Look carefully at the tax implications of financial structured products to
avoid being caught by the taxman, Michael Rudnicki, Tax Manager at
PricewaterhouseCoopers, says.
In an article in S A Accountancy magazine, he says these products package a
variety of instruments including bonds, shares, options, futures, forward
rate agreements and interest rate swaps, in a way that looks like an
attractive investment.
But the investor`s possible exposure to tax risk is often not explained, he
says.
In the case of pension, provident and retirement annuity funds, receipts
and accruals are exempt from income tax. But since introduction in 1996 of
The Tax on Retirement Funds Act, these funds are taxed at 25 percent on
gross interest and net rental income.
This includes returns from interest rate swap agreements.
"The temptation, therefore, is to have a product that does not yield
interest on an investment made by pension funds, but some other form of
return."
Interest, in the act, must be associated with an "instrument", which is
defined as "any form of interest-bearing arrangement, whether in writing or
not" and includes stocks, bonds, debentures, bills, promissory notes, bank
deposits, loans, purchases or sales of rights to receive or pay interest
and repurchase or resale agreements.
"Interest" includes "the gross amount of any interest or related finance
charges, discount or premium payable or receivable in terms of or in
respect of a financial arrangement". In isolation, Rudnicki says, a gain or
loss on the exercise of an option would not be interest as defined in the
act.
"It is only when an option or options are combined with other transactions
in a packaged structure that interest may arise.
"It is important not to lose sight of the product as a whole and the
intention of the taxpayer, not only at the time of the initial investment
but throughout the period of the investment."
In the case of capital guaranteed products, he adds, the investor is
exposed to tax risk if the transaction is aimed only at converting one type
of income (taxable) into another (non-taxable) with the true intention
being to derive a fixed interest rate.
"Where downside risk is limited and the upside capped, there is room for
arguing that, in substance, what was entered into was a fixed deposit at a
fixed or variable interest rate. This risk may be reduced where limited
downside exposure is taken.
"Clearly, each product needs to be evaluated to assess its exposure to tax
risk," Rudnicki says.
For investors outside retirement funds, he says, an additional
consideration is whether the investor is required, for income tax purposes,
to include as trading stock the cost of options.
"This leads to the question whether a gain or loss on the exercise of the
options is taxable or not. Presently, there is no specific tax legislation
covering options - general principles apply which are probably inadequate
in this regard.
"But proposed legislation for the taxation of financial options and
derivatives in general is being considered and is expected to be enacted
next year, which bodes ill for a product in midstream."
At the moment, Rudnicki concludes, there is no clarity on the tax treatment
of financial structured products. Each product entails different rights and
obligations and is bought for different purposes. Each product, its
purpose, use and effect, must be considered before considering the tax
outcome. "Invariably the tax outcome dictates the decision whether or not
to buy a product."