Oct 26,2011 / News / Legal Brief

South Africa’s domestic tax system is hampering the local investment management industry as it seeks to benefit from heightened foreign interest in African investments.

“As high return investments in emerging markets in the East and South America prove increasingly scarce, Africa is becoming a popular destination for foreign investment,” says Shayne Krige, director at Werksmans Attorneys and head of the firm’s newly-formed Investment Funds Practice. “But government’s strategy to date has focussed on creating attractive fund structures, rather than on creating an attractive environment for the investment management industry which services these investment funds.”

Krige adds that international investors tend to set up their holding companies and fund entities in countries that have the lowest tax rates. South African tax considerations make it difficult for South Africa to compete as a Pan-African investment fund location.

“The reality is that a country the size of ours with the delivery backlogs and other problems we face will have a hard time competing with tax havens.”

He believes that demand for new African investment fund structures is limited since a range of jurisdictions already offer low tax, low regulation environments, with the Cayman Islands and the British Virgin Islands by far the most popular locations for fund incorporation.

“Despite Mauritius’ attempts at attracting this business, the bulk of investment funds targeting Africa are still set up in the Caribbean,” adds Krige. “It would be extremely difficult for South Africa to compete for fund incorporations in this context. We would only succeed if we forfeited tax revenue.”

But he says the investment managers who manage these funds are in fact more interesting in terms of the taxable revenues they generate. “Rather than seeking to create a competitive fund regime, South Africa’s tax system should play to the country’s competitive advantage which lies in our skills as managers of African investments and our infrastructure and quality of life,” he says.

“Unlike funds and holding companies that will go wherever the tax rate is lowest, investment managers are not mobile. They have children who need schooling; they want access to culture and travel; and they are prepared to pay some tax for quality of life.”

The South African Treasury’s Draft Tax Laws Amendment Bill, released in May, was expected to make improvements to the country’s tax code. But Krige says that the current draft does not address all of the challenges in a way that materially improves the position for the investment industry. These include foreign funds being treated as South African tax residents if they use local fund managers. SARS’ interpretation of the fund’s “place of effective management” contrasts with the approach of many foreign jurisdictions which determine a fund’s residency based on where its high-level strategic decisions are taken.

“SARS’ rules for determining tax residency are relatively vague. It stresses a case-by-case approach influenced by where investment decisions are implemented rather than where the investment objectives, policy and restrictions are set,” explains Krige. SARS has recently published a discussion document on potential amendments but it suggests that SARS’ policy will be tweaked rather than fundamentally changed.

“It is important that the law is unequivocal in relation to South Africa’s taxing rights so that investors are left in no doubt regarding the consequences of using a local manager before they commit to employing local skills.”

Hiring a South African investment manager has another major tax consequence for foreign funds under the current system: any profits that are deemed to have a South African source are taxable in South Africa. This may be the case if the local manager has discretion to contract on behalf of the foreign fund. “The ‘source risk’ is one that is easier to manage in other jurisdictions and it is difficult for a South African manager to compete for a discretionary mandate against a manager located in a country that has the exemption,” says Krige.

Krige points to the UK as one example of a country that has created an investment management exemption in terms of which only the investment management fees paid by a foreign fund to a manager based in the UK are taxable.

“The management activities neither create a local source of profits nor do they result in the fund becoming a UK tax-resident,” he says. “The result is that 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.”

Krige says further amendments to the South African tax regime are in the pipeline and should focus on attracting investment managers rather than investment funds.

“What South Africa 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,” he says. “This would help grow and expand the local investment management industry, create jobs at all skill levels and attract highly paid individuals who would then pay taxes on the money they earn and the cash they spend locally.”