You, collective investment portfolios and Capital Gains Tax

Overview

Compared to other investment vehicles, collective investment portfolios are a great deal in terms of Capital Gains Tax (CGT), which became from effective 1 October 2001:

1. Collective investment portfolios are exempt from paying CGT and collective investment portfolio investors will only incur CGT when they sell their units in a collective investment portfolio.
2. Collective investment portfolio investors will only bear a CGT cost once - when they sell their units. When a portfolio manager restructures a collective investment portfolio portfolio, that is sells an underlying share or bond in adherence to its mandate, CGT will not be incurred. Certain other investment products, in comparison, will not be as tax effective. They will sustain a CGT cost every time a transaction in the portfolio is realized, which could be many times over the lifetime of a product. In the US, for example, where in contrast, collective investment portfolios do pay CGT within the collective investment portfolio, extra costs to investors were more than 0,5% in 1999.
3. Having CGT paid outside of the collective investment portfolio means that collective investment portfolio portfolio managers can focus on their core business of managing an investment portfolio according to a mandate, rather than being distracted by tax issues. This could result in more focused and better investment performance.
4. The CGT rate applicable to collective investment portfolio investors could be as low as 4,5% depending on the investor's marginal tax rate or as high as 10,5%, which is on par with shares.
5. Collective investment portfolio investors are empowered to decide when to become liable for CGT, allowing them to defer tax and to plan their investments appropriately. Relief measures such as the R16 000 exemption and the offsetting of losses against gains, can also be used.
6. CGT policy for collective investment portfolios is transparent. Collective investment portfolio investors will know when CGT is incurred.

In conclusion, CGT policy is in line with the objective of a collective investment portfolio as a medium- to long- term savings and investment vehicle and should encourage collective investment portfolio investors to treat them as such. You could, for example, not pay CGT for as long as 20 years, if you hold onto your investment. Collective investment portfolio investors should, however, not become obsessed with not paying CGT, thereby losing sight of their overall investment objectives.

All local and foreign collective investment portfolios will be subject to CGT, except for money market funds, which have a fixed price and which generate income rather than capital gains or losses.

Understanding the Basics

On 1 October 2001, Capital Gains Tax (CGT) was implemented in South Africa. Up until this date capital gains have not been taxable in South Africa, only income as defined in the Income Tax Act, 1962.

To give effect to the proposals relating to CGT, an Eighth Schedule has been added to the Income Tax Act, which determines what constitutes a taxable capital gain or assessed capital loss. A new section 26A of the Act provides for the inclusion of a taxable capital gain in taxable income. Gains or losses are therefore not treated in terms of a separate taxation mechanism, but included in the existing income tax mechanism as set out in the Eighth Schedule.

Gains or benefits you may receive, by definition, are either capital or income. Whereas prior to 1 October 2001, if the amount was not income, the gain was tax free, it is now either included in your income or excluded by exemption in the Eighth Schedule. Understanding the treatment of various types of capital gains that you may enjoy in your lifetime is therefore important. This brochure sets out the treatment of one such asset, your collective investment portfolios.

CGT as it Applies to Collective investment portfolios

The Association of Collective Investments, in its representations to SARS when CGT legislation was being drafted, strongly motivated that collective investment portfolio portfolios should be exempt from CGT. Unlike other share portfolios, CGT is not triggered when the portfolio manager sells shares within the portfolio. Collective investment portfolio portfolio managers are therefore enabled to manage the portfolio according to their mandate, without having to concern themselves with CGT.

However, upon deciding to sell your investment in a collective investment portfolio, CGT will be triggered. Thus the investor is empowered to decide when to become liable for the payment of CGT, with the benefit of deferring the tax and planning appropriately. Furthermore, there are other relief measures that can be utilized by the unit holder - these are explained below.

How Gains are Included in Your Income

The taxation of capital gains is triggered by your disposal of an asset. In this sense your role in managing your exposure to this tax is very important. When you decide to sell an asset, such as units in your collective investment portfolio portfolio, you are triggering a "CGT event".

Measuring Gains
To measure a gain, it is necessary to have a base off which to measure that gain. This "base" is referred to as the "base cost" in the Act. Hence, the gain or loss becomes the difference between the market value of your units at date of sale, less the base cost. It is important to realize that this gain or loss is calculated per individual asset that you may have sold. For collective investment portfolios, the calculation is therefore done per fund.

Determining Aggregate Gains
Once the gain or loss has been calculated for each individual asset sold, the gains and losses are added together to determine an overall gain. Three relief measures apply:

1. The first R16 000 profit is exempt from CGT for each taxpayer.
2. Losses can be offset against gains.
3. Losses can be carried forward.

Each tax year, the South African Revenue Service (SARS) will allow each taxpayer an exclusion of R16 000 on the sum of all realized capital gains and losses. This means that should you have sold units, the first R16 000 gain will be exempt from CGT. It also means that should units sold in one fund have been sold at a loss and the units from another sold at a gain, you have the benefit of setting off the loss against the gain. The net gain is then further reduced by the R16 000 exclusion benefit. If the sum of the capital gains and losses is negative, the aggregate loss must also be reduced by the annual exclusion of R16 000. In future years your net capital loss as assessed by SARS may be used to further reduce this figure, which is then referred to as a "net capital gain" or "assessed capital loss".

Rate of Inclusion in Your Income
In addition to the measures mentioned above, further relief is provided by including only a percentage of the "net capital gain" in your taxable income for the year. This rate is 50% for trusts and companies, and 25% for individuals. Hence, only 25% of the gain as calculated above is included in your taxable income and taxed at your marginal tax rate. It is important to realize that only gains are taken into account at this stage. Losses cannot be used to offset income. Such an assessed capital loss is, therefore, ring-fenced and can only be set-off against capital gains arising during future years of assessment.

Practical Considerations

Base Cost for Investments Made Prior to 1 October 2001
For unit holders invested before 1 October, an average price will be calculated, by using the average of the repurchase or sell price at which a unit would be redeemed by a collective investment portfolio management company, for the preceding five business days. Foreign collective investment portfolio funds, however, do not necessarily price their units every day, and will therefore be valued according to the last published sell price before 1 October 2001.

To make it easy for you to determine the base cost of existing collective investment portfolio investments, ASISA will publish a list of all calculated prices for local and foreign collective investment portfolios registered with the Financial Services Board and who are associate members of the Association on its web site at www.asisa.org.za. These prices will, in due course, be published in the Government Gazette by SARS. Furthermore, your individual collective investment portfolio management company should send you a statement following 1 October, clearly recording the base cost of your investment.

Base Cost for Investments Made on or After 1 October 2001
For investments made on or after 1 October 2001, the actual cost that you pay for the units, including any initial charges, is used to calculate the base cost. The collective investment portfolio management company will track your cost of purchases (e.g. debit orders) over time on a weighted average base cost basis, so that, when you sell units, the base cost will have been automatically calculated over time on your behalf. Each time you buy units the management company will recalculate the weighted average base cost by multiplying the existing number of units by the existing base cost of the units The total cost, calculated at the buy price, of the new units bought is added to obtain a new monetary value. This is then divided by the sum of existing units and new units to arrive at the new weighted average base cost of all units in the account.

The above method of calculating the base cost of units has been adopted as an ASISA standard and is the method of calculation that management companies are required to use when reporting capital gains to SARS in terms of legislation.

However, a unit holder is entitled to use any of the methods provided for in the Eighth Schedule of the Income Tax Act when computing gains or losses and reporting these to SARS. Section 30 of the Schedule provides for the time-apportionment method and section 32 deals with the base cost of identical assets and provides for using any one of the specific identification, first-in/first-out or weighted average methods.

A unit holder wishing to use any method other than the weighted average must ensure that all records are available to be furnished with the annual income tax return. It is recommended that the unitholder consults a tax expert or financial adviser prior to using the alternative methods.

Foreign Currency Gains
The regulations on foreign currency transactions are available as a draft and have as at the date of writing, not been finalized by SARS. This is expected by the end of 2002. It is, however, expected that foreign exchange gains realized at the time of sale of units in a fund denominated in a foreign currency and converted back into Rands, will represent a taxable gain.

Tax Returns
At the end of the tax year you will receive a statement (IT3E) from all South African collective investment portfolio management companies reflecting any gains or losses you may have incurred during the tax year. It is then up to the taxpayer to include any net gains in his or her tax return. All local management companies are obliged to send copies of the IT3E to SARS. Foreign collective investment portfolio funds will not issue tax statements and unit holders in these schemes are required to calculate the gains and losses themselves.

Events that trigger a CGT event and need to be taken into account in your tax return:

1. Sales of units or switches out of a fund.
2. Transfer of units, where beneficial ownership of the units change.
3. The death, sequestration or emigration of a unit holder.
4. The divorce of a unit holder married in community of property.

The management company will report the event as at the date of the transaction. However, a valuation certificate for an account can be obtained from the management company for the actual date of the event and be used in the unit holder's income tax return.

Events That DO NOT Trigger a CGT Event

Where a unit holder transfers units from a personal account with a management company to a bulk account of a Linked Investment Service Provider (LISP) or vice versa, or where a unit holder donates units to a spouse, no CGT event is triggered. The original base cost has to be transferred to the new account. To facilitate this management companies will issue valuation certificates to enable the base cost to be carried forward.