By Mogola Makola
By now most people will have heard the rumours that the laws governing the taxation of collective investment schemes (“CISs”) is set to undergo a lot of changes. Currently, the provisions governing the tax treatment of CISs are scattered throughout the Income Tax (“ITA”). The proposed legislative amendments, which are contained in the Draft Taxation Laws Amendment Act of 2009 (“the Draft Bill”), will introduce a single provision (a new section 25BA of the ITA).
One of the important consequences of the proposed amendments is that it will apply the conduit principle, which applies in respect of the tax treatment of trusts (as provided for in section 25B of the ITA), to the tax treatment of CISs. In terms of the proposed section 25BA, any ordinary revenue distributions by a CIS which invests in securities will be treated as if the underlying amounts (e.g. interest and foreign dividends) received by the CIS will flow directly to the CIS unit holders. If a distribution is made to multiple unit holders and the distribution contains amounts derived from multiple sources of revenue, these sources of revenue are allocated pro rata. What this means is that the CIS will not pay any income tax on the amounts distributed to its investors. Instead, the investors will be subject to income tax on the distributions.
It is important to note that the flow-through treatment of revenue received by or accruing to a CIS will only apply if the ordinary revenue received by the CIS is distributed investors within one year after its receipt by or accrual to the CIS. This requirement is nothing unusual and follows the principles stated in case law concerning the tax treatment of trusts. The principle is to the effect that in order to ensure that income received by or accruing to a trust beneficiary to retain its nature, care must be taken to ensure that the income is distributed before the end of the tax year in which it received or became entitled to the income. A CIS that fails to distribute income within the prescribed one-year period will be taxed on the income. However, subsequent distributions to investors will not be taxed in the investors’ hands. What section 25BA does not do is to deal with the question of the deduction of expenses incurred in the production of the income received by or accruing to a CIS. It would be interesting to find out whether the omission was deliberate or not and to understand the reasoning behind it. The explanatory memorandum does not shed any light on this.
Another important consequence of the proposed amendments is that CISs will no longer qualify as companies for the purposes of the ITA. However, they will retain their company status for two limited purposes. Firstly, CISs will be treated as companies for the purposes of the “connected person” definition in the ITA. According to the explanatory memorandum accompanying the Draft Bill, this is because the “connected person test for trusts is too broad (i.e. all trustee beneficiaries are connected, meaning that all CIS investors would otherwise be connected persons in relation to each other). Secondly, CISs will be treated as companies for reorganisation purposes. The intention here is to allow CISs to remain eligible for the favourable tax treatment provided for by the corporate restructuring rules contained in sections 41 to 47 of the ITA.
The one thing that will not be changing with regard to CISs is that they will remain exempt from CGT.