Caution required! Finding a place for tax free investments in your portfolio

The budget for the year to come brought a large variety of idiosyncratic changes to the ways in which income will be taxed in the year ahead and onward. A bit of good news was the offering by the Treasury to investors, to enjoy tax free incentives up to R30k. In the below piece, Franscois van Gijsen walks us through the tax free investment incentive, exactly why Government are being so generous, the stipulations involved, how they can be applied by the average investor, and where the loopholes aren’t. – CH

By Franscois van Gijsen*

Franscois van Gijsen Finlac Trust, Nedgroup TrustWith the long awaited “tax free investments” finally a reality, investors and advisors would do well to consider what SARS and the treasury are trying to achieve.

The new “tax free investments” are the result of the exemption created in terms of section 12T of the Income Tax Act which became effective on 01 March 2015. This exemption however, does not provide a tax deduction in respect of contributions to such “tax free investments” as is the case with retirement annuity contributions. What it does is exempt the proceeds of these investments from income tax, dividends withholding tax and capital gains tax. Finance Minister Nene has issued regulations with which an investment has to comply in order to qualify as a “tax free investment”. These regulations, among other things, limit the fees that may be charged in respect of making and withdrawing such an investment. Frequently, high investment fees are the reason why an investment fails to perform as expected and I believe that these limitations will especially benefit less sophisticated investors.

An interesting question arose during an estate planning seminar recently when one of the attendees asked whether one would be able to make such an investment on behalf of a minor child and whether doing so could be viewed by SARS as a form of tax avoidance. While section 12T itself is quiet on the issue, the regulations make it clear that “tax free investments” on behalf of minors are acceptable. The “tax free investment” is a great way of saving on behalf of a child who will then benefit from the years of compounded tax free investment growth.

Paragraph 7 of the regulations addresses the possibility of abuse by parents who try to “acquire” the child’s tax benefit for themselves by fraudulently purporting to contribute to a tax free investment on behalf of a minor child. Where a “tax free investment” is made on behalf of a minor paragraph 7 determines that the proceeds on withdrawal of such an investment may only be paid to an account held in that child’s name or to that child’s deceased estate. Parents however have signing powers on their minor children’s bank accounts. The lifetime contribution limits (below) see to it that those parents who abuse the “tax free investment” by purportedly making an investment on behalf of a child but who later withdraw and use such money themselves will be restricting the child’s ability to contribute to “tax free investments” in future.

While the regulations limit who may offer these investments (banks, long term insurers, managers of collective investment schemes, the government), “tax free investments” may, as far as asset allocation is concerned, be structured in almost any way that the investor wishes. The regulations allow not only for low risk investments such as fixed income, cash or bonds, but also for high equity investments, provided that not more than 10 per cent of the investment’s value may be invested in the shares of any single company and at least 80 per cent of any shares must be listed on a recognised exchange.

As can be expected though with anything this good, these investments come with a number of strings attached. A “tax free investment” can in terms of sub-section 12T(1)(b) only be owned a) by natural persons or b) by the deceased estate or insolvent estate of a natural person. This I believe is also wide enough to allow a trust to invest capital to which a trust beneficiary has a vested right on behalf of such a beneficiary in a “tax free investment”. Persons who wish to avail themselves of these investments also face a number of restrictions in respect of their contributions to the investments. 1) Contributions must consist of an amount in cash. 2) Investors are limited to contributions not exceeding R30 000 in aggregate during any year of assessment. 3) Finally investors are limited to contributions not exceeding R500 000 in aggregate. This is not to say that the value of the investment may not exceed R500 000 but what amounts there are in excess of R500 000 will have to be the result of investment growth. Enforcement of these limitations of contributions is achieved in a very unusual manner. In terms of sub-section 7, if a taxpayer in any year of assessment contributes in excess of the allowable R30 000 in respect of tax free investments, then his excess contribution will be taxed at 40% in respect of that year of assessment. (It is assumed in view of the increased rates of tax for the 2015/2016 year that this will be amended to 41%.) Considering that these investments are made with after-tax money, the taxpayer will effectively be taxed twice in respect of his excess contribution, whereafter the investment will continue to provide a tax free income.

It is the aforementioned limits on annual and lifetime contributions that provide us with the reasons for treasury’s generosity. As is obvious these “tax free investments” are intended to encourage taxpayers to save. What is also clear is that treasury, in creating this exemption, is searching for an alternative to the existing interest exemption which has failed to encourage people to save on an ongoing basis, while still costing the fiscus in respect of taxes not collected annually. With this new exemption, to get any real tax benefit one would have to remain invested for a very long period of time. It will take an individual at least 17 years of diligent investing to reach his R500 000 lifetime contribution limit and once he withdraws from the investment he is unable to make good the withdrawal by making a later additional contribution. The benefit in terms of the withdrawn contribution is lost for good and the fiscus does not repeatedly lose tax revenue in respect of what amounts to the same savings.

Bearing the above in mind investors should think carefully before availing themselves of these investments. They should take particular care not to let the tax tail wag the investment dog. There are many other factors to consider when making an investment and it is advisable to get advice from a reputable financial planner professional before deciding on a specific investment. To obtain the most benefit from them, these “tax free investments” should be approached with an ultra-long investment horizon. Investors should not place money that may be needed in an emergency in a “tax free investment”. Although the funds in the “tax free investment” are available to withdraw, once withdrawn contributions cannot be reinvested.

It is worth remembering that the new “tax free investment” is not the only tax beneficial manner of investment. It is one of a number of incentives aimed at getting taxpayers to provide for themselves in order that they do not later become a burden on the state. For as long as the interest exemption – at present R23 800 – is still available to them, I would suggest that investors invest money that may be needed for contingencies in an interest bearing account. This will enable them to also take advantage of the tax benefit that is offered by the interest exemption. However, in order to earn interest of R23 800, assuming interest at 6%, one would have to invest R396 667 in an interest bearing investment. This is a large amount of money and the investor should consider whether such large provision is necessary to cover emergencies. The amount placed in interest bearing investments should be determined not by the extent of any tax benefit that may be achievable, but rather by the need to provide for emergencies and the individual investor’s risk profile. These investments are generally lower risk, but at around 6% annual return, also a lower return. There comes a time where additional investment growth makes up for the loss of tax levied on the investment’s growth.

After making provision for emergencies, investors should consider contributing as much as legislation allows to a retirement annuity. Retirement annuities, similar to the new “tax free investment”, also exempt the investment proceeds in the retirement annuity from tax, but in addition retirement annuities also provide a tax deduction in respect of the contributions made.

Contributions to retirement annuities are made with money that is not taxed, while contributions to “tax free investments” and interest bearing accounts are made with money on which tax, at a rate between 18% and 41%, has already been paid. This can be illustrated as follows:

Assume an investor earns R25 000 per month and accordingly falls into a 31% tax bracket. Income tax on that amount is R5 354 per month, leaving the investor with R19 646 after tax. Our investor has monthly expenses of R16 000 per month leaving the investor with R3 646 after tax disposable income. Based on the aforesaid our investor is of the opinion that he can afford to save R2 000 per month with R1 646 for unforeseen monthly expenses. In this scenario our investor saves R24 000 per annum.

However, our investor could choose to contribute to a retirement annuity. Because the contribution to the retirement annuity is taken out of the tax equation before tax is calculated on the remainder of his income he could save R2 420 per month in the retirement annuity and have more expendable income left after saving. The calculation now looks as follows: The investor earns R25 000 per month. He pays R2 420 per month to his retirement annuity which means that R22 580 is taxable. Income tax on R22 580 is R4 658 leaving the investor with R17 922 with which to pay his monthly expenses of R16 000 and put R1 922 in his pocket for unforeseen monthly expenses.

By using the retirement annuity the investor manages to save an additional R420 per month and leaves him with an extra R272 in his pocket. True, the investor will later, upon retirement from the retirement annuity, have to pay income tax upon his withdrawals – both as lump sums and the annuity income received, but these too are to an extent exempted and/or taxed at beneficial rates. Meanwhile the investor has received tax free growth on money that would otherwise have been paid in tax.

As shown, the “tax free investment” has to be left untouched for a number of years, if the investor is to obtain any substantial benefit. I would therefore propose that investors should only consider using the new tax free investment once sufficient cash has been put away for contingencies and the maximum use of the RA deduction has been made. This would safeguard the investor from having to withdraw from the investment and, depending on whether the withdrawal is from investment growth or contributions, possibly losing the tax benefit that this investment provides them. The loss of tax benefit that results from a withdrawal from the new “tax free investments” should force investors to save on a continual basis and to remain invested – which is what the authorities are hoping to achieve in encouraging South Africans to increase their household savings.

*Franscois van Gijsen, FISA member and Director: Legal Services at Finlac Risk and Legal Management.

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