The average investor now faces the prospect of capital gains tax on unit trusts. What will be the impact? How should investors react? Our guest columnist, Martin Swanepoel, of Momentum Advisory Service, writes.
The planned introduction of capital gains tax on unit trusts next year will obviously reduce returns from one of the few remaining tax-efficient instruments to the public. But the tax will not suddenly turn a prudent option into an investment no-no.
Unit trusts are - and will remain - a highly effective medium or long-term investment instrument. The prospect of tax, hopefully at modest levels, should not be a signal for radical revision of savings strategies.
The introduction of capital gains tax and increased collection efficiency at the SA Revenue Service (Sars) will more probably result in a new focus
on longer-term savings strategies and a reduction in feverish investment switching.
Investors may start to put new questions to their financial advisers. Prudent questions investors could ask might include:
* What is the investment mandate of the unit trust fund you recommend?
* Is it geared towards medium or longer-term savings strategies and a reduction in feverish investment switching?
* Is it geared toward medium or long-term investment build-up?
* If I receive a tax query, just how efficient is the record-keeping of the fund managers?
* Will any investment switches be motivated by research?
The reason for questions like these is the issue of active trading rather than the question of capital gains.
However, these subjects are related as Sars' intention to extend capital gains tax to the unit trust industry shows its confidence that it has the resources to track investment returns over a myriad of local funds.
Accurate tracking would enable Sars to make a ruling on whether the pattern of investment switches indicated trading rather than investing.
Should an individual be regarded as a trader, then gains could be taxed as income.
This change in tax treatment would be hugely in favour of the fiscus and hugely to the disadvantage of the investor. This is the reason for the accent on mandates that stress longer-term investment and the need for
quality record-keeping.
The unit trust industry and wrap fund managers will have to respond to these consumer concerns. They also have a duty to educate consumers about
the general issue of tax treatment of various financial products. This will help prevent a backlash against the unit trust option.
It should be pointed out that the unit trust industry to date has enjoyed favourable tax treatment compared to, say the life insurance industry. Currently unit trust funds are not taxed on their profits. In contrast,
life insurance investment products attract 30 percent tax on investment income.
Nor is it likely that capital gains in this area will reach punitive levels. The management company is liable for the tax if a capital gain is realised. At this stage it is proposed that only 25 percent of the capital gain will
be taxable. The individual investor is liable if a capital profit is realised.
If a capital gain is realised, the gain will be taxed at 7.5 percent. That is, the current company tax rate (30 percent) x 25 percent. Any capital profit will be taxed at 10.5 percent. That is, the highest marginal tax rate (42 percent) multiplied by 25 percent.
A local management company will pay capital gains tax each time it realises a capital gain (at 7.5 percent).
But a foreign unit trust company will not be liable for capital gains tax as it falls outside South African tax law.
This discrepancy prompted the suggestion that in the case of foreign unit trusts, an investor should be liable for any capital gain during the investment term (the investment value at date of redemption less the
investment value at inception).
Such an investor would then be taxed at the top marginal tax rate (currently 42 percent) because he has the advantage of zero tax on capital gains during the term of his investment as the management company was not taxed.
Keep in mind, however, that capital loss can be set off against capital gain to limit your tax liability.
To combat any onset of anti-unit trust prejudices among consumers, investment advisers can point out that the proposed capital gains tax is in line with similar legislation in other countries:
* In the United Kingdom, unit trust companies are exempt from tax on gains, but not unit holders;
* In the United States, funds are taxed at corporate rates and investors pay capital gains tax;
* Unit holders in France are taxed at 26 percent when redeeming their investments, but the funds are exempt; and
* In Canada both the funds and the investors can be taxed on 75 percent of the gain.
Should the current proposals become law, the efficient management of unit trust portfolios will limit the tax liability of investors.
Within the unit trust industry itself, all players should take seriously the hint that Sars is well positioned to the tax the industry.
Now Sars has its interactive computer system (the New Income Tax System or Nits) up and running, the monitoring and taxing of gains could become
commonplace.
From a consumer perspective this creates the previously mentioned danger that an investor switching regularly between funds could be considered a
trader in terms of the Income Tax Act.
For wrap fund managers, the issues are not so clear cut. No clear rules exist here. To avoid being classified as a trader, a wrap fund manager should limit the
amount of switches in his portfolio to the minimum and keep to a mandate of long-term capital growth.
Several wrap fund managers currently embrace this philosophy, including Momentum Advisory Service, Citadel and Barnard Jacobs Mellet. Any switch should be well documented, well motivated and backed by
extensive research.
Should a wrap fund manager deviate from his mandate or switch indiscriminately, he could risk being classified as a trader.
Even if the wrap fund manager is not classed as a trader for tax purposes, a client who entrusted his investment to such a manager might be liable for
additional tax if too many switches took place, too often, and for no apparent reason.
Proposed legislation is unclear on the effect a fund manager's mandate will have on a fund's tax liability.
A case in point is a flexible unit trust fund where the mandate is to actively trade between various asset classes and their stocks.
It is expected that the unit trust industry will vehemently oppose the suggested tax.
The average investor can only hope that the net result of industry lobbying will be that the tax committee now looking into these proposals will not deal too harshly with unit trusts.
After all, this is one of the few incentives to prudent long-term saving by the public. As the low rate of saving is generally perceived to be a key structural weakness within the South African economy, it makes little sense to tax unit trusts too onerously.