The government, desperate to find new avenues of raising money, wants to change the way it taxes unit trusts. But its plans threaten to increase investor costs and risk undermining the very goal it aims to achieve – fostering a savings culture.
In mid-November, the National Treasury released a discussion document outlining its proposals on the taxation of collective investment schemes (CISs) such as unit trusts. The proposals date back to ideas first mooted in 2018, but interested parties were given only a month to respond, with follow-up talks involving the South African Revenue Service (Sars) scheduled for January 17.
You can see why unit trusts may be a lip-smacking target: the industry has more than R3.6-trillion in assets under management. Meanwhile, our flatlining economy is pushing up our debt-to-GDP metrics, forcing the state to downscale how much revenue it can collect. Then there’s the dwindling pool of taxable people in the firing line, with Deloitte estimating that just 5.9-million pay 75% of personal income taxes, the biggest contributor to the state budget (more than a third).
The issue at play is whether gains derived in unit trusts should be characterised as revenue or capital in nature. If classified as revenue and not distributed by the fund within 12 months of receipt or accrual, these amounts would be taxed in the fund at a rate of 45%.
If distributed by the fund within 12 months, investors would be taxed on the amounts at their applicable marginal tax rates (the tax rate applied to income earned above a certain threshold). Distributions made to exempt investors, such as retirement funds, would remain tax-free.
Currently, all gains are treated as capital in nature and are exempt from tax within the fund itself.
Funds typically do not distribute gains annually. Instead, non-exempt investors pay capital gains tax when they dispose of their units, provided they hold the units for more than three years.
One of the proposals in the document is to treat all gains generated within the CIS as revenue, significantly altering the tax treatment.
The Treasury’s beef is with fund managers who profit by frequently trading in securities such as shares, bonds or derivatives. It wants such activity taxed at 45% if not distributed within 12 months, arguing it is revenue in nature. In its discussion document, the Treasury also highlights that more conservative fund managers complained they were at a disadvantage to rivals who bought and sold investments more regularly.
No resolution
Another of the options put forward by the Treasury to address the regular buying and selling of investment assets is a “flow-through” system, in which investors in the unit trusts are taxed as if they had invested directly in the underlying investments rather than through a CIS.
Investors would be liable for taxes, and the CIS itself would not be responsible for “potential tax payments from trading activities”. Fund managers would characterise, calculate and allocate gains and income to investors daily. However, this approach, as the Treasury acknowledges, does not resolve the ambiguity around classifying income.
The other option is using turnover as a “safe harbour”, where a fund’s annual trade turnover ratio determines whether returns are treated as capital or income. A turnover ratio below a certain threshold would mean gains are taxed as capital, while exceeding it would trigger a “facts and circumstances” test to decide how much is taxed as income.
The problem, though, is that some revenue gains made by a fund are beyond the control of investment managers. This includes corporate actions by listed companies such as takeovers, share buybacks or stock splits. Changes in the weightings of indices, such as a firm falling out of the top 40, also force funds to rebalance their holdings – in other words, to buy or sell shares in the company moving into or falling out of an index.
In response to e-mailed questions, the Treasury tells Currency that “the proposal to have a safe harbour is intended to provide investors and fund managers with more certainty regarding the capital vs income taxation issue”.
However, Webber Wentzel partner Joon Chong argues that it is “unknown whether a fund would fall within the safe harbour ratio until after the year of assessment has ended”. An investor could also receive gains that were classified by the fund manager as capital only for Sars to determine they are revenue in nature in a tax audit. The fund would have to bear the tax on such gains at 45%.
More radically, the Treasury has proposed no longer giving hedge funds the same tax treatment as a typical unit trust, and removing the asset class as a CIS, to introduce “a targeted and separate regulatory framework”. The aim is to recognise “the unique characteristics” of hedge funds and distinguish them more from CISs, the Treasury’s discussion document says.
South Africa became the first country in the world to formally regulate hedge fund products in 2015, classifying them as CISs, to enhance investor protection, improve transparency, and align the industry with global best practices.
More uncertainty
Chong suggests that until there is clarity about the hedge fund industry’s future, the Treasury should grant it the same tax treatment as other CISs.
“To remove hedge funds from the existing CIS tax regulatory regime would result in more uncertainty and curtail the development of the hedge fund industry,” she said in her submission to Treasury.
That development has been hard fought in South Africa, but growth is there: assets under management in the hedge fund industry rose 13.7% to a record high of R106.8bn in 2023, fuelled by growing interest from retail investors and strong returns, according to the Novare Annual South African Hedge Survey released in November.
It makes no sense to remove them from the CIS classification now, says Cy Jacobs, the CEO and co-founder of 36One Asset Management.
“They took years to decide to put hedge funds in so they could be more highly regulated,” Jacobs says, “and they put parameters around that. So, I don’t really know why they want to take it out now. What’s the point?”
If gains in the fund are characterised as revenue and distributed to investors annually, individuals would be “disincentivised to invest directly in unit trusts, which is unfortunate”, Chong tells Currency. Not everyone relies on pension funds for retirement. Besides, unit trusts are often used for shorter-term goals, such as saving for a downpayment on a house or education.
The proposals are “unduly punitive on investors, particularly individuals who invest in CIS for long-term growth and to have available cash before retirement”, she says. The tax proposals may even lead to a bizarre situation where investors would be forced to sell some of their units each year just to pay income tax.
Poor savings
As it is, South Africa has a dismal savings culture. According to data from the South African Reserve Bank, household savings amounted to just 1.5% of GDP in the third quarter. That compares with the latest readings of 15.6% from Europe, 3.2% in Australia, 4.4% in the US and 10% in the UK, according to data compiled by Trading Economics.
Savings also help fund infrastructure projects, such as building roads or rail networks, and are channelled into businesses and startups, or invested in the stock market or bonds, which contribute to job creation and economic growth. Households with savings are also better equipped to deal with financial shocks.
The amendments punted back in 2018, specifically to tackle the issue around frequent trading, were later withdrawn to allow for more public comment.
It’s possible that the Treasury – now under the government of national unity and with a DA deputy minister in tow – may not be that keen to ram the proposals through.
“There are no proposals to tax all CIS returns as income, and the aim of the proposals is not to raise additional revenue,” the Treasury says.
The workshop later this month “will be a good opportunity to address all concerns, possible misunderstandings and suggestions in detail”.
“It is important to note that what is currently published is a discussion document, to encourage responses from affected stakeholders,” says Treasury.
About 50 responses were received by the Treasury, including some that were received after the deadline, it said.
Paying the price
The Treasury argues that South Africa has a “flow-through model”, though not one that is “fully transparent for tax purposes”. However, this doesn’t mean that “taxpayers will face a heavier tax burden”, because capital and income gains will each be taxed appropriately, the Treasury says.
But 36One’s Jacobs is worried that investors, the financial services industry and ultimately the economy will pay the price.
Not only would it deter people from investing in unit trusts, but it could also cause investors to move more money offshore, where rules aren’t as costly, resulting in less stock exchange trading.
By forcing funds to trade less, money managers will buy shares and bonds, and only hold them for the long term, drying up liquidity on stock exchanges.
Trading volumes and local fund managers have already suffered because the government in 2023 allowed investors to move as much as 45% of their assets overseas, up from 25% previously. This has seen more money flow to international fund managers or those with offshore capabilities and reach.
“We need to stimulate more trading, more liquidity” locally, says Jacobs.
And then there’s the incredibly complicated issue of changes in the weighting of index constituents; the rebalancing team at 36One is one of the busiest every day, he adds.
“Index weightings are continually changing, resulting in managers having to constantly adjust their portfolios,” Jacobs points out. “The resultant sales from those trades are not trades made for financial gains.”
Increasingly complex and punitive local tax rules may force more investors to choose international markets, eventually eroding tax revenue.
“I don’t think they’ve really thought through the ramifications,” Jacobs says.
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