In life, there are only two certainties: death and taxes.
The only difference between them is that death does not get worse every time the government meets. And by the way, you don’t pay taxes – the government takes taxes.
At this time of the year and with the tax season around the corner, most of us are trying to balance all our New Year’s resolutions while, in the back of our minds, doing some tax planning for our businesses and personal financial life. When reviewing your investment portfolio, the tax effects and structures of your investment vehicle should also be properly investigated and understood, as the taxman can and will stake his claim on your portfolio growth. The saying ‘Give to Caesar what belongs to Caesar’ is not in vain.
Tax can get technical and there are many different rules that apply to different income earned. Investors are particularly wary of capital gains tax (CGT) on their investment portfolios.
Tax and your investment portfolio:
Many investors begrudgingly pay taxes, CGT in particular, as they often feel their taxes are not being spent efficiently or on the government services they would prefer for their [personal] circumstances. Consequently, they sometimes select investments that will deliver lower returns and thus attract lower CGT. The question to ask is – would you be happier being invested in a portfolio with exceptional growth which will result in paying higher taxes, or will you be happier in minimising the tax burden and being invested in a portfolio with sub-par returns?
The growth in an investment portfolio is positively correlated with the tax burden incurred on this growth once the asset is sold. If investments have shot out the lights, expect Sars to knock at your front door.
For the average individual, two main taxes apply:
- Income tax: Tax on a salary or income received from other sources.
- CGT: This tax is levied on the increase in value of an asset (selling price – base cost). It is important to remember that this tax is only triggered when the asset (such as property/shares/land) is sold – not when the face value is simply higher than the cost price.
Before you select the more average returns, fearing tax, have a look at the following investor scenarios:
Investor 1 and Investor 2 each inherited R1 million. Both have a marginal tax rate of 18% and decided to invest it in two different investment portfolios with two different wealth managers. Both had the same investment time horizon of five years, being January 2015 to December 2019. Let’s review their performance together with their tax implications:
- Invested in a portfolio consisting largely of South African equity funds and SA cash and bonds.
- Returns of 7% per annum over five years.
- Capital after year five: R1 402 551 before CGT paid.
- Growth: R402 551
- CGT on growth: R26 103
- Net amount: R1 376 448 available to the investor after tax.
- Invested in a portfolio consisting of feeder funds invested in largely offshore equities.
- Returns of 15% per annum over five years.
- Capital after five years: R2 000 000
- Growth: R1 000 000
- CGT on growth: R119 040
- Net amount: R1 880 960 available to the investor after tax.
Investor 2 has more than four times the tax liability of Investor 1. However, Investor 2 is R500 000+ better off than Investor 1.
Here is the important thing to remember: you can’t have your bread buttered on both sides i.e. achieve growth and minimise tax.
As mentioned, the amount of CGT payable is positively correlated to growth in your portfolio. Far too often investors complain about the tax burden and having to pay a substantial amount of tax when withdrawing capital or doing switches within the portfolio after achieving excellent returns. Even though the example above is a simplified scenario (there are many other factors to consider), the core aspect remains: be happy with paying more tax for exceptional growth or be happy with an underperforming portfolio and putting less money in your pocket.
The tax advantage of investing directly offshore vs feeder funds:
There are two ways of being invested in offshore assets:
- Investing in feeder funds that are priced in rands, but the funds never actually ‘leave’ the country. You still get the exact same growth on the same asset, and the currency fluctuation (e.g. rand/US dollar) is also priced in on your portfolio.
- Investing directly offshore, where your rands are exchanged for foreign currency. You once again get the same growth as in point 1 above.
There is one small tax advantage that investors are not always aware of. When investing capital in feeder funds (Option 1), the depreciation of the rand and the growth of the asset will both effectively be taxed.
When investing capital in the same assets directly offshore, the CGT is only calculated on the growth of the underlying asset that is bought. You are not taxed on the depreciation of the rand to the dollar.
This is an illustration to show that being liable for CGT in your investment portfolio, means that you have made the right choices in selecting assets to invest in.
A fine is a tax for doing wrong. A tax is a fine for doing well.
You will be liable for one of these; it’s up to you to decide which one.