Dividend tax causes headaches
Hedge fund industry still battling to find ways to manage and account for it
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.