Taxes are a vital part of any investment decision. But always remember that taxes are only a part of an overall investment strategy. Financial advisers recommend that you make investment choices not solely for the possibility of reducing taxes, but on what you can expect to earn, the level of risk you’re willing to take and the diversification of your portfolio. A careful evaluation of your overall financial picture is required, which includes consideration of your personal circumstances and the tax implications of your investments.

Equities

In South Africa one of the most tax-efficient investments is local equities, where shareholder dividends are exempt from income tax and the growth in value generally subject to favourable capital gains tax (10 percent in the case of individuals). Since dividends received are not subject to tax, interest on any amount borrowed in order to acquire shares may not be deducted as it would not have been incurred 'in the production' of 'income' as is required by the Income Tax Act, No 58 of 1962 ('the Act').

'Income' referred to in this context is all income received (gross income), less exempt income such as local dividends. Generally, foreign dividends received by or accrued to any South African resident would not be exempt from income tax, subject to certain exclusions. One of the most significant exclusions is where that person holds at least 20 percent of the total equity share capital and voting rights in the company declaring the dividend. A credit would be granted for any foreign taxes paid in respect of the foreign dividends. The credit, however, cannot exceed the South African tax liability arising on such foreign dividend. Foreign investments may be an efficient way to hedge against country/currency risk in respect of South African corporates.

The buying or selling of equities may result in tax implications. If a share is held as trading stock (i.e. bought for the main purpose of reselling it at a profit), any gain or loss on disposal will be of a revenue nature. Revenue gains are subject to income tax at the marginal tax rate in the case of individuals. On the other hand, if a share is held as a capital asset (i.e. as a long-term dividend-producing investment), any gain or loss on disposal will be of a capital nature and subject to capital gains tax. A capital gain arises where the proceeds from the disposal of the asset exceed the 'base cost'. In the case of assets acquired after 1 October 2007, the base cost is essentially the acquisition cost of the asset. By contrast, where the base cost of an asset exceeds the proceeds on disposal it would result in a capital loss which cannot be used to reduce other taxable income, but is carried forward to be offset against future capital gains. Capital gains are subject to tax at a lower rate than ordinary income. In the case of an individual, the first R16 000 of net capital gains or losses in a tax year is exempt for capital gains tax purposes. Of the balance, 25 percent is included in the individual’s taxable income and taxed at the marginal tax rate.

In terms of a specific provision in the Act, proceeds on the disposal of shares held for longer than three years are automatically regarded as being of a capital nature, subject to certain exclusions.

Property

Property is a popular investment vehicle in South Africa. Where property is held as trading stock (i.e. in the case of property traders), any gain or loss on disposal would be regarded as being of a revenue nature and taxable as such. In this scenario, any expenditure relating to the property dealings may be deducted for tax purposes on the basis that it is incurred in the production of taxable income.

Where property is acquired with the intention to hold it as a long-term investment, it would constitute a capital asset in the hands of the taxpayer and fall within the capital gains tax regime. Any proceeds on disposal would accordingly be subject to capital gains tax in the year in which the asset is disposed of. As mentioned above, the base cost of the asset is essentially the acquisition cost. However, certain additions to the base cost are permitted by the legislation, for example, estate agent’s commission, transfer duty and advertising costs to find a buyer or seller.

Property remains a tax-efficient investment where the investor is prepared to hold such property for a longer period, mainly since the inclusion rate of any capital gain realised is significantly lower than the marginal income tax rate.

Money market instruments

Many investors invest in money-market instruments such as bonds, which yield an interest return. The term 'bonds' generally encompasses the wide sweep of fixed income securities, meaning that bonds have a contractual payment schedule. Interest is, by its very nature, revenue and thus subject to income tax. The Income Tax Act specifically deals with the taxation of interest on financial instruments, which include bonds, and provides for interest to be spread over the period from the date of disposal or maturity. The spreading will be effected by applying the compounding accrual basis (yield to maturity) over the term of such instrument.

Unit trusts

Unit trust (or collective investment scheme) investments are still a convenient and low cost way of investing in the share and gilt markets.

Unit trusts are tax-efficient investments. They earn two types of income from their investments — dividends and interest. A South African collective investment scheme in securities is regarded as a company for tax purposes. Collective investment schemes are exempt from tax on all local dividend income. Dividend income received from a collective investment scheme in property shares is subject to income tax. Dividend income received from non-South African sources (i.e. foreign dividends) is also subject to income tax in the hands of the investor. Interest income accruing to a collective investment scheme is exempt from income tax to the extent that it is distributed to investors. A deduction is allowed for the annual fee payable to the management company.

Unit trust investments are generally considered to be medium to long-term investments and, accordingly, of a capital nature in the hands of the investor. For capital gains tax purposes, collective investment schemes in securities are treated as companies and the legislation expressly provides that the scheme must disregard any capital gains or losses. Instead, the investor accounts for capital gains tax on the disposal of his units.

Property unit trusts (collective investment schemes in property) are treated differently for tax purposes and taxed as a trust. To the extent that income (rental income and limited interest income) is not distributed to investors, the taxable income of the collective investment scheme in property is taxed at a rate of 40 percent. The underlying property companies in which the collective investment scheme holds shares are taxed on rental income at 28 percent. Similarly, for capital gains tax purposes, collective investment schemes in property are treated as trusts, while the investors are treated as beneficiaries with vested rights to the trust capital. Consequently, the investors would have to account for capital gains and losses whenever they are realised in the collective investment scheme. However, the capital gains tax legislation provides that an investor in a collective investment scheme in property must only account for capital gains or losses in respect of the disposal of the units by the investor.

Retirement annuities

Finally, investments in retirement annuity funds may be beneficial from a tax perspective. A retirement annuity fund can be used by a self-employed person or by an employee, either in place of, or in addition to, his pension fund. On retirement, one-third of the total benefit may be paid out as a lump sum, with the balance being paid in monthly instalments. Although the monthly annuities will be subject to tax, the contributor may deduct the contributions to the fund, subject to certain limitations.

The Income Tax Act has recently been amended to provide for a favourable basis of taxing lump sums derived from retirement annuity funds. To conclude, one should consider the tax implications for any taxable investments or tax-free investments pursued without being jaded by the idea of high returns when those returns could shrink significantly as a result of taxes. Investors should ensure they are well aware of all the tax implications whenever funds are invested, since it will only serve to increase long-term returns.

Published courtesy of Blue Chip magazine

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