Taxation of collective investment schemes (“CIS”)
Taxing collective investment schemes robs gains in our investment culture
The Income Tax (Amendment) Bill, 2023 has proposed several changes that affect many of us, directly or indirectly. Among the changes that I have seen being debated is the taxation of a collective investment scheme (“CIS”). The big question being why the Uganda Revenue Authority (“URA”) is seeking to tax the beneficiaries of a CIS. I share below some of the insights I gained from these debates as well as my thoughts on the taxation question.
A CIS is an arrangement where a person, people, or entities etc with a common investment objective pool money and invest it in a portfolio of assets that generates profits or income for them as investors. Typically, investments are made in what is known as a unit trust scheme (unit trust) which is a type of CIS. A unit trust has a trustee who holds property in trust for the members also known as unitholders who could be you, investment clubs, pension funds etc. The property is owned in form of units. The units are formed on the basis of underlying assets acquired by the unit trust, such as treasury bonds and bills, promissory notes, fixed deposits, shares etc.
According to the Capital Markets Authority report for the quarter ended December 2022, the fund managers of these unit trusts had a total of UGX 1.629 trillion in assets under management (AUM). There has been an absolute growth in AUM of UGX 1.502 trillion when compared to UGX 127 billion registered in the quarter ended December 2018. With such growth, you can bet on this investment vehicle promoting our savings culture and changing the capital markets landscape. Why then should such a product be subject to tax? I explain the taxation of CISs below.
Current taxation of unit trusts
Generally, tax is imposed on a person and this person must have derived income that is subject to tax under the income tax law. Therefore, if you derive income that is exempt from tax, the taxman has no legal basis of demanding any tax from you. Tax only arises where income earned is subject to tax.
The income tax law exempts a CIS from income tax in Uganda on condition that CIS distributes the income it makes to its unitholders. Based on practice, it’s common for income distributions to be made to the unitholders, so the tax exemption quite often applies to the unit trust’s income such as interest on government securities with minimal ambiguity.
On the other hand, if you are paid a salary and you are not exempt from income tax, your salary is subjected to Pay As You Earn by your employer because you have earned that income. Likewise, if you use this salary to buy units in a unit trust these units will earn you income in the form of interest or dividends when distributed to you by the unit trust. Accordingly, the income derived by you as a unitholder, unless exempted from tax, is liable to income tax. The tax applicable on interest and dividends is generally 15% on the gross amount paid. The tax should be withheld by the unit trust when making distributions to the unitholder. This tax does not result in double taxation. This is because the tax is imposed on income that you make from your savings and not on your savings (because these were already subject to PAYE). Also there is no double taxation when the interest income is paid to the CIS because the CIS is treated as exempt from income tax as earlier explained.
However, there has been some controversy in the industry as to whether the income distributions made to the unitholder should be subject to tax and how in practice this tax should be imposed. This is because the industry argues that this product was meant to be a tax-free investment vehicle for both the unitholder and unit trust to encourage savings. Indeed, the AUM of over UGX 1.6 trillion are a clear testament of the level of increased savings that we have achieved as a country over the years. If you ask me, this growth gives a justifiable reason to exempt the unitholder’s income at least for a specific period to encourage our savings culture as a country. Currently, Uganda has no product that encourages tax-free investments or savings, a unitholder’s tax exemption would fill this space. Additionally, there are some practical challenges regarding the point at which tax is withheld, should it be at each time the unit trust account is credited or when a distribution is made at the year-end?
New tax proposal on unit trusts
The income tax bill proposes to introduce 5% and 15% withholding tax (WHT) rates on the profit (interest/dividends) earned by unitholders from their contributions made to Unit Trusts in Uganda. Additionally, a CIS will be unconditionally exempt from income tax. All these amendments are effective 1 July 2023 if the bill is eventually passed into law.
The 5% WHT rate will be imposed on unitholders with total contributions not exceeding UGX 100 million, while the 15% WHT rate will be imposed on unitholders whose contributions are above UGX 100 million. The WHT will be imposed at the time of crediting the profit to the unitholders’ accounts.
If one only considers the WHT rates being proposed, the tax proposal seems welcome. This is because a unit trust as an investment vehicle still offers the most tax-efficient investment structure when compared to some direct investments. For example if you buy a treasury bond whose maturity period does not exceed ten years, the interest earned off this instrument is subjected to WHT at a rate of 20%. If the same government security is bought through a unit trust you will only suffer WHT at a rate of 5% or 15%. Further, when paying interest to the unit trust for government securities that form the basis of the unitholders investment in the unit trust, the Bank of Uganda or any commercial bank will not withhold tax from this interest considering it will be unconditionally exempt from income tax. This means that the only tax will be the 5% or 15% when the profit (interest) is credited to your account as a unit holder. There will not be double taxation. On the basis that government securities contribute about 78% of total AUM as of 31 December 2022, an investment through a unit trust vehicle seems attractive despite the proposed tax changes.
That said, in my view the best option would be for the distributions to be made by the unit trust to the unitholder tax-free for reasons stated above but I guess half a loaf is better than none.
By Trevor Bwanika Lukanga, Senior Manager - Tax at PwC Uganda
