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Tuesday, October 25, 2011
Investments and the tax implications
24 October 2011
By Matthew Lester, Professor of Taxation Studies at Rhodes University, Grahamstown
Investment returns have been under huge pressure in recent times. The prime interest rate is at its lowest level since the 1970s. And the Johannesburg Securities Exchange has been trading in a band of 30 000 – 33 000 points for nearly two years. All of this makes it all the more imperative that the investor understands the tax implications of investment so that the South African Revenue Service (SARS) does not walk off with a substantial chunk of whatever returns are achieved.
The two crucial components of tax investment strategy are:
- Understand ‘the quality of income’ received or accrued to the taxpayer
- Understand ’the category of taxpayer’ receiving the investment income and the tax rates attributable thereto.
There are three qualities of income for tax purposes:-
Exempt income
- In most instances exempt income consists of South African dividend Income.
- Foreign Dividends are mostly taxable.
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Most of the ‘tax free instruments’ associated with our past have now mostly been withdrawn.
Investors must exercise caution with regard to dividend income in the following circumstances:-
- Preference share dividends can be deemed to be interest income (and fully taxable) where the preference share (or a similar instrument) is issued for a period of less than three years or the holder has some or other right to sell the share or cause it to be redeemed within three years.
- Extraordinary dividends can cause the recipient to incur capital gains tax if the share is sold within the short term.
Dividends tax is scheduled for implementation in South Africa on 1 April 2012 but will have little effect on these principles.
Revenue Income
- Interest Income
Interest receipts are recognised as fully taxable and accrue to a taxpayer as it accrues on a day-to- day basis in terms of section 24J of the Income Tax Act. Premiums and Discounts on redemption of instruments are subject to these provisions as well.
It is critical to note that interest rates have reduced substantially in recent years.
There seems to be little prospect of rates increasing due to a fundamental change in the policy of the Reserve Bank, especially as economic conditions remain very difficult. This leaves the fully taxable investor receiving a mere 3 – 4% after-tax return on interest, a rate that can sometimes be achieved in tax-free dividend yield.
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Trading Profits
Without going into too much depth, the deciding factor when dealing with a share portfolio is whether the gain results from:
- an actively managed portfolio (giving rise to a fully taxable revenue gain), or
- a passively managed portfolio (giving rise to a partially taxable capital gain).
Enquiry has to be conducted into how the portfolio managers behave. If they are actively monitoring the portfolio on a day to day basis and making decisions based on predetermined benchmarks of performance, it can be very difficult to defend a fully taxable position. This represents an enormous risk to the taxpayer.
When in doubt the taxpayer is probably best off by simply maintaining an investment position for at least three years, whereafter the proceeds from sale of most shares are deemed to be capital in nature and only partially subject to tax.
Often taxpayers find it easier to protect their capital gains position by investing through Collective Investment Schemes rather than through individually managed private portfolios. Simply put, it is very difficult to maximise the investment potential of a portfolio without creating an actively managed portfolio (the gains from which are subject to tax in full).
- Capital income
Capital income arises where there was no intention to trade with an asset and it was held ‘for better or for worse’, or so to say ‘for keeps.’ Prior to the introduction of Capital Gains Tax on 1 October 2001, capital gains were tax-free exempt income. Today capital gains are taxed at rates ranging between 0 and 22% according to the type of taxpayer.
Conclusion: Quality of the income
Given that the quality of the receipt of accrual can give rise to a tax rate of anything between 0 and 40% the investor has to take into account the quality of the income prior to making an investment decision.
Thereafter the investor is in a position to choose the type of investment vehicle (or type of taxpayer) that is most suitable to be in receipt of the income.
Category or Type of taxpayer or investment vehicle
Once the investor has analysed the quality of income it is then necessary to address the type of taxpayer to be in receipt of the income.
Most investors prefer to receive income in their own names where it is taxed at the personal taxpayer rates. Although the top rates of personal tax in RSA are the highest of all tax rates one needs to recognise that individual tax rates are applied to taxable income (after deducting allowances) and on a sliding scale, after which rebates are granted.
The general tax threshold (for individuals less than 65 years old) is currently R59 750; for those 65 – 75 years old R93 150; and those over 75 years old R104 261. This represents the level at which they actually start paying tax.
However there is also the tax-free interest allowance. The general allowance is R22 300 (for individuals less than 65 years old) and R32 000 for those over 65 years old.
Putting the tax-free interest allowance on top of the tax threshold one gets the actual level at which a person starts paying tax on investment income in retirement. The general tax threshold (for individuals less than 65 years old) is currently (R59 750 + R22300 = R82 050), for those 65 – 75 years old (R93 150 + R32 000 = R125 150), and those over 75 years old (R104 261+ R32 000 = R136 261).
Added to the above is an annual tax-free Capital Gains Tax Allowance of R20 000.
Before even looking at the different investment alternatives available to investors it is appropriate to acknowledge the different categories of the RSA population when it comes to tax.
Trusts
There are many misunderstandings about the taxation of trusts.
In short, unless a trust can be classified as a ‘special trust’ for tax purposes, it will be taxed at the flat rate of 40% on revenue income and 20% on capital Income.
Special trusts are not that common and are generally trusts established for disabled persons or Will Trusts where the youngest beneficiary is less than 21 years old.
It is possible to reduce the inherent tax rate of a trust by causing the income of the trust to ‘flow through’ the trust and be taxed in the hands of the beneficiaries (at the lower individual tax rates). This is achieved by causing the income to ‘vest’ in the beneficiaries and that may not necessarily achieve the investor’s intention.
The use of trusts must be very carefully considered and specialist advice is most often needed in establishing and administering a trust.
Insurance policies
Many investors completely misunderstand the taxation of insurance policies, believing that the returns they generate are completely tax free. This is incorrect. Tax is imposed within the policy and the after tax proceeds accrue to the investor when the policy matures.
The tax rates on insurance policies have been stable for many years and are supposed to represent the average tax rate of all South Africans, being 30% for revenue income and 7.5% for capital income. Taxpayers have to earn more than R325 000 per annum before they will be any better off paying tax within an insurance policy rather than in their own names.
Second hand insurance policies
Capital Gains Tax is imposed as an additional tax on second hand insurance policy withdrawal benefits. For many investors this has made the second hand policy experience more or less obsolete.
Company tax rates
Corporate tax rates are the lowest of all at 28% and this often sends investors off in the wrong direction.
Yes it is true, a wealthy investor stands to reduce tax on interest receipts from 40% to 28% by investing through a company. However,
- The investor should rather be saying ‘should I not be investing in equities. Not because of the tax rate, but rather because the interest rate is so low. Saving 12% on a 6% return does not amount to much; or
- What about the administrative expenses of running the company; or
- When ultimately I withdraw the after tax income from the company, the STC is paid at 10%. This increases the total corporate tax charge to 35,2%; and
- If the company invests in equities then the CGT rate on the returns will be 14% plus STC, resulting in a combined effective tax rate of 22,6% - more than double the CGT rate applicable to the individual.
Exempt Institutions
Exempt institutions generally carry out charitable or philanthropic activities and have little place in the investment debate.10 concluding observations
- Very few South Africans need complicated investment structures.
- Most South Africans would be better off concentrating on maximising the returns on their investments than protecting their returns from taxation.
- Taxation can be contained to a maximum of 10% capital gains tax on investment income if taxed in the hands of the individual investor.
- Only when income exceeds R325 000 per annum is there any need to seek the protection of an investment vehicle.
- Fully taxable interest income is a problem. Not so much because of the tax rate but rather because of the poor interest rates.
- Fully taxable income can arise in forms other than interest. Fully taxable gains from trading in shares are of primary concern.
- Before using any type of investment vehicle, always consider any further taxes, primarily CGT or STC that may be payable on withdrawal/maturity of the investment.
- Before using any type of investment vehicle always consider costs of establishing and maintaining the vehicle.
- It all goes to show that there is more to investing than just generating a return.
- Most South Africans need a financial adviser to get the balancing act right and generate the best ‘after tax return’ without taking unnecessary risks.