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South Africa - At Risk of Losing Private Equity Investment to Other Emerging Markets

Investment in private equity funds is becoming increasingly popular, both locally and internationally.  However, one questions whether the South African tax regime is sufficiently attractive enough to retain and attract future resident and non-resident investment in South African private equity funds?  Unless some form of beneficial tax treatment is legislated for the South African private equity industry, there is a danger that potential investors may be driven to other emerging markets.

South Africans seem to have accepted that private equity funds are a good alternative investment option.  European funds and investors have also identified a number of jurisdictions as emerging markets stable enough to attract offshore funds, one of which is South Africa.  In order to be competitive as a jurisdiction which attracts private equity investment, however, the rate of return on funds invested must be consistent or better than that offered in other markets.  To achieve this, investment proceeds should be returned to investors free of tax or taxed at a beneficial rate.  Unfortunately, South Africa does not currently provide for a beneficial tax regime applicable to private equity investment and returns. 

In the international context, a number of jurisdictions provide preferential treatment for returns generated from private equity funds.  For example, in the UK, proceeds from the disposal of equities will be taxed at a preferential rate or will be exempt subject to a holding period being complied with.  In Australia, gains made on the disposal of equities will also be exempt provided certain requirements are met. Germany also provides for the preferential treatment of proceeds on the disposal of equities.

In South Africa, the taxation of investment proceeds in the private equity context is dealt with in accordance with the general principles of the Income Tax Act.  This means that the age old debate of the capital versus revenue nature of proceeds will apply to returns derived by investors.   In determining this question, reliance may be based on case law from which various guidelines and principles can be extracted.  In essence, the courts will be looking at whether the investment was made to acquire a long-term dividend producing asset in the context of equities.  This may not always coincide with private equity investments made and disposal of equities due to the fluid nature of the investment market. As a result, proceeds on the disposal of certain equities may be classified to be revenue in nature and taxed as such.  The fact that the private equity industry is not separately regulated to ensure the capital treatment of returns from investments may therefore negatively impact on the perception of South Africa as a suitable jurisdiction to attract both resident and non-resident investors.

The nature of investment proceeds (i.e. are they revenue or capital) is also an important question in relation to non-resident investors and will impact on the rate of return offered by South African funds.  If the return is considered to be revenue in nature, the proceeds will in all likelihood be taxed in South Africa.  If the returns are capital in nature, the returns will only be taxed in South Africa if the non-resident has a permanent establishment in South Africa.  The structure of funds and activities of the fund managers are therefore critical in determining how non-resident investors will be taxed in South Africa.  For example, the use a partnership which is managed in South Africa will in all likelihood result in a taxable presence for non-resident investors. This needs to be managed carefully given the lack of legislation dealing specifically with private equity investments.

The inflow of capital from non-resident investors can only benefit the South African economy.  Until recently, the level of both local and international funds invested in the private equity market perhaps justified the view that there was no need to adopt a special tax regime applicable to private equity investment.  However, given the increase in popularity of investment into private equity funds, the time has come for South Africa to hold itself out as a beneficial or equitable jurisdiction in relation to the treatment of investment proceeds derived from South African private equity funds.  Should this opportunity be missed, other jurisdictions in Africa, South America and Asia may attract that portion of funds designated by fund managers for emerging markets. 

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