Taxing rights do little to help our cause
Investment managers need to be able to work without attracting tax risk
WITH high-return investments in emerging markets in the East and in South America proving increasingly scarce, Africa is becoming a popular destination for international capital.
The continent remains dark for many foreign investors and, perhaps more so than in any other region, investors need investment managers to assist them in deploying their cash.
Given the dominance of the South African economy, the country is the most likely destination for African capital and South Africans having proven adept at managing investments elsewhere in Africa, local skills are also sought after for investors targeting the rest of Africa.
This is good news for SA. An expanding investment management industry creates jobs at all skill levels and attracts highly paid individuals who pay taxes on the money they earn and the cash they spend locally. Unfortunately, as things stand, this potential is difficult to tap because hiring a South African investment manager is a bad idea for a foreign fund. It results in two major tax consequences for the fund.
Firstly, any income that is deemed to have a South African source, is taxable in SA which, because of the way our law is interpreted may well be the case if the local manager has a discretion to contract on behalf of the foreign fund. This is a risk that is easier to manage in other jurisdictions and it makes it very difficult for a local manager to fulfil a discretionary mandate.
The second, and more serious, issue relates to tax residency. A fund that has its “place of effective management” will be deemed to be South African tax resident. Internationally, this is the place where the fund’s high-level strategic decisions are taken.
The South African Revenue Service’s (SARS) interpretation differs such that a fund will be effectively managed where the investment decisions are implemented rather than the place where the investment objectives, policy and restrictions are set. This is a South African problem and although the note setting out SARS’s interpretation is not law and is widely held to be incorrect, it nevertheless has a chilling effect on the allocation of investment mandates to South African managers who are under pressure to move their operations to places such as London, Geneva or Mauritius.
The UK is one of many countries that have created an investment management exemption in terms of which only the investment management fees paid to a UK-based manager are taxable. The management activities neither create a local source of profits nor do they result in the fund becoming UK tax-resident. London remains the de facto financial capital of Europe and the global investment management hub despite the high cost of living and relatively high personal tax liability UK managers face.
In May 2010, the Treasury proposed changes to the Income Tax Act which focused on creating a “regional investment fund regime”. I would venture that the demand for an African investment fund structure is rather small. Investment funds with a multijurisdictional focus are mobile entities and usually set up shop in jurisdictions that have low tax and low regulation. A panoply of jurisdictions offers attractive regimes for investment funds. De- spite Mauritius’s attempts at attracting this business, the bulk of investment funds targeting Africa are still set up in the Caribbean or Europe. It would be difficult for SA to attract the actual fund business. On the other hand, the investment managers who manage these funds are less mobile and in fact more interesting in terms of the taxable revenues they generate.
The proposal document does recognise that “the possibility of creating a taxable South African permanent establishment makes the country unattractive to foreign investors seeking to utilise [structures] with a portfolio manager within SA”, and proposes tax relief to remedy this situation. The actual implementation has to date fallen somewhat short of achieving the stated aims. Although the amendment has been widely welcomed as a positive step, it has been criticised for:
Focusing on the fund structure rather than the relationship between the fund manager and the fund prompting the question as to why contractual investment management mandates are not covered;
Being limited to funds set up as partnerships and trusts, excluding funds set up as corporate entities and essentially focusing on foreign private equity funds; and
Dealing exclusively with the permanent establishment issues that funds and their investors currently have and not extending to the issue of a fund's tax residence being in SA by virtue of the discretionary actions of its South African managers.
In the 2011 budget speech, the minister of finance indicated that further amendments are in the pipeline. SA’s competitive advantage lies in our infrastructure and skills. These play to our ability to provide investment management services rather than our ability to offer a competitive fund regime. The government would be well-advised to play to SA’s strengths by attracting investment managers rather than focusing on investment funds.
What the country needs is a regime that allows investment managers to conduct discretionary activities, whether under a contractual mandate or through a particular structured participation, without creating any tax risk for a foreign fund. It is important that the law is unequivocal in relation to SA’s taxing rights so that investors (individuals or funds) are left in no doubt as to the consequences for them of using a local manager. When it comes to investment management activity, it is not far-fetched to imagine Cape Town or Johannesburg as the African equivalent of the City of London.
If SA does not react soon, this business will establish itself elsewhere and it remains to be seen whether the changes that are due in 2012 will, by creating a true investment management exemption, give the country the tools it needs to capitalise.