Following the release on 12 September 2012 of a proposed framework for the regulation of hedge funds, the National Treasury and the Financial Services Board released draft regulations (Draft Regulations), together with an explanatory memorandum (Memorandum), on 16 April 2014.

The Memorandum cites two factors that influenced Government’s decision to regulate hedge funds, not only at manager level, but also at portfolio level:

■ the global financial crisis of 2008; and
■ South Africa’s commitments as member of the G20.

Hedge funds are to be regulated in terms of the existing legislative framework provided by the Collective Investment Schemes Control Act, No. 45 of 2002 (CISCA) and specifically as a scheme declared by the Minister of Finance under s63 of CISCA.

The Draft Regulations define a 'hedge fund' as:
"…a collective investment scheme which uses any strategy or takes any position which could result in the portfolio incurring losses greater than its aggregate market value at any point in time, and which strategies or positions include, but are not limited to –
(a) leverage; or
(b) net short positions".

While the Draft Regulations make provision for the registration of hedge fund managers, and set out various prudential and reporting requirements for financial regulatory purposes, it is important to appreciate the significance of bringing hedge funds under the framework of collective investment schemes for tax purposes.

Provisional amendments have already been introduced into the Income Tax Act, No. 58 of 1962 (Act) in 2013 to cater for the taxation of hedge funds as collective investment schemes, and these amendments will take effect as soon as the Minister of Finance declares hedge funds to be collective investment schemes under s63 of CISCA.

Essentially, hedge funds are to be taxed on a flow-through basis similar to that of traditional collective investment schemes. S25BA of the Act provides that amounts received by or accrued to a portfolio of a collective investment scheme (other than property schemes) are deemed to have accrued to the participant if such income is distributed to the participant within 12 months of accrual to the portfolio. In these circumstances the portfolio is exempt. However, if no distribution is made within the 12 month period, the amounts are deemed to have accrued to the portfolio, and the portfolio will be taxed accordingly. Also, dividend income will then not be exempt in the hands of the portfolio. Collective investment schemes (other than property schemes) are however exempt from capital gains tax in terms of paragraph 61 of the Eighth Schedule to the Act.

This treatment will apply whether the hedge fund is a 'qualified investor' or a retail fund, and irrespective of whether the hedge fund is structured as a company, trust or partnership.

In respect of the disposal by a participant of a participatory interest in a hedge fund, s9C of the Act has been amended to include such participatory interest in the definition of an 'equity share' and the disposal of the interest will be deemed to be on capital account where the participant has held the interest for more than three years (as is the case with 'equity shares' as defined). In other circumstances the ordinary rules will apply in respect of determining whether the disposal of the participatory interest should be treated as being on capital or revenue account.

Managers of hedge funds as well as investors should take note of the Draft Regulations and understand the tax consequences that will arise when final regulations are published and the Minister of Finance declares hedge funds to be collective investment schemes.

Written by Heinrich Louw, Senior Associate, Tax, Cliffe Dekker Hofmeyr