New draft tax bill hides a "stealth tax" in your unit trust investments

Key topics:

• Draft TLAB ends tax-neutral treatment for CIS mergers

• Investors face immediate CGT on fund mergers, even without selling

• Proposals risk undermining long-term savings and retirement security

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By Joon Chong, Partner & Graham Viljoen, Director at Webber Wentzel

For millions of South Africans, a unit trust or a portfolio of a Collective Investment Scheme (CIS) is one of the pillars of their financial future, serving as a vehicle for retirement savings, children's education funds, and long-term wealth creation. Under National Treasury's proposed amendments in the draft Taxation Laws Amendment Bill (TLAB), these CIS investors could face an unexpected tax bill on their holdings even if they have not sold any units.

The issue arises from the effective exclusion of CIS mergers from the definition of an 'amalgamation transaction' under section 44 of the Income Tax Act (ITA). This means that the exchange of participatory interests in a CIS during a fund merger will no longer qualify for tax-neutral treatment.

Current rules provide for tax neutrality

Imagine your investment manager decides to merge the CIS you are invested in (CIS 1) with another fund (CIS 2). This is a common practice done for various non-tax commercial reasons such as industry consolidation, achieving economies of scale, or realigning investment mandates. Crucially, these decisions are made entirely outside an investor's control.

Under the current rules, this merger is tax neutral for all parties under section 44 of the ITA. In a merger, CIS 1 transfers its assets to CIS 2 in exchange for units in CIS 2, which CIS 1 then distributes to its investors. Upon completion, CIS 1 is terminated. For tax purposes, while investors exchange their CIS 1 units for new CIS 2 units, the investors are deemed to have disposed of their CIS 1 units at their tax cost. As a result, any tax is 'rolled over' until they eventually sell their new CIS 2 units. This means capital gains tax (CGT) is deferred until a sale of CIS 2 units occurs.

Proposed section 44 exclusion triggers potential CGT for CIS investors

The draft TLAB proposes to scrap this relief for CISs entirely. The merger of CISs and subsequent distribution of new units to unitholders would no longer be tax-neutral. Instead, the merger would have the same tax impact as though investors had sold their CIS 1 units for the market value of the new CIS 2 units, triggering an immediate CGT liability for the unitholder on any capital gain.

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An investor who wishes to remain fully invested would have to fund the CGT as a 'dry tax' either in provisional tax payments or upon assessment. Alternatively, they could be forced to sell a portion of their new CIS 2 units to pay the tax bill. The result is that the investor's overall asset worth is reduced by the CGT payable, even though they never chose to exit their original investment.

Notably, the Explanatory Memorandum (EM) provides no specific examples of how section 44 amalgamations are being used for tax avoidance.

Removal of section 42 tax-neutral rollover relief applying to CISs

The draft TLAB also removes tax-neutral rollover relief for 'asset-for-share' transactions under section 42 for all CISs due to National Treasury's concerns about 'unintended tax avoidance. The EM highlights a scenario where an investor transfers listed shares to a CIS, which then sells them, with the subsequent capital gain being tax-exempt at the CIS level.

This potential for tax avoidance was noted in the Discussion Document on the Taxation of Collective Investment Schemes. During a January 2025 workshop, participants suggested that this risk could be better managed by disallowing section 42 relief only for closely held CIS rather than a blanket ban for all CIS. Unfortunately, the draft TLAB favours a comprehensive removal over a specific remedy. As written, the proposed amendments will no longer provide for tax-neutral section 42 CIS transactions.

Capital distributions would trigger CGT

Another proposed amendment would treat any CIS distribution that is not income or gross income as a CGT event for the investor. The EM notes that capital distributions are typically "infrequent and relatively minor," arising from the fund's 'capital' rather than its income or profits. While National Treasury's observation on the frequency is correct, the quantum may be anything but minor considering the proposed amendments to section 44 to exclude CIS mergers. Further, it is unclear what constitutes a capital distribution in a CIS context.

Read with the proposed amendments to section 44 for CIS mergers, the distribution of CIS 2 units in the CIS merger example above would be considered a 'capital distribution', triggering a potential capital gain for investors. This is because the new CIS 2 units distributed would not be income or gross income distributions from CIS 1.

Proposals undermine CISs as a long-term investment vehicle

The proposals introduce potential 'stealth' taxes for investors and negate the intended long-term, tax-efficient compounding that makes a CIS an attractive investment vehicle. This policy shift is especially concerning when viewed against the backdrop of South Africa's precarious savings landscape with fewer than 6% of South Africans being able to retire and maintain their standard of living.

Given this stark reality, every aspect of fiscal policy should be geared towards actively promoting and simplifying long-term savings using CISs. By introducing unexpected tax liabilities and eroding the tax efficiency of CISs, the proposed amendments actively deter the very savings culture South Africa desperately needs.

Founded in 1868, Webber Wentzel is a leading full-service law firm providing clients with innovative solutions to their most complex legal and tax issues across Sub-Saharan Africa. With over 450 lawyers, their multi-disciplinary expertise is consistently ranked top tier in leading directories and awards, both in South Africa and on the African continent. Their collaborative alliance with Linklaters and their deep relationships with outstanding law firms across Africa provide clients with market-leading support wherever they do business.