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Best investment choice in terms of tax

29 May 2006 Paul Ferreira, Werksmans

Paul Ferreira of Werksmans takes a look at some investment choices available to South Africans with regard to the tax implications. The focus is on tax and other investment decision factors are not really considered.

To illustrate the tax implications it is assumed that John is the investor, that he is a South African tax resident younger than 65 years, he has R1m to invest and he already derives an annual taxable income of more than R400 000. This means that that his investment taxable income will be taxed at the rate of 40%, and in most cases any capital gains made by him from the disposal of investments will be subject to capital gains tax (CGT) at an effective rate of 10%.

Bank deposits
The safest and simplest investment that John could make would be a deposit with a bank or other deposit-receiver. Assume John invests his R1m in a bank term deposit at an interest rate of 8% pa. The annual interest will be R80 000 per annum. The first R16 500 of his total interest income for a tax year will be tax-exempt, and the balance will be taxable at 40%. Assuming he has not otherwise utilised this interest exemption, his after-tax return will thus be 5.46%, and there will no growth or appreciation in the investment. A safe investment offering a real return (after inflation), but hardly an exciting investment. In addition, in most cases the interest will be taxable on an annual accrual basis even if the interest is not actually received by him in that tax year.

Fixed property
John could sell his primary residence and use the proceeds plus his R1m available for investment, to acquire a bigger or better primary residence. The first R1.5m gain made from the sale of his existing primary residence, or of his new primary residence or residences, would be exempt from CGT.

Ironically, the CGT primary residence rebate, more so after its recent increase from R1m to R1.5m, and the recent reduction in transfer duty rates, encourage the owner of a primary residence to sell it and buy a new one when the appreciation in the value of each primary residence reaches to R1.5m. The primary residence rebate is serial and applies for each primary residence disposal.

Alternatively, he could use the R1m to improve his existing residence. To the extent the R1m is used to effect permanent improvements it will be deductible in calculating the capital gain when he sells the residence, and the first R1.5m of the gain, after this deduction, would be exempt from CGT.

John, alone or together with others, could use the R1m to acquire an investment property - residential, commercial or industrial - for renting out. The rent, net of expenses, received by him would be subject to income tax and, if he holds on to the property long enough, the gain made on its disposal should not be subject to income tax, but rather to CGT at 10%.

Or he could look at a more formal property investment in, say, a fixed property collective investment scheme (CIS) or a listed loan stock company.

In the case of a fixed property CIS, its net income (mostly rentals) is distributed to its investors, or participants, which moves the income tax liability on this income from the CIS to its investors. The CIS is effectively exempt from CGT, and its capital gains are normally re-invested. But if the CIS actually pays its capital gains to its investors or participants, they must, for CGT purposes, include these gains in disposal proceeds when they subsequently dispose of their investments or participations in the CIS (which also applies for a CIS in securities).

John would be liable for CGT on any gain made from the disposal of his investment in the CIS.

An investment in a loan stock company is usually an investment in a linked unit, comprising a linked share and a loan or debenture issued by the company. The company avoids income tax on its net rentals to the extent it pays (tax deductible) interest on the debentures, which interest, less the R16 500 annual exemption, if not already utilised, would be taxable in the hands of the investors. The company may also pay dividends on the share element of the linked unit, which potentially would be subject to secondary tax on companies (STC) in the company, but would be tax-exempt in the hands of the investors.

A loan stock company is not exempt from CGT, and John would be liable for CGT on any capital gains made by him from the disposal of his linked units in the company.

Offshore investments
In terms of exchange control regulations a South African resident can invest up to R2m offshore.

One attraction of an offshore investment is the potential to make foreign exchange gains. The question is how these gains would be taxable in South Africa. The answer lies in some rather complicated tax rules, which take into account the type of offshore asset and the currency of expenditure and the currency of receipt.

But to simplify matters and to take a typical situation, assume John uses his R1m to make an offshore US$ investment, which at the current exchange rate of, say, 6:1 will give him an offshore investment of about US$167 000. He subsequently disposes of the investment for US$200 000 when the exchange rate is 7:1, which will give him a Rand receipt of R1.4m. If the foreign investment were a "foreign equity instrument" (which includes shares, bonds and a participatory interest in an offshore CIS), his South African CGT gain would be his Rand economic gain, R400 000. If the asset were a foreign equity instrument, his CGT Rand gain would be the US$ gain converted to Rands at the then exchange rate of 7:1, ie US$33 000 x 7 = R231 000, as long as he keeps the proceeds in US$.

Of course there will always be the risk of John rather making foreign exchange losses, as the past two or three years have shown.

John's offshore foreign currency income, for South African income tax purposes, would be converted to Rands at the spot rate on the date of accrual of the income or, as elected by him, at the average exchange rate for the relevant tax year.

With South African residents being taxed on a world-wide basis, income and capital gains made from offshore investments will be taxable in South Africa on a basis no different from South African income and gains, except for foreign dividends (discussed below). Credit will be given for foreign taxes paid on offshore taxable income or capital gains against the South African tax liability on the same income or capital gains.

Offshore investments may, however, present opportunities to defer tax until the offshore investment is realised or disposed of, or until the income or capital gain actually accrues to the South African resident investor.

Importantly, foreign dividends, ie dividends paid by a company that is not a South African tax resident, are subject to income tax in the hands of South African resident recipients, subject to exceptions or exclusions. One exception is dividends paid by some dual listed companies, such as Anglo American and Old Mutual, which dividends are tax-exempt.

An alternative would be for John not to use his R2m exchange control foreign investment allowance, but to invest his R1m in South African securities that have significant offshore exposure, such as the ITRIX (a JSE listed CIS in foreign securities) or BHP Billiton, or a portfolio of offshore securities operated by a local asset manager.

Debt settlement
If John is bewildered by these investment choices and the tax implications or if he is not quite ready yet to take the investment plunge, he could use his funds to repay his existing interest-bearing debts, such as a mortgage bond on his property, particularly where the interest is not tax deductible. With a mortgage bond, the repayment could, in most cases, be re-advanced when John is ready to invest.

Get your copy of the June edition of FAnews to read more about the tax implications of listed equity shares, preference shares, collective investment schemes, endowments policies, annuities and hedge funds. E-mail [email protected] to subscribe or order a copy of the June edition.

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