We found an interesting article written by Prof Lester of Rhodes Business School on the subject of preference shares. He is questioning the role of preference shares in a portfolio and whether it is still a good investment.
"Twenty years ago financial advisers sold preference shares like supermarkets sell soap... and rightly so. The combination of a low-risk profile with an attractive inherent tax rate just couldn't be beaten. But life has changed and now could be a good time to reassess the underlying features of these products."
"Twenty years ago financial advisers sold preference shares like supermarkets sell soap... and rightly so. The combination of a low-risk profile with an attractive inherent tax rate just couldn't be beaten. But life has changed and now could be a good time to reassess the underlying features of these products."
The graph says it all: monetary strategy in South Africa has changed. In the past, South Africa's money supply was governed by the philosophy of Dr Chris Stals, a monetarist who believed that everything could be controlled by adjusting interest rates.
If inflation rates increased, Dr Stals tried to control the rate by burdening the consumer with interest-rate increases. If international and local speculators chose to pick on the rand, he increased interest rates again. And if international investors ran away from South Africa due to political risk, Dr Stals tried to lure them back with even higher interest rates.
His strategy didn't work and he was replaced as Governor of the Reserve Bank by Tito Mboweni in August 1999. It was clear to Mboweni that he would strangle attempts to regain the new RSA if he tried to dominate the economy by adjusting interest rates. He also knew that the interest-rate approach would incur the wrath of Cosatu - an organisation crucial to the powerbase of the ANC through the tri-partite alliance. There are many influences on interest rates but one must never forget the political considerations, which are perhaps the most important.
Mboweni moved on and was replaced by Reserve Bank Governor Gill Marcus in July 2009. Trevor Manuel moved on and was replaced by Minister of Finance Pravin Gordhan in May 2009.
Marcus and Gordhan have encountered additional restraints when it comes to interest rate strategy, namely:
- Gordhan needs consumer spending as his national budget is hugely dependent on VAT, customs and excise duties, and fuel and electricity levies. If the consumer is throttled with high interest rates, transaction tax receipts will plummet and Gordhan's carefully determined national deficit (basically measured as tax receipts less government expenditure) will escalate.
- If the national deficit escalates, the international rating agencies will target RSA, interest rates will have to be increased and RSA will dip into economic and possibly social chaos à la Greece!
The fundamental change affecting all investors is that RSA's pre-tax interest rate for the investor (5-6%) is now below the inflation rate (6-7%). Risk-free investment in preference shares made sense in the high-interest rate society of our past. Those times are long gone. Money invested risk-free is literally rotting away.
Fundamentals of preference shares
Preference shares will generally be offered by an institution seeking to
utilise a tax-assessed loss. Fully taxable interest income is offset
against the tax-assessed loss, allowing the institution to pay a
dividend with dividend tax being the only consideration. The institution
charges 20-30% of the interest return for providing this facility,
which turns fully taxable interest into tax-free dividends.
Prior to 1993 preference shares were just beautiful. No dividend tax was paid due to the complete exemption of dividends from tax. Sadly, that ended when Secondary Tax on Companies (STC) was introduced in March 1993. And now STC has been replaced by dividend tax with effect from 1 April 2012.
The sting in dividend tax is that the rate has been increased from the 10% enjoyed in the STC era to 15% in the dividend tax era. Many preference shares are structured on the basis that the liability was absorbed by an 'STC credit'. Initially it was announced that the STC credit would continue for five years into the dividend tax era, that is until 31 March 2017. But announcements contained in the February 2012 National Budget Speech now make it clear that the National Treasury seeks to shorten the STC credit window to three years (until 31 March 2015). We can expect that the STC credit expiry date will be hotly debated once the draft income tax bill is put to the Parliamentary Committee on Finance this month. But the final outcome will only be known when the 2012 Income Tax Act is signed into law, probably in December 2012.
Once the STC credit relief expires, all dividends will be subject to dividend tax at 15%. With interest rates ranging between 5% and 6%, the tax-free return offered by preference shares of 4-5% is now 2% below the inflation rate. And that's simply not much use to investors.
The investor must also never lose sight of section 8E of the Income Tax Act. This provision is complex and seeks to target dividends from shares that are redeemable within three years of issue, or where the holder has rights to cause an on-sale or redemption. If section 8E is applied, the dividend is fully taxable in the investor's hands. Investors are advised to always seek written assurance that their preference shares are not vulnerable to section 8E.
During 2011 the National Treasury attempted to extend the 'three-year rule' contained in section 8E to 10 years. After much debate this amendment was abandoned, probably due to the looming implementation of dividend tax. The combination of the shortening of the STC credit window and the provisions of section 8E creates an interesting dilemma: it's simply impossible to issue preference shares for the remaining proposed STC credit window without transgressing section 8E.
Some financial gurus have predicted that the expiry of the STC credit window will inevitably result in a shortage of preference shares in the market. And that perhaps the shortage will create a premium price for existing preference shares. Maybe they're right, but it's a speculative call.
Conclusion on preference shares
Irrespective of when the STC credit window finally expires, the
bottom line is that it will expire. The National Treasury has been
trying to contain preference shares for years and one must view the
implementation of dividend tax as the start of the final nail in the
coffin. Existing preference share investments should be retained as
short-term investments. Perhaps the taxpayer will get lucky if a
shortage occurs in the market.
Change in investment philosophy
Perhaps investment philosophy should change. Try this approach:
- The investor should start by answering the question, 'How much cash do I need to survive the next three years?' The cash requirement for this period should be set-aside in interest-bearing investments and existing preference shares. The income-tax exposure will be protected to some extent by the tax-free interest allowance (R22 800 per annum for taxpayers under 65 years old and R33 000 per annum for those over 65).
- The next step is to determine the investor's cash requirement for the period three to seven years. This portion is then invested in a blue-chip portfolio. The investor should achieve a dividend yield of 3% per annum less dividend tax of 15%. But hopefully the loss in interest earnings (approximately 2% in after-tax terms) will be more than compensated for by an increase in equity prices over the next seven years. Remember that the capital growth in the investment should only be taxed at the individual's CGT rate (maximum 13,3% if taxable income exceeds R617 000 per annum), and the individual will receive tax-free capital gains of up to R30 000 per annum.
- The remainder of the portfolio can then be placed in a general suite of investments. The investment period of seven years or more will allow the portfolio to be structured to take on a higher risk profile in the expectation of higher returns.
- This portion of the portfolio should also contain an offshore component or rand hedge. The risk inherent to the rand over the next seven years should never be ignored in any portfolio.
- Dependent on the investor's age and income tax profile, investment through retirement annuities should also be considered in order to maximise the opportunity of tax-deductible contributions (which can be offset against the interest income earned in the short-term portfolio) and protect investment growth from taxation.
