Published Articles

Tax Law:

Cornwell Dauds

Should Carried Interests in Private Equity Be Taxed As Capital or Revenue?



  1. The favourable tax treatment of private equity profits has been a cause for concern for many revenue authorities, precisely because of the apparent tax base erosion effect. In some countries, even the public has expressed its outrage at the favourable manner in which private equity profits are taxed.
  2. As an emerging economy, South Africa relies heavily on investment and, like many other economies, government uses a number of options at its disposal – including tax measures – to encourage investment into the country. The South African National Treasury has acknowledged the benefits of private equity investment by stating that private equity transactions can contribute to economic growth in various ways. Even so, the tax benefits thus far enjoyed by private equity fund managers have raised concerns.


Nitty gritty of private equity

  1. Private equity funds are often set up as partnerships which, in turn, comprise a number of investors (mostly institutional) such as pension funds, for instance. If set up offshore, the fund will typically be organised as a limited liability partnership (an LLP). If set up onshore, the fund tends to be legally known as an en commandite partnership (a limited liability partnership). Often the partnership will have a general partner (“GP”) who is responsible for the management of the affairs of the partnership. The GP is rarely an individual – in fact, in most cases it is itself a partnership consisting of a number of individual partners.
  2. Alternatively, the funds of the partnership (the investors) may be managed by an investment management company (this may be unwise though, as the same profits will be taxed twice – when they are earned, and again when they are distributed). The brief of the GP, or investment management company, typically includes the identification, evaluation, and negotiation of investment opportunities – and the monitoring and realisation of those investments on behalf of the fund. For this, the GP, or management company, earns a management fee – typically amounting to 2% of the fund value.
  3. To align the interests of the fund manager with those of the investors, the GP, or investment management company, may be required to co-invest with the investors in the fund. This requisite co-investment is typically as little as 1 – 2% of the total capital in the fund. In return, the fund manager becomes entitled to up to 20% of the total growth of the fund. However, 18 – 19% of this (20%) entitlement is only triggered once the fund manager has achieved a certain agreed level of performance, and the ordinary investors have received their specified return. Since the fund manager only contributes 1 – 2% of the fund’s capital, yet becomes entitled to 20% of the fund’s growth, the 18 – 19% constitutes what is often referred to as “carried interests” (otherwise simply known as “the carry”).


Current tax treatment

  1. The fund manager does not receive carried interests in return for any corresponding capital contribution to the fund. Rather, the carry is based solely on the fund manager’s performance which in many jurisdictions enjoys favourable tax treatment in that it tends to be taxed at capital gains tax (“CGT”) rates, instead of the ordinary rates which may be as high as 45% for individuals in South Africa.
  2. Fund managers often organise themselves into partnerships so that the carry is taxed in their hands as individuals at the maximum effective CGT rate, which in South Africa is 16.4%. In other words, the carry is treated as capital, rather than revenue, and taxed accordingly (i.e. at CGT rates). This treatment has unleashed vigorous criticism in many jurisdictions where carried interests is taxed favourably at CGT rates. Even the South African National Treasury has on occasion said that the tax treatment of carried interests, which according to them constitute a reward for services rendered by fund managers, and which (reward) may take the form of shares/equity, should be investigated with a view to, ultimately, taxing the carry at ordinary rates (rather than the more favourable CGT rates) for individuals.




Should carried interests private equity fund managers earn be taxed as capital or revenue?

  1. There appears to be agreement that any growth in the investment of the ordinary investors constitutes a capital gain, and therefore deserve be taxed at the favourable CGT rates since the shares purchased on behalf of these investors are typically held as capital assets. However, it is contended by some commentators (a view seemingly shared by the South African National Treasury) that, when 18 – 19% of the shares/equity (which appreciated in value) are transferred from the investors to the fund manager as reward for the manager’s performance, the shares undergo a change in character and become ordinary income in the hands of the fund manager, and should thus on this basis be taxed as ordinary income. This proposed treatment is supposedly supported by the argument that the shares, though held as capital by the investors, in the fund manager’s hands constitute compensation for services rendered by the manager. More specifically, the shares represent performance fees.
  2. The counter-argument goes along the lines that the shares do not, and should not, undergo a change in character when they flow from the investors to the fund manager – even if the fund manager provided services rather than capital for those shares. According to this argument, to maintain that the shares undergo a character change is tantamount to imposing an artificial re-characterisation on the shares. What was capital in the hands of the investors should apparently remain capital in the hands of the fund manager, unless the manager unequivocally makes the decision to acquire and hold the shares as trading stock.


Settling the debate

  1. While the debate rages over how precisely carried interests in private equity deals should be taxed, and National Treasury as far back as 2008 undertook to investigate the issue by developing a discussion document which raises options and elicits public comment, we appear to be nowhere close to settling the debate!


  • The Debt/Equity Conundrum”   Cornwell I. Dauds

Published in: The Law Magazine, Nov. 2007, Vol. 7 No. 10

This article explains the increasingly difficult distinction between debt and equity instruments, their use as capital-raising sources for companies, as well as the tax implications of both.


  • Securitisations . . . and the Revenue”    Cornwell I. Dauds

Published in: The Law Magazine, Feb. 2008, Vol. 8 No. 1

This article explains the mechanics of securitisation, its use as a more efficient capital-raising tool for companies and banks, the different securitisable asset types, and the general approach to the taxation of securitisation transactions.


  • The Private Equity Debate”   Cornwell I. Dauds

Published in: The Law Magazine, May 2008, Vol. 8 No. 4

This article explains the mechanics of private equity, the tax treatment of carried interests, as well as criticism of the favourable tax treatment given to private equity.


Cornwell Dauds

Securitisations and their Tax Treatment



  1. Corporates are almost always in need of cash – whether for growing and expanding the business, settling maturing debt obligations, or funding a take-over. Depending on its credit rating, a company may meet this need by issuing unsecured debt securities. However, raising capital this way may be a tad expensive. A less expensive alternative may be for the company to pledge its existing assets and borrow against them. Yet another way to raise cash is through factoring of the company’s book debts. However, none of the three options may be suited to the company’s needs. Issuing securities is an on-balance sheet form of financing – the debt must be recorded on the company’s balance sheet as a liability. This may increase the company’s debt-to-equity ratio, leaving it more leveraged and thus increasing the perceived risk attached to the company. Factoring might involve some recourse to the company as seller of its book debts.
  2. Enter securitisation. The prime advantage of this funding tool lies in the fact that it is a less expensive off-balance sheet form of financing – it also does not add to the company’s leverage, and accordingly perceived risk.


Fundamentals of securitisation

  1. Securitisation involves the conversion of a bank’s, or company’s, loans/financial assets into ready cash, rather than relying on the smaller regular cash flows generated by the asset over a period. Just about any financial asset is securitisable – common asset classes include mortgage loans, corporate loans, credit card payments, motor vehicle loans, lease payments, insurance premiums, student fees, royalties, etc. Securitisation is particularly useful for banks since the fewer the assets on their balance sheet, the less the regulatory capital and reserve funds they should be required to maintain.
  2. A securitisation transaction involves three important players – an originator, a special purpose vehicle (SPV), or special purpose entity (SPE), and investors. The originator (bank or company) is usually the capital raiser. As part of the securitisation process, the bank will bundle its loans together (pool the loans), and sell them to the SPV/SPE set up specifically for the purpose of the transaction. The SPV/SPE will package the loans into securities and sell them to investors. The cash raised from the sale of the securities is then used to pay the originator for the sale of its financial assets to the SPV/SPE.
  3. Once the assets are transferred to the SPV/SPE, the latter (and no longer the originator) becomes entitled to the cash flows (regular payments by, for instance, debtors on their loans) generated by those assets. These cash flows are used by the SPV/SPE to service the securities it had issued by making regular interest payments, and for the repayment of the principal amount to investors (purchasers of the securities). Since the securities are backed/supported by the underlying assets (the loans, credit card payments, insurance premiums, lease payments, student fees, royalties) which generate the cash flows, they are alternately referred to as-
  • mortgage-backed securities (MBS), if the underlying assets constitute loans extended for the purchase of property;
  • asset-backed securities (ABS), if the underlying assets constitute, for instance, credit card payments or loans extended for the purchase of motor vehicles;
  • collateralised loan obligations (CLOs), if the underlying assets constitute corporate loans.
  1. The securitisation industry is replete with acronyms – in addition to the above, others include CMOs (collaterised mortgage obligations), CDOs (collateralised debt obligations), CBOs (collateralised bond obligations).
  2. No securitisation transaction is complete without a credit enhancement facility – provided by either the originator itself or purchased as a form of risk cover from an insurance company, or bank. Where the facility is provided by the originator, it may take the form of either:
  • over-collateralisation – the originator transferring more assets than the value of the securities to be issued by the SPV/SPE; or
  • the originator subscribing for the junior (and accordingly more risky) securities of the SPV/SPE.
  1. The purpose of the credit enhancement facility is to improve the rating of the securities, thus making them attractive to potential investors as well as to protect investors from losses that might occur if the underlying loans which generate the cash flows were to become bad.




Tax aspects

  1. There is no specific provision in the South African Income Tax Act that regulates the tax treatment of securitisation transactions. As a result, one is compelled to look to general tax principles, augmented by case law.


The originator

  1. Receipt of the purchase price by the originator upon the sale of its financial assets (the loans, credit card payments, lease payments, insurance premiums, royalties, etc.) may be of a revenue or capital nature. The originator may argue that what had been sold to the SPV/SPE is, in fact, a part of its business (income-earning structure), and the receipt should accordingly be of a capital nature, so that any gain is taxed at the more favourable CGT rates. The tax authority, on the other hand, may argue that what the originator sold is income streams, and receipt of the purchase price is therefore of a revenue nature, which is includible in the originator’s gross income and taxed at ordinary rates for companies (the corporate tax rate).
  2. The originator may sell its financial assets at a discount, or premium. In this regard, CSARS v Creative Productions (Pty) Ltd [1999 (2) SA 14 (N)] provides some guidance – the Court held that the loss from the discounting of the promissory notes was, like a factoring charge, of a revenue nature and, therefore, deductible under section 11(a) of the Income Tax Act. It may thus be argued that the loss to the originator from the discounted purchase price paid for its assets is similarly deductible.



  1. Prior to the sale of its assets, the originator would usually have been entitled to a section 11(i) deduction in respect of interest payments by its debtors that had become bad. When the SPV/SPE steps into the shoes of the originator, it (the SPV/SPE) should henceforth be entitled to the same deduction. The SPV/SPE should also be entitled to a deduction for doubtful debt under section 11(j).
  2. Where the SPV/SPE obtains the assets at a discount, two scenarios present themselves:
  • should the SPV/SPE recognise the entire discount at the point of sale? or
  • may the SPV/SPE rely on section 24J of the Act to spread the gain (arising from the discount) over the term of the loans?
  1. The section 24J proposition may be supported by the argument that, while there is no interest-bearing arrangement between the originator and the SPV/SPE, once the latter steps into the former’s (the originator’s) shoes, an interest-bearing arrangement between the SPV/SPE and the originator’s erstwhile debtors comes into being, thus rendering section 24J applicable.
  2. That the purchase price of the assets may be capital or revenue in the originator’s hands does not mean that payment by the SPV/SPE will necessarily follow the same characterisation. The tax authority may still apply the capital/revenue test to determine the nature of the payment. The SPV/SPE should not find it too difficult, though, to argue that the payment is of a revenue nature, and therefore deductible in full under section 11(a).
  3. Once the SPV/SPE has issued the securities, the amount of interest payments on them are ordinarily determinable under section 24J, and deductible under section 11(a).



Competition Law:

Cornwell Dauds

Criminalisation of Cartels

  1. Time to ratchet things up on cartels! From a report in the Business Day of Friday, 22 April 2016, that’s effectively the message of the Minister of Economic Development, Mr Ebrahim Patel. The Minister appears bent on using section 73A of the Competition Amendment Act to criminalise hard-core cartel practices such as price-fixing, market division and collusion in tenders (bid rigging). Granted, cartel practices have worldwide been declared a most egregious offence which has no place in a sound economy and, for this very reason, most jurisdictions have imposed an outright prohibition on these practices. This is because of the very harmful effect cartel practices have on consumers – they cause a rise in the prices of products and services (often a steep rise!).
  2. So far – in South Africa, that is – only administrative sanctions in the form of fines have been imposed on those firms found to have engaged in cartel practices. But it is the companies which end up paying these fines – not the directors or executive managers personally. Now the Minister wishes to go after these individuals by way of section 73A – he wants criminal sanctions to be imposed on the directors and executive managers of those companies that are found to have engaged in hard-core cartel practices. His desire is to have these individuals criminally prosecuted, and upon conviction sentenced to a jail term. As a way of deterring cartel practices – which are harmful to consumer welfare – one probably could not fault the Minister’s thinking.
  3. But what success does the Minister hope to achieve with the criminalisation of cartels? It is not easy to expose a cartel whose activities are typically kept secret. Competition authorities worldwide have long appreciated this difficulty, and have resorted to the use of what is known as the “corporate leniency policy” to break the mould. They have offered cartel members – who have been sworn to secrecy by the cartel – leniency if they came forward and said “mea culpa” (I’ve done wrong), and then immediately spill the beans on their co-cartel members. The South African competition authority has followed suit in implementing this leniency policy. In fact, most of the successful prosecutions of cartel practices have been obtained through the use of the leniency policy – both here and in other jurisdictions. This policy allows “turncoat” cartel members to escape the full might of the law. To any member that invokes the leniency policy, it is about self-preservation. A cartel member will typically only make use of the leniency policy and confess if there is a suspicion that the competition authority is onto them, or if the cartel members had a fall-out, and one of the members considers it wise to move first and take advantage of the leniency policy. Even so, without the corporate leniency policy, competition authorities would have found it incredibly difficult to successfully prosecute cartel practices.
  4. Now the Minister wishes to move to the next level – he wants to have criminal sanctions, not only administrative sanctions, imposed on those found to have engaged in cartel practices. With a criminal prosecution comes a heavy burden of proof – guilt proved beyond a reasonable doubt is required. So how does the Minister hope to overcome this hurdle? He hopes to do so by the use of section 73A of the Competition Amendment Act, which he believes allows him to criminally go after the directors and the executive managers of a firm found to have violated section 4(1)(b) of the Competition Act (the price-fixing, market division and collusive tendering provisions), and have these individuals sentenced to a jail term upon a successful conviction. Understandably, the Minister wants to discourage any dabbling in the cartel “cancer” by fighting the practice on two fronts – through administrative sanctions and through criminal sanctions. But just how realistic is the criminal sanctions front? While the US have had some success with the criminal prosecution of cartel practices, other jurisdictions which have also introduced criminal sanctions have not been particularly successful. The relative success in the US is largely attributable to the fact that that country’s law enforcement institutions and procedures are uniquely suited to the criminal prosecution of cartel practices. For instance, that country’s Department of Justice (DoJ) administers the leniency program and is also the prosecuting authority – it does not have to rely on another prosecuting authority to prosecute the individuals alleged to be involved in cartel activities. The US is thus able to co-ordinate the leniency program and criminal sanctions for violations of the law.
  5. By contrast, other jurisdictions – including South Africa – lack this co-ordination between the corporate leniency policy which allows cartel members to open up, and the prosecution of individuals. While the leniency policy is administered by the competition authority, criminal prosecution is the responsibility of another authority (in South Africa, the National Prosecution Authority). This means the competition authority itself is not able to offer individuals (directors and executive managers) a lesser sentence, or immunity, in exchange for co-operation. Sentencing and the issue of immunity will be entirely in the hands of the prosecuting authority and the Court where there is no guarantee of a lesser sentence or immunity.
  6. The question that follows therefore: Will the directors and executive managers of a firm confess their cartel sins where there is a chance they might face the full criminal might of the law? Methinks not.




Articles due for publication:

Tax Law:

  • Using Derivatives As Tax Planning Tools”   Cornwell I. Dauds

This article looks into how financial derivative instruments may be used in tax planning, especially in cross-border transactions.


  • Corporate Break-ups in SA – Are They Hard To Do?” Cornwell I. Dauds

Measures were incorporated into the Income Tax Act to facilitate corporate unbundlings, i.e. demergers. This article looks into how easy or difficult it is to meet the requirements of the Act for the purpose of executing an unbundling tax-efficiently.


  • The SA Headquarter Company Regime: A Blatant Case of Tax Base Erosion?” Cornwell I. Dauds

This article looks into the rationale for the introduction of the headquarter company regime and the various tax concessions that went along with that. It poses the question whether the country has to date derived much benefit from the regime and whether the tax concessions have simply eroded the country’s tax base.


  • Do CFC Rules Serve Their Purpose?”       Cornwell I. Dauds

This article questions whether, while they were designed to serve as an anti-avoidance measure, the controlled foreign company (CFC) rules are actually able to fulfil that function. The article concludes that tax avoidance remains possible (and provides illustrations) even with the CFC rules in place.


  • SA Taxation of Dividends: Too Complicated A Regime?”       Cornwell I. Dauds

This article deals with the core dividends tax regime in the South African Income Tax Act as well as the dividend-deeming rules scattered all over the Act which operate as anti-avoidance measures. The article suggests that the taxation of dividends in South Africa has (unnecessarily) become too complicated.



  • The Transfer Pricing Issue”   Cornwell I. Dauds

This article deals with transfer pricing, what it means and the motivation for manipulating transfer prices, as well as efforts tax authorities around the world have made to combat the phenomenon.


Financial Regulation

  • The South African OTC Derivatives Market: Has A Case Been Made For Its Formal Regulation?”       Cornwell I. Dauds

This article deals with National Treasury’s proposed formal regulation of the South African over-the-counter (OTC) derivatives market which is apparent from Treasury’s two draft policy documents, Ministerial Regulations and Board Notices issued under the Financial Markets Act No. 19 of 2012. The article argues that a case may well not have been made for the formal regulation of the OTC derivatives market.




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