This article follows an article written by Jutami Augustyn and published on 3 May 2024 (available here) which dealt with the life cycle of a typical private equity fund and various considerations when these funds approach the exit phase. Upon exit, so the article provides, fund managers may be faced with investments that are performing well and exiting these investments may either have a diminishing impact on the portfolio value, or market conditions may not be conducive for an immediate exit. Jutami’s article suggests, as a practical alternative, the creation of a ‘continuation fund’.
Continuation funds are used as a vehicle to extend the term of holding investments, even when the initial vehicle has come to the end of its contractual term. The creation of a continuation fund is achieved usually by way of the dissolution of the old fund and the remaining partners rolling over their interests to a new fund.
Continuation funds offer many commercial benefits; they offer flexibility for investors to maximise their returns on well-performing assets in the fund, whilst also providing investors an opportunity to realise existing investments in the case of liquidity concerns.
This article focuses on some of the more salient taxation aspects concerning the creation of a continuation fund pursuant to the dissolution of the old fund and the distribution of the old fund’s assets (which, for the purposes of this article, will be limited to shares held by the partners in the portfolio companies) to the exiting partners and their contribution to the continuation fund.
From a tax perspective, the dissolution of the old fund and the creation of a continuation fund require careful consideration.
Dissolution of the old fund, formation of a continuation fund, and the resultant tax consequences
The tax consequences for each partner of the fund will depend on the legal construct of the partnership concerned. Private equity funds typically take the form of an en commandite partnership (and this article also then focusses on this type of private equity fund, as opposed to a permanent capital vehicle).
A partnership does not enjoy a separate legal or tax persona. In terms of South African common law, the property of a partnership is co-owned, in an abstract sense, by the partners themselves in undivided (but not necessarily equal) shares, proportionate to their interest in the partnership and on the terms and conditions laid out in the partnership agreement.
In terms of South African common law, the dissolution of a partnership terminates the respective partners’ interests in the underlying assets and the distribution of the partnership assets to the partners will transpose the holding of a ‘partner interest’, in the abstract sense, to a divided interest of the partnership’s assets, or a ‘shareholder interest’. The dissolution of a partnership will attract capital gains tax (CGT) for the respective partners if the division of the assets of the partnership constitutes a ‘disposal’ or deemed disposal for tax purposes.
A ‘disposal’ is defined in paragraph 11 of the Eighth Schedule to the Income Tax Act, 58 of 1962 (Income Tax Act), and includes ‘any event, act, forbearance or operation of law which results in the creation, variation, transfer, or extinction of an asset’. The definition then provides particular inclusions with terms such as ‘conversion’, ‘sale’, and ‘exchange’.
The principles underlying paragraph 11 of the Eighth Schedule to the Income Tax Act are that a person must have disposed of an asset (as defined in paragraph 1 of the Eighth Schedule to the Income Tax Act) in the sense of having parted with the whole or a portion of it.
Partners disposing of their interests in the underlying partnership assets to third parties or existing partners
In the case of partners disposing of their respective interests in the underlying partnership assets in order to monetise their interests, and on the assumption that the respective partners’ undivided interests in the partnership assets were held on capital account, the disposal will give rise to a CGT event for each partner.
When a partner initially makes their capital contribution to the private equity fund, the partner acquires an undivided share in the respective assets (see Chipkin (Natal) (Pty) Ltd v Commissioner for the South African Revenue Service (190/2004) [2005] ZASCA 45) (Chipkin v CSARS). The judgement confirms that the undivided share in the asset and its ‘partnership interest’ are mutually exclusive.
Cloete JA in Chipkin v CSARS confirmed that when a partner disposes of their interest in the partnership, for tax purposes the partner disposes of their undivided share in the underlying asset. This disposal of a partnership interest, where ownership is transferred to a third party or an existing partner will, following the decision in Chipkin v CSARS, result in a disposal of an ‘asset’ for CGT purposes. The proceeds from a disposal of the partner’s interest in the asset of the partnership are treated as having accrued to that partner at the time of disposal, as contemplated under paragraph 36 of the Eighth Schedule to the Income Tax Act.
The proceeds less the base cost of the asset concerned will result in either a capital gain or a capital loss in the hands of the partner. In the instance of a partner being a South African company, the partner would be subject to CGT at an effective rate of 21.6% in the event of a gain. In the case of a loss, the capital loss may be capable of being set off against capital gains realised by the partner, provided none of the loss limitation rules apply.
Partners ‘re-investing’ their interest in the underlying assets of the ‘old’ fund in the continuation fund
The dissolution of a partnership would, at face value, constitute a ‘disposal’ for tax purposes, and by implication attract CGT. However, as set out above, the principle underpinning a disposal is that a person must have disposed of an asset in the sense of having parted with the whole or a portion of it.
This view is corroborated in the Comprehensive Guide to CGT issued by the South African Revenue Service, Issue 9 (CGT Guide). SARS, in the CGT Guide, confirms that if: ‘…the partnership assets comprise 100 shares in a single company and there are two partners A and B sharing profits equally. On dissolution partner A takes 50 shares and partner B takes 50 shares. Before dissolution each partner had a fractional interest in 50 shares and after dissolution each partner still holds 50 shares. While it could be argued that the 50 shares taken over by partner A consist of 25 shares formerly held by partner B and 25 shares formerly held by partner A it is not considered appropriate to trigger a disposal in these circumstances because each partner’s bundle of rights in the shares has remained unchanged’ (CGT Guide, page 392).
In terms of a typical private equity fund, partners’ rights and interests are established upfront by having regard to inter alia the profit-sharing waterfall that would be set out in the partnership agreement. Until the disposal of a partner’s interest in the underlying partnership asset, the value of each partner’s interest in an underlying asset typically fluctuates as one moves from the return of committed capital to any hurdle and then finally to ‘carry’ participation. Particular to a general partner of a fund, the value fluctuates disproportionately to the general partner’s initial capital contribution. But the value fluctuations arise as a result of the partnership interests established upfront, particular to the right to share profits.
A distribution of the old fund’s assets on its dissolution will be according to the contractual interests of the respective partners set in the partnership agreement. Mechanically, the termination of a partnership will trigger a replacement of the abstract proportionate co-ownership of the underlying assets with actual ownership of the underlying assets in the proportion of that partner’s rights in the partnership agreement. In this regard, the investor has not parted with anything, nor gained anything. The subsequent contribution of the respective assets to the continuation fund is then represented by a partnership interest in the new fund.
In the continuation fund, a partner’s interest may differ from that of the old fund, although the analysis in this article assumes the partner’s interest does not differ in value. For example, the exiting partner may have been a general partner in the old fund and a limited partner in the continuation fund. In respect of the asset itself and the partner’s co-ownership rights in the asset, provided the partner does not monetise value, the partner will have parted with nothing. A limited partner in the old fund which contributes its shares to the continuation fund, as a general partner, will not give up value on the date of admission to the new partnership. This is because the value of the contribution equals the value of the shares distributed from the old fund. The profit-sharing waterfall in the continuation fund needs value accretion or depreciation from that point on. Accordingly, a disposal for CGT purposes should not arise upon admission into the continuation fund.
The application of this view is supported in SARS Binding Private Ruling 391 (15 June 2023) (BPR 391). BPR 391 dealt with the tax consequences for the partners in an en commandite partnership following the termination of the old partnership and the associated distribution of partnership assets in accordance with their interests in the partnership. The partners, via the old partnership, held shares in a company on capital account. The old partnership was dissolved so that each partner obtained a direct investment in the underlying shares rather than holding its investment through the partnership itself. Under BPR 391, SARS confirmed that for purposes of a distribution, there will be no change to each partner’s bundle of rights/interests in the shares pre-and post-distribution.
Deemed disposals
Included within the ‘disposal’ rules, is a deemed disposal referred to as a ‘value shifting arrangement’. This means: ‘an arrangement by which a person retains an interest in a company, trust, or partnership, but following a change in the rights or entitlements of the interests in that company, trust, or partnership (other than as a result of a disposal at market value as determined before the application of paragraph 38), the market value of the interest of that person decreases and– the value of the interest of a connected person in relation to that person held directly or indirectly in that company, trust or partnership increases; ora connected person in relation to that person acquires a direct or indirect interest in that company, trust, or partnership.’ (our emphasis)
The value-shifting provisions apply primarily to a movement in a partnership interest in respect of an existing partnership (the definition references ‘that’ partnership). Accordingly, the value shifting provisions should not apply on dissolution of a partnership as the said partnership is no longer in existence.
This view was also confirmed in BPR 391 in which SARS held that the dissolution of a partnership did not result in any change in the rights held by the partner and therefore would not constitute a ‘value shifting arrangement’.
Concluding remarks
The rights/ entitlements of each partner would need to be carefully considered upon dissolution of a partnership to determine whether a disposal event, for tax purposes, arises. Unless a particular partner monetises its interest in the dissolved partnership, the contribution of the co-owned interest in the underlying assets to the continuation fund, should ordinarily not result in a disposal for CGT purposes.
