Private equity (PE) investments are known for their significant potential for returns, but navigating the path to a successful exit can sometimes be challenging.

Historically, typical South African PE funds are structured as en commandite (limited liability) partnerships with a predetermined term, often 10 years (plus two one-year extensions). At the end of the term, the investments are usually realised, and the investors share the returns. Common ways of exiting private equity funds are either via sales to other companies or secondary buyouts to other PE firms.

However, fund managers may face the challenge of trying to exit at the end of the pre-agreed life of the fund when investments are performing well and an exit would diminish value, or when market conditions are not conducive to an immediate exit. A practical solution may be to set up a continuation fund.

Continuation funds
A continuation fund is a vehicle used to extend the life of a PE fund beyond its original term. Existing investors have the option to roll over their interests into a new fund structure, allowing the fund manager to continue managing the portfolio beyond the initial investment.

However, navigating a continuation fund as a way to exit a PE fund requires careful consideration due to the tax implications.

Tax implications
The en commandite partnership of a typical PE fund does not enjoy a separate legal or tax persona. In terms of 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.

The dissolution of a partnership will attract capital gains tax (CGT) for the partners if the division of the assets constitutes a ‘disposal’ or is deemed a disposal for tax purposes.

Disposals
A ‘disposal’ is defined in South Africa’s Income Tax Act, 1962 as including ‘any event, act, forbearance or operation of law which results in the creation, variation, transfer or extinction of an asset’. The definition provides particular inclusions with terms such as ‘conversion’, ‘sale’ and ‘exchange’.

When partners initially make their capital contributions to the private equity fund, each acquires an undivided share in the assets. In Chipkin (Natal) (Pty) Ltd v Commissioner for the South African Revenue Service (SARS) (the Chipkin Case), it was confirmed that the undivided share in the asset and its ‘partnership interest’ are mutually exclusive.

Following the Chipkin Case, the disposal of a partnership interest where ownership is transferred to a third party or an existing partner will result in the disposal of an ‘asset’ for CGT purposes.

The proceeds less the base cost of the asset will result in either a capital gain or a capital loss in the hands of the partner. If the partner is a South African company and there is a gain, it will be subject to CGT at an effective rate of 21.6%, while a capital loss may be capable of being off set against capital gains realised by the partner, provided none of the loss limitation rules apply.

Partners ‘re-investing’ in the continuation fund
While the dissolution of a partnership would, at face value, constitute a ‘disposal’ for tax purposes, 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.

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 typically fluctuates. Particular to a general partner of a fund, the value fluctuates disproportionately to the general partner’s initial capital contribution. These changes arise as a result of the partnership interests established upfront.

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 this regard, the investor has not parted with anything, nor gained anything. The subsequent contribution of the 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 we assume, for the purposes of this article, that the partner’s interest does not differ in value. For example, an exiting partner may have been a general partner in the old fund but 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 the value, the partner will have parted with nothing.

A limited partner in the old fund that 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 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. 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 (2023 (BPR 391)).

Included within the ‘disposal’ rules is a deemed disposal referred to as a ‘value shifting arrangement’. The value-shifting provisions apply primarily to a movement in a partnership interest in respect of an existing partnership. Accordingly, these shifting provisions should not apply on the dissolution of a partnership as the said partnership is no longer in existence.

This view was also confirmed in BPR 391, where 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’.

Once the benefits of utilising a continuation fund to cater for specific commercial needs at the end of the term of a fund have been taken into account, one would also need to consider the rights/ entitlements of each specific partner in such fund to determine whether a tax disposal event 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.

Jutami Augustyn is a Partner, Michael Rudnicki an Executive in Tax, Diwan Kamoetie an Associate, and Eamonn Naidoo a Candidate Legal Practitioner | Bowmans South Africa.

This article first appeared in Catalyst, DealMakers’ quarterly private equity publication.

DealMakers is SA’s M&A publication.
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