Div­i­dend tax causes headaches

Hedge fund in­dus­try still bat­tling to find ways to man­age and ac­count for it

Business Day - Business Law and Tax Review - - BUSINESS LAW & TAX REVIEW - DALE LIPPSTREU

THE new div­i­dend with­hold­ing tax regime is prov­ing to be prob­lem­atic and cum­ber­some for the hedge fund in­dus­try to im­ple­ment. The tax be­came ef­fec­tive at the be­gin­ning of April but hedge fund man­agers, ad­min­is­tra­tors and prime bro­kers are still bat­tling to find ways to man­age and ac­count for it.

Div­i­dend with­hold­ing tax is to be cal­cu­lated and de­ducted by so-called “reg­u­lated in­ter­me­di­aries” and for the most part it is suf­fi­ciently clear what is re­quired of them and how this can be in­te­grated into their busi­ness pro­cesses. In the case of in­vest­ment funds con­ducted un­der the Col­lec­tive In­vest­ment Scheme Con­trol Act the fund man­age­ment com­pany is the reg­u­lated in­ter­me­di­ary. This in ef­fect en­ables the in­vest­ment fund to re­ceive the div­i­dend gross and then man­age the with­hold- ing process as div­i­dends are dis­trib­uted on­wards to in­vestors.

The ad­min­is­tra­tion of the tax is de­mand­ing but the re­quire­ments im­posed on the op­er­a­tor of the in­vest­ment scheme are clear.

Hedge funds do not, how­ever, fall un­der this dis­pen­sa­tion with the re­sult that div­i­dends must ac­crue to the fund net of any with­hold­ing tax due. Pro­vided the fund ad­min­is­tra­tor has the re­quired in­for­ma­tion re­lat­ing to the fund in­vestors it is not par­tic­u­larly dif­fi­cult to cal­cu­late the amount of tax due but ac­count­ing for it there­after cre­ates ma­te­rial is­sues. The most fun­da­men­tal prob­lem is that the fund can­not ac­count for the net div­i­dend re­ceived be­cause to do so will prej­u­dice ex­empt in­vestors and ben­e­fit non-ex­empt ones. The most prac­ti­cal so­lu­tion is to split the fund into tax­able and un­taxed classes but these re­sults in a huge ad­min­is­tra­tion over­head.

To ap­pre­ci­ate the ex­tent of the prob­lem you need only con­sider that most hedge funds al­ready have a num­ber of classes and un­der­ly­ing se­ries, and that each new tax­able class (for ex­am­ple, taxed, par­tially taxed, un­taxed) re­sults in a dou­bling of each class and se­ries. Fund man­agers are be­ing forced to weigh the cost of achiev­ing tax ef­fi­ciency against the quan­tum of the tax sav­ing.

The prob­lem, how­ever, is not limited to the fund ad­min­is­tra­tor. The reg­u­lated in­ter­me­di­ary charged with man­ag­ing the div­i­dend with­hold­ing tax process in the case of hedge funds is the prime bro­ker (a bro­ker which acts as set­tle­ment agent, pro­vides cus­tody for as­sets, pro­vides fi­nanc­ing for lever­age, and pre­pares daily ac­count state­ments for its clients).

The prime bro­ker is in turn faced with an­other set of chal­lenges. Sim­plis­ti­cally it would not be par­tic­u­larly cum­ber­some for the prime bro­ker to man­age the with­hold­ing process based on the per­cent­age par­tic­i­pa­tion of in­vestors in the fund by tax sta­tus as ad­vised to it by the ad­min­is­tra­tor.

The prob­lem is whether the South African Rev­enue Ser­vice (SARS) would ac­cept such a crude process. It is quite clear that SARS has set out to build a com­pre­hen­sive re­port­ing frame­work for div­i­dend with­hold­ing tax which will in time en­able it to ac­count for all div­i­dends paid to all in­vestors through all the chan­nels that div­i­dend in­come will flow. In these cir­cum­stances it seems un­likely that they would al­low the en­tire frame­work to be un­der­mined by in­ad­e­quate re­port­ing through a sin­gle chan­nel.

The prime bro­ker’s prob­lems are not limited to ad­min­is­tra­tion only as they need to de­ter­mine whether in­di­vid­ual funds can prop­erly pay gross div­i­dends to ex­empt in­vestors. This will largely de­pend on the na­ture of the fund and specif­i­cally whether the so­called con­duit prin­ci­ple ap­plies. In sim­ple terms div­i­dends can be ac­counted for on the gross ba­sis where the le­gal struc­ture of the fund is such that the div­i­dend can be said to ac­crue to the ex­empt in­vestor. In broad terms this would be the case where the fund op­er­ates as a part­ner­ship but the test would fail if the un­der­ly­ing struc­ture were a dis­cre­tionary trust.

The an­swer is how­ever not al­ways as clear as this, and the task and risk of ac­count­ing for div­i­dend with­hold­ing tax cor­rectly fall to the prime bro­ker.

The above dis­cus­sion deals with the prob­lems and com­plex­i­ties at a high level. There are many un­der­ly­ing is­sues which flow from these is­sues which are am­pli­fied where more com­plex struc­tures such as funds of funds are used. It is quite clear that ac­count­ing for div­i­dend with­hold­ing tax will be chal­leng­ing and in some in­stances an in­ex­act process un­less the leg­is­la­tion is amended in a way that deals with the unique cir­cum­stances of al­ter­na­tive in­vest­ment struc­tures.

The log­i­cal al­ter­na­tive is to bring all col­lec­tive in­vest­ment funds, in­clud­ing hedge funds, within the perime­ter of the Col­lec­tive In­vest­ment Schemes Con­trol Act.

This would not only solve the tax prob­lems but also bet­ter align our reg­u­la­tions with in­ter­na­tional trends.

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