Harry Joffe, the head of legal services at Discovery Life and an expert in tax, trusts and estate planning, was a speaker at the recent Discovery Life/Personal Finance Life Focus seminars held around the country. Joffe discussed capital gains tax (CGT), and the impact of CGT on estate planning.
Capital gains tax (CGT) was introduced as a back-up to all the other taxes, and to pick up revenue that would otherwise "fall through the cracks", Harry Joffe says.
To make his point, Joffe gives the example of an entrepreneur who started an information technology business in 2001 with seed capital of R500 000. When he approached Joffe for tax advice two years later, his business was worth R10 million.
He wanted to put his shares in his company into a trust, to save on estate duty. In order to move his shares into the trust, he would have to sell the shares to the trust.
This would have resulted in a capital gain of R9.5 million, which would have attracted CGT of R950 000, Joffe says. As a result, the businessman decided not to transfer his shares to the trust.
Although the South African Revenue Service (SARS) did not get CGT from the businessman at that point, it will get more tax in the form of estate duty when the man dies, because his estate will be worth a lot more than would have been the case had he transferred the shares into the trust. In this case, CGT deterred the businessman from avoiding estate duty, Joffe says.
Overall, CGT will achieve an increase in the collection of estate duty, income tax, transfer duty and donations tax.
Joffe says CGT was also introduced to force South Africans to disclose their capital assets. SARS wants to know what your capital asset base is so that it can identify tax-evaders. SARS can ascertain from your income tax return whether you are earning enough money to justify owning the assets that you do, Joffe says.
How much CGT you will pay
If you are an individual, you calculate your capital gain by taking 25 percent of your gross capital gain (profit), deducting the annual rebate of R10 000 and applying your marginal tax rate. If you pay tax at the maximum marginal rate of 40 percent, your effective rate of CGT will be 10 percent. This means that an effective 10 percent of the profit you make when you dispose of an asset has to be paid in CGT.
Joffe says that if your marginal rate is lower than 40 percent, your CGT rate will also be lower, but the effective rate at which you pay CGT will never be higher than 10 percent.
The rate of CGT depends on whether the assets are held in a company, close corporation (CC) or a trust. A company or CC pays CGT on 50 percent of the gain at a tax rate of 30 percent, resulting in an effective tax rate of 15 percent. A trust pays CGT on 50 percent of the gain at 40 percent, resulting in an effective rate of 20 percent.
What is a capital gain?
Your capital gain is the sale price of the asset less the base cost. The base cost of an asset is the price at which you acquired the asset. Obviously, the higher the base cost, the lower your CGT, Joffe says.
In certain instances, you are allowed to add to the base cost certain capital expenses and improvements that you made to your asset. This allowable expenditure includes:
- Remuneration of a surveyor, valuer, auctioneer, accountant, broker, agent, consultant or legal adviser for services relating to the asset;
- Transfer costs;
- Stamp duty;
- Advertising costs;
- Any donations tax paid; and
- Expenses relating to improving the asset (but when you dispose of the asset, the improvement must still be in place).
Assets acquired before CGT was introduced
You are only required to pay CGT on gains made on assets after October 1, 2001, when the tax was introduced.
You can choose how to calculate CGT on your assets:
1. The time apportionment method
This method apportions the gains made before the implementation of CGT and the gains made after the introduction of CGT. It also apportions the improvements made before and after CGT was introduced.
The time apportionment formula is complex and has been the subject of much debate. The formula is on SARS's website, www.sars.gov.za
Here is a simple illustration of how the time apportionment method works: If you owned a property for 40 years and 30 of those years were before October 1, 2001, only 10/40, or one quarter, of the gain will be subject to CGT.
2. The 20 percent method
If you have no proof of what you spent on the asset, or if your documentation is not satisfactory, SARS will simply deem 20 percent of your proceeds to be the base cost of the asset.
3. Revaluing your assets
Up until the end of September this year, you had a third option and that was to have your assets valued as at October 1, 2001. However, you cannot use this method unless you had your assets valued by that date.
By valuing your assets as at October 1, 2001, you would automatically strip out any growth in the assets that took place before that date, Joffe says.
Many people who had valuations done are uncertain what to do with them, Joffe says.
What you should do with the valuation depends on the value of the asset.
- In the case of an intangible asset (for instance, a trademark or copyright) worth R1 million or more, and any tangible asset worth R10 million or more, you must submit the valuation to SARS together with your next annual income tax return.
- For all other assets, you should keep the valuation on file and only submit it with the tax return that is due at the end of the tax year in which you dispose of the asset.
When you sell your assets, you can download a valuation form from SARS's website, Joffe says.
Policies
Joffe says you (or your beneficiaries) do not directly pay any CGT on the proceeds of a life, endowment or retirement policy, provided you are the first owner of the policy.
CGT is payable on second-hand ceded policies.
However, CGT is paid within the fund or portfolio by the life assurer on your behalf.
An endowment policy owned by a natural person (not a company or CC) will be subject to CGT on 25 percent of any capital gain accruing to the fund and taxed at 30 percent. This amounts to an effective rate of 7.25 percent (25 percent of 30 percent).
Should the policy be owned by a company or CC, 50 percent of the capital gain accruing to the fund will be taxed at the corporate rate of 30 percent, which amounts to an effective rate of 15 percent.
Deceased estates
There is now a double tax on death - estate duty at 20 percent and CGT at 10 percent.
Joffe says CGT protects SARS's source of estate duty, because if your executor undervalues your estate for estate duty purposes, your base cost for capital gains purposes will be lower and you will pay more CGT. If taxpayers overvalue their estates for CGT purposes, it works against them when they come to pay estate duty.
For CGT purposes, when you die, you are deemed to have sold your assets to your estate for their market value at the time of your death. The first R50 000 profit made by your estate is exempt from CGT at your death. In addition, you qualify for a rebate of R1 million on your primary residence (see "Property" below).
CGT on any bequests left to your spouse are deferred until the death of your spouse.
Estate duty is 20 percent of the value of the assets in the estate over and above the first R1.5 million.
Joffe say it is important to ensure that there is enough cash in your estate to pay estate duty and CGT. A life assurance policy is a good way to ensure that there is money in your estate to cover these taxes.
You will not have to pay CGT on such a life assurance policy. As long as you do not cede the policy to anyone, insurance policies are exempt from CGT. Collateral security cessions to a bank in order to obtain a home loan or cover a debt will not trigger CGT, he says.
Trusts
CGT makes it vital that there is liquidity in your estate and that you do proper estate planning.
A trust remains a basic estate-planning tool, because it can be used to reduce your estate duty liability, and CGT makes a trust even more attractive, Joffe says.
If your assets are in a trust when you die, you do not have to pay estate duty or CGT on those assets, assuming there are no loan accounts. (In order to transfer your assets to a trust, you must sell the assets to the trust. If the trust does not have any money to buy the assets, a loan account may be created in your favour.)
The downside is that a trust pays a much higher rate of CGT (20 percent) than an individual (10 percent). This means you must be careful how you use a trust for estate planning. You should not put assets into a trust that you plan to sell in the short term.
However, the law says if you make a capital gain in your trust and in the same tax year distribute the gain to your beneficiaries, the beneficiaries pay the CGT and not the trust. And the beneficiaries pay tax at a lower rate than a trust. So, you can use a trust to distribute benefits to beneficiaries at a lower tax than would ordinarily apply.
However, there are anti-avoidance tax provisions relating to trusts, Joffe say. If you transfer, donate or sell assets to a trust via an interest-free loan to the trust for the benefit of minor beneficiaries (for instance, your child) and try to pass the gain down to the beneficiaries, SARS will hold you, the donor of the assets, liable for CGT and not the beneficiaries of the trust, he says.
Property
SARS gives you a rebate on the first R1 million profit you make when you dispose of your primary residence. Joffe says a primary residence can be any structure, boat, caravan or house, but there are several provisos:
- The property must be owned by an individual and not a company, CC or trust.
- You must personally and ordinarily live in that property;
- The property must be used for domestic or private residential purposes; and
- The property must not exceed two hectares in size.
How CGT is Levied at death
Luke's share portfolio, which he bought for R200 000, was worth R3 million when he died.
When Luke got divorced, he took out a loan of R2.5 million, using the share portfolio as security, to pay his ex-wife a divorce settlement.
The net value of Luke's estate, after all allowable deductions (such as fees for winding up the estate) is R300 000 (R2.8 million share portfolio less R2.5 million loan). Luke's estate will not have to pay estate duty, because the value of his assets is less than R1.5 million. Luke's estate will, however, have to pay capital gains tax (CGT) on the profits he made from his share portfolio. The calculation of how much CGT his estate will have to pay is as follows:
- Capital gain on death:R2 800 000
- Annual exclusion:R50 000
- Taxable capital gain:R2 750 000
- 25 percent of the gain is taxable:R687 500
- Tax at 40 percent:R275 000
Therefore, Luke's estate will have to pay CGT of R275 000, which almost wipes out the value of his estate (R300 000).