Treasury’s CIS tax proposal risks breaking a savings system that works
The Association for Savings and Investment South Africa (ASISA) does not usually discuss tax matters with the media, except when the proposed tax change has a major impact on its members and savers. ASISA leveraged its regular annual portfolio statistics update webinar to address a recent National Treasury discussion paper, titled ‘The Tax Treatment of Collective Investment Schemes (CIS)’.
What is this unit trust tax issue?
Dr Stephen Smith, ASISA consulting senior policy advisor, took to the podium to give an update on the industry’s response to (and thoughts on) Treasury’s CIS-focused tax proposals. He described the document as “quite out of the ordinary” and acknowledged the breakneck speed of the consultation process to date. Advisers and other industry stakeholders were allowed just over a month to give feedback on the discussion document and were soon thereafter invited to an all-day-long tax lab to dialogue on the evolving tax policy.
“This is a very complex issue in tax law, but a fairly simple issue when it comes to the CIS environment,” Smith said, before ploughing into the detail. The consultant praised representatives from the Financial Sector Conduct Authority (FSCA), the South African Revenue Services (SARS), and Treasury for an open, textured kind of conversation. “These are constructive policymakers and regulators and tax administrators,” he said, suggesting that the engagements to date had yielded a good outcome. So, what is the problem?
In South Africa, capital gains and ordinary income are taxed at different rates, with a top marginal rate individual paying 18% on capital gains. The tax treatment of unit trusts (or CIS) follows a flowthrough model, meaning that interest and dividends are taxed in the hands of investors while capital gains inside the fund are not taxed until such time as the investor sells his or her units. At the end of the tax year, asset managers have to send investors an IT3(a) form showing taxable dividends and income on their unit trust investments and / or an IT3(c) form for any transactions attracting CGT.
The capital versus income tug-of-war
Treasury’s concern appears to stem from how the Income Tax Act distinguishes between capital and income, particularly when applied to CIS portfolios. They say that some investment gains inside a CIS may resemble active trading profits, which could lead to SARS reclassifying certain capital gains as ordinary income, resulting in higher tax liabilities in the investor’s hands. The big unknown is whether the proposed changes would improve tax fairness or merely complicate things.
Your writer found the early part of the ASISA CIS taxation presentation somewhat unclear. Surely, things even out when an investor submits their annual tax return, using the capital gains statements provided by their unit trust manager. Capital gains tax is already applied when investors sell their units, meaning Treasury eventually collects its share. To progress the debate further: if a unit trust is an investment vehicle rather than a trading business, why should investors be taxed on its day-to-day operations (whatever these may be) rather than its final investment outcome?
Things will become clearer as you consider the three possible fixes proposed by Treasury. Today’s article borrows from Smith’s slide, which he said he borrowed from the Treasury document.
Option 1: Make CIS fully tax transparent
In this solution, fund managers will have to produce unit trust valuations and records of disposals on a daily basis. Any tax consequences arising from this daily accounting will be dealt with in the taxpayers’ hands. “And what this means is we pass all the income and gains straight through to the investor in the unit trust,” Smith said. He said the issue here was that the market had traditionally viewed unit trusts as an investment instrument; but in the context of activities within a fund, it could be construed as a business trading stocks and securities.
If you have some spare time to burn, you can dive into the SARS CGT guide, currently running to just over 960 pages. In Smith’s words: “Go and have a look at how many different ways one could look at this; and now ask yourself: in such a system, who is going to make up the committee of wise people to decide which way the gain versus income decision must go?” The association anyway dismissed Option 1 out of hand, saying that it was simply not viable.
Option 2: Introduce a safe harbour
The idea here would be to create some sort of transaction threshold below which all proceeds within the unit trust will be taxed as capital per the current process. An assessment would be made of any proceeds above the threshold to determine whether these be treated as capital or income. The threshold might be set as a ratio between portfolio trading turnover and portfolio size, say at one third of assets under management.
“This approach kind of links to three-year rule in section 9C, where if you hold it for three years, as a minimum, it is going to get guarantee capital treatment,” Smith said. ASISA felt this option was better than the first but warned that the safe harbour design would be critical and getting it wrong would have operational consequences. For example, asset managers would have to weigh up tax considerations, deflecting from fund’s mandate and / or client-centric risk-return considerations.
Option 3: Take hedge funds out of the CIS dispensation
A third solution was to move the short-term orientated hedge funds out of the CIS dispensation in recognition that they “differ from CIS in terms of their investor profile as well as investment philosophy”. In response to this option, ASISA said a distinction should anyway be made between the CIS regulation, CISCA, as a means to regulate hedge funds (on one hand) and taxation, on the other. “Our members are of the view that hedge funds should not be removed from the CIS regulatory regime,” they wrote. “But there is scope to consider a basis for the categorisation of hedge funds to resolve the tax concerns.”
In its general response to Treasury’s document, ASISA took issue with the possibility that a regulated CIS portfolio, after being offered to the public as a scheme approved for investment, could somehow be re-characterised as a scheme for profit making. “We would prefer the avoidance of special conventions which disturb the natural portfolio management function,” they wrote. “Any changes to the CIS taxation regime should be in line with efforts to encourage more savings while retaining the principles of a fair tax system.”
Risk-return versus income tax
Portfolio managers are not tax professionals, why add an additional dimension which is either transaction-limiting or has tax issues associated with it? mulled Smith. He argued that a notional hurdle (per Option 2) might require portfolio decision makers to weigh up whether trades beyond a predetermined frequency or value would be worth making; their investor-based risk-return focus would be skewed by tax considerations. Rather than being caught up in a new taxation paradigm, financial sector stakeholders should find ways to improve household savings.
ASISA offered some overarching principles to frame the ongoing CIS taxation discussion including growing domestic savings, tax certainty, and an equitable tax framework that promotes broad public access in line with international best practice. Moreover, the outcome should be simple and easy to understand. “Any changes to the CIS taxation regime should be in line with efforts to encourage more savings while retaining the principles of a fair tax system,” Smith said. “The preeminent test of intention should remain with the investor, and the portfolio management function or powers better defined for investment.”
This is not another tax grab
Smith noted that ASISA broadly agreed that the ‘facts and circumstances’ approach to CIS taxation was neither appropriate nor practical. He reminded journalists that Treasury was not looking to increase tax revenues, but rather to redefine the tax treatment of CIS portfolios for consistency. “There is going to be more dialog in the coming months, and [the industry] is looking forward to working with the regulators to find a solution that retains the elegance of the arrangement as it currently exists,” he concluded.
Writer’s thoughts:
Treasury’s CIS taxation proposals risk adding unnecessary complexity to a well-functioning investment structure. Should portfolio managers be forced to prioitise tax concerns over sound, return-based buy or sell decisions? Please comment below, interact with us on X at @fanews_online or email us your thoughts [email protected].
