Onshore (South African)
Hedge Funds are mainly structured as follows
Hedge Funds come in various forms so it is very important to consider the legal aspects from the very beginning. In South Africa the various forms of Hedge Funds can be structured in the following ways, noting that each structure has several legal implications:
- En Commandite Partnerships
- Collective investment schemes
- Debenture structures
- Private companies
- Segregated Depository Accounts (SDAs)
With a variety of legal structures available, choosing the right Hedge Fund structure depends on the following:
- The relative ease of investing and divesting
- Transparency of the structure
- Who receives benefits from, and is ultimately taxed on, the income from the fund
The Hedge Fund Manager has many strategies he may employ in an attempt to manage risk and run the fund in a way that is most beneficial to the recipients of the fund. The preference of the investors, although valuable, should not be a determining factor in the structure to be employed.
With that being said it must be noted that a great number of Hedge Funds employ the legal structure of a limited liability partnership or Debenture structure.
En Commandite Partnerships
This type of partnership involves an undisclosed partner who makes contributions in the form capital in return for a percentage of the profits. This “partner” is often referred to as a limited partner in the partnership regarding section 24H of the Income Tax Act. With regard to a Hedge Fund, the partnership agreement should explicitly state that business will be conducted through one partner. That partner contributes his managerial expertise to the Hedge Fund partnership. An En Commandite (or limited liability) partnership creates the legal structure for co-partners to be exposed to limited liability. This limitation of the partnership’s losses means that the individual assets of the partners are safe from being seized by third parties should the Hedge Fund partnership become liquidated.
How does it work?
Partners make contributions to the partnership in exchange for a share of its profits, however, should the partnership make a loss – the partners would share in that loss as well. Contributions are usually those of a monetary nature, but partners may also contribute by way of their expertise, know-how and contacts. Limited partners are promised a fixed share of the profits of the fund but are not involved in the day-to-day business activities. Losses are limited to a fixed amount as well, usually their capital investment.
Because all the partners have access to partnership records, and thus access to the Hedge Funds themselves, they can see how their portfolio is being hedged.
Partnerships are not seen as separate tax-paying entities. It is, therefore, the partners who pay tax (included in their gross income or capital gains) on behalf of the partnership. A partnership agreement must be entered into stipulating, amongst other things, the partners’ details, profit sharing ratios, contributions made and terms agreed upon, the details of any silent partners and any limitations imposed on specific partners.
When the partnership dissolves, a new partnership needs to be entered into. This means that all the assets (and liabilities) from the old partnership are transferred to the new partnership. This may result in Capital Gains’ Tax (CGT) and Provisional tax is also payable in a partnership amongst other applicable taxes imposed by law. This will usually be paid by the partners from the Hedge Fund profits. This means that the profits accumulated by the partnership will be included (in the profit-sharing ratio) in the taxable incomes of the individual partners.
Collective Investment Schemes (“CIS’s”)
CIS’s are the most efficiently regulated legal hedge fund structure. Essentially a CIS is a pool of funds where investments are deposited in order to gain exposure to the fund’s holdings. These structures have well defined rules regarding portfolio position sizes which ultimately creates a basis of risk which is acceptable by the type of investor the fund targets. E.g. Retail or institutional investors. CIS’s are promoted as a legal structure with little systemic risk because of their well-defined rules and are thus popular amongst asset allocators such as pension funds.
This form of legal structure is beneficial to the investors because the company will be liable to repay the Debentures. This proves particularly useful if the Hedge Fund was to subdivided and the Debenture holders are trying to retrieve capital investments.
This type of legal structure is referred to as a variable Debenture structure due to the way profits are paid out; that is, it varies depending on how well the fund has performed during the period.
Becoming an investor in variable Debenture Hedge Funds is done with relative ease. Investors merely purchase the debt instrument and become a part of the Hedge Fund, which allows for a large number of investors to invest in the fund using relatively low investments, in comparison to En Commandite partnerships.
Transparency in the fund may not be as easily obtained because the investors do not control the company in which the Debentures are held and the management of the portfolio and information regarding those portfolios in not readily accessible to them.
Investors receive interest payments from the company issuing the variable Debentures. Regarding income tax consequences, the income will be taxed under s24J of the Income Tax Act No. 58 of 1962 (the Act)as a Debenture is a debt “instrument” envisaged in the Act using the yield to maturity method. That is to say, if the debt instrument is not classified as trading stock, the amount taxable will be the amount of interest received. The Act also provides for some other categories which qualify for tax exemptions (examples of these include, the elderly, residents who receive interest income and foreign investors).
Exemptions include: section10(1)(i) for taxpayers who are natural persons, taxpayer above the age of 65 on the last day of the year of assessment or the amount of R22 800 and section 10(1)(h) which deals with non-residents whether natural or juristic.
Debt instruments may be classified by the investor company (i.e. the holder thereof) as trading stock if the main activity of that company is trading in debt instruments. In this case, the market valuation method will be utilised (regarding section 22(1)), this means that section 24J in its entirety will not apply. It must also be noted that because of this provision, stock valued at market value and interest will be taken into account in terms of changes in market values over the accrual period.
An exemption dealt with in section 10(1)(hA) provides on any amount which is received by or which accrues to the holder of debt if the holder of the debt instrument is part of the same group of companies (if it is the same juristic person), and secondly if the issuer is defined in terms of s23K(1) (these amounts are not deductible because of the application of section 23K). Interest income, therefore, accrues to the investor and he or she will be liable for tax thereon from the date on which it accrues.
A private company/ corporation is generally used as a means to an end for Hedge Fund managers and not an end in itself. This means that they are used in conjunction with one of the other structures to meet the objectives of the Hedge Fund.
Income earned in this type of structure is taxable within the fund itself (because companies as juristic persons must pay tax). If the investor is a retirement fund-type Hedge Fund, the effect of the taxation will have severely negative consequences on that investment.
Segregated (depository) accounts
Where segregated accounts (or portfolios) are used for Hedge Funds, the investor may not be left in the most advantageous position (in terms of divesting) as he would have been – had he opted for another structure. On the plus side segregated depository accounts, also allow for the investors of the fund to acquire full ownership should the manager of the Hedge Fund be found to be in default or acting outside the scope of his directives as found in the mandate.
Segregated accounts do not offer the limited liability as with other Hedge Fund structures. The amount invested, although treated separately, flows as income to the investor and is taxed in his/her hands. Segregated depository accounts try to mitigate the risk of limited liability by offering more control over the account.
Segregated portfolios are among the most transparent of the Hedge Fund structures. The investor can view how the Hedge Fund is performing and may also have some additional controls.
The income from the segregated portfolio as well as segregated depository account is directed at the investor and is taxed in his hands.
A Trust is broadly defined as a legal relationship created during the lifetime of the founder or on the death of a person who places assets under the control of another for the benefit of a beneficiary or a specified purpose.
Where the Hedge Fund structure of a Trust is employed, investors are, more often than not, also the beneficiaries of the Trust. Gains from the Trust flow to the beneficiaries and these gains are then taxed in their hands; and depending on the form of Trust that is set up, the requirements for one to qualify as a beneficiary will differ.
Hedge Fund Trusts are ordinary Trusts and are characterised as bewind Trusts as the ownership vests in the beneficiaries. Beneficiaries are listed on the Trust deed and may be added or removed upon request – with the consent of the founder. This may impede the investing/divesting process; especially if the (potential) beneficiary cannot contact the founder.
It should be said that the investors may be listed as the original co-founders of the Trust.
As with an En Commandite partnership, the setting up and operation of a Trust quite are clear, regardless of which form it takes. The beneficiaries are the ones who appoint the trustee/s and can determine the gain that should accrue to them. One or more of the trustees will be appointed as the Hedge Fund manager/s.
The tax rate at which a Trust will be taxed depends largely on the form that a Trust takes (an Ordinary or Special Trust). Ordinary Trusts are taxed at a rate of 40% in accordance with the provisions of the Income Tax Act. The gains that flow to the beneficiaries are taxed in their hands and retain their form. An example of this is that dividend income going into a Trust will be dividend income for the beneficiary with all the regular exemptions in force still applying.
Beneficiaries have a vested interest in the gains; these issues are provided for in section 7 (2) through (8), with the exception of subsection (5)of the Income Tax Act, No. 58 of 1962 (the Act).
Section 25B(1) and (2) of the Act determines how income tax is allocated and calculated concerning Trusts. The guiding principles as submitted by Arbieet al may be summarised as
- If it is established firstly that a person is taxable in terms of one of the provisions of section 7 then that income is taxed in the hands of the person as provided by section 7, and not in the hands of the Trust (which is recognised as a legal person in section 1 of the Act) or its beneficiaries.
- If any untaxed income remains, the second step is to establish whether the income was awarded to a beneficiary of the Trust. A beneficiary who has received an award or who has the right to claim a benefit is taxed on the income. The same provision regarding the taxing of the Trust and beneficiaries applies here as well.
- Thirdly, if there is still any untaxed income in the Trust, in other words, income that (i) was not taxed in terms of section 7 and (ii) was not awarded to a beneficiary. If such income exists, only then will it be taxed in the hands of the Trust.
Subsection (1) and (2) of section 25B are authoritative sources that help determine that a beneficiary of a Trust is subject to taxation on any income he or she receives from a Trust.
Section 7(5) seems to have a greater impact than any of the provisions of section 7. It refers to donations which are made subject to a condition. Donations received or made to a discretionary Trust regardless of the purpose are made with the provision that the fiduciary duty of the trustees towards the beneficiaries be upheld. When someone donates an amount which is greater than R30 000 to a Trust, the donor will have to pay a donations tax of 20% on the amount which is in excess of R30 000.
Types of Trusts
Testamentary Trust (Mortis Causa)
This is the commonly used Trust in today’s market. They are mainly used to protect youths and other individuals who are unable to fend and provide for themselves. These Trusts are only “activated” after the death of a testator. The will of such the testator assigns the management of the fund to a trustee or trustees. The trustees’ management of the fund ends after a set period, stipulated in the will, or after an unwavering occasion (where the youngest beneficiary attains major status or upon the death of the testator). It must be noted further that beneficiaries must all be alive or have been conceived beforethe date of the death of the testator.
Whether or not there are limited rights, i.e. usufruct, assets that comprise a portion of the estate may be shifted into this type of Trust. Instead of forming a Trust using a Trust deed, a Trust clause is placed in the will in its stead. Upon the death of the testator and completion of the administration of the estate, the trustees apply to the Master of the High Court in the area where the estate is registered for a letter of authorisation. A discretionary and vested Trust may both take the form of a Testamentary Trust.
Living Trust (Inter Vivos)
Another common structure of a Trust is the Inter VivosTrust. These trusts, unlike the Testamentary Trust, come into existence during the lifetime of the founder. The types mainly used to keep “growth assets” separate from the estate. Therefore one can see that these is an outstanding medium in restricting the duty placed on the estate, and generation to generation asset protection. A Living Trust is created during the period in which the founder is still living, in which time the registration and signing of the Trust is executed. The founder initiates the process of creating the Trust; the Trust Deed provides for the appointment of persons and companies charged with the management of the Trust funds and assets. The Trust is agreed upon by the founder and trustees.
Once the Trust has been agreed upon, and all relevant documentation signed, the Trust is registered with the Master of the High Court. The majority of the assets under the Trust are placed under the jurisdiction of The Master of the High Court.
A Living Trust may take several forms:
- Family Trust
- Charitable Trust
- Umbrella Trust
- Guardian Trust
- Special Trust
This Trust is created when a contract is agreed upon between the Trustees (who are usually family members) and founder for the purpose of protecting family assets. The Trust can enter into transactions such as purchasing assets and even receiving donations. Donations in the form of assets, however, must comply with tax regulations to be lawful.
Is one in which the trustees have discretion regarding which benefits they wish to award to the beneficiary. Furthermore, all income which is non-allocated is subject to tax in the hands of the Trust. Thus through the use of this particular Trust income tax may be saved through splitting incomes. Only at a later period may capital beneficiaries determined.
This type of Trust, under the Income Tax Act No. 58 of 1962, is categorised as a non-taxable Trust. The Trust is structured in such a way that it pays no tax and receives capital loans. From these non-taxable loans, the Trust makes donations to various institutions, i.e. schools or churches, on behalf of the beneficiary. Large donations are the norm in the case of these types of Trust due to the tax benefits.
This particular Trust is associated with different types of group schemes. Therefore these types of Trusts are not sanctioned, and not regulated and governed by the Pension Funds Act. Thus they are not authorised to make deposits regarding death benefits to beneficiaries who are unable to take care of their own concerns. Thus these Trusts must be managed on behalf of the beneficiaries, as agreed upon by authorities and subsequent legislation.
Should the beneficiary of the Trust be a minor, the legal guardian of the particular minor will be placed in charge of the management and administration of the funds on behalf of the beneficiary until they attain the age of majority. These types of Trusts bring their fair share of disadvantages for the founder as he runs the risk of the funds being used for other means instead of the sole benefit of the beneficiaries.
From the above descriptions and explanations, we are able to see the various types of Trusts that may be taken out by the individuals. These explanations also show the pros and cons of each Trust and all that accompanies them.
The names and details of both capital and income beneficiaries are known. The income and capital beneficiaries may be the same individual, with the income being subject to tax in the hands of the income beneficiary. This will all be dependent upon the provisions of the Wills Act No. 7 of 1953, Trust Property Control Act No. 57 of 1988 and the will. The capital beneficiary will be entitled to property rights which vest in him.
This type of Trust may only be created for the benefit of one or more persons who have a disability as defined in Section 18(3) of the Income Tax Act, or as defined in Section 1 Mental Health Care Act No. 17 of 2002 for individuals who suffer from mental illness. It should be noted that these Trusts, should they be set up, are subject to taxation which is the same as a natural person, and this will happen until the youngest beneficiary has turned 21 years of age. Special Trusts may also encompass a Testamentary Trust which benefits family members, however, the youngest member of that particular family must be under 21 years of age within that tax year.
Who Needs a Trust?
Persons who are Unable Take Care of Their Own Affairs
Individuals that are incapable of managing their undertakings due to either physical or mental conditions should have their assets placed in the care of a custodian. The Master of the High Court will sign off on every expense that is paid, and every investment which is made.
Should a minor be the recipient of a death benefits policy, the assets and/or funds should be placed in under the management of the Guardians’ Fund under the Master of the High Court. The same applies when a minor is the beneficiary of an estate in the absence of a will or if there is no Trust clause present in the particular will.
Various assets may not be transferred to more than one individual, either due to the state of affairs or the nature of the particular asset, for example, agricultural land may not be sub-divided without the written approval of the Minister of Agriculture.
Assets growing faster than inflation
Various investments have the ability to appreciate at a rate that is faster than inflation. These may include shares, Unit Trusts and market-related policies. Should the owner of such assets keep control of them, it will more than likely result in estate duty. Thus these assets should be placed into a Trust to keep the growth separate from the estate.
Complex Family Situations
Due to divorces and inheritance, wills can be very complex documents. The settlement of an estate can be a lengthy and complicated process, setting up a Trust, in this case, helps to manage affairs better.
Protection of Assets
A Trust allows one to separate and distinguish those assets which fall inside the Trust and those that do not. The advantage of this distinction means in the event of insolvency creditors have no claim or attach Trust assets as they do not fall within the debtor’s estate.