market liquidity, as active management is penalized.
Hedge funds make use of a wide toolbox of financial instruments, derivatives being an example. How derivatives and other non-traditional instruments are treated in terms of a turnover ratio, may provide more confusion.
Separate rules for hedge funds
As stated before, hedge funds are still largely under-represented in investors’ portfolios due to their unique investment strategies and complex structures. This leads to the average investor perceiving them all as high-risk. It can, however, be agreed that hedge funds do differ from most collective investment schemes, leading Treasury to propose that hedge funds be excluded from the CIS tax regime. In the future, National Treasury will look to implement a regulatory framework specifically catered to hedge funds.
The hedge fund sector, while notably smaller compared to the CIS industry, plays an immeasurable role within the broader financial ecosystem. Its influence extends across market efficiency, liquidity and innovation. All, while significantly enhancing investors' ability to navigate and mitigate market risks.
However, the current proposals outlined in the discussion document concerning the tax treatment of CIS’s, appear insufficient in promoting the growth and stability of the industry. It can even be argued that these proposals may have unintended consequences, potentially hindering expansion and the safeguarding of the sector's long-term interests.
Marina Kotsopoulos is a senior Business Analyst AG Capital
BUSINESS REPORT