Recent market declines may benefit CGT liabilities

The recent volatility and massive declines across both local and global markets due to COVID-19 as well as the sharp decline in the oil price, has overall had a very negative impact on both the economy as well as investment returns.

However, while the current situation may be bad news for the overall performance of your portfolio, from a tax perspective (particularly capital gains tax) it could actually provide you with a sweet-spot to make changes, as the tax implications will be much lower.

Benefits of wrap funds

Holistically, wrap funds allow for significantly more flexibility in structuring the most suitable portfolio for clients, further reducing costs and enhancing the risk-adjusted returns for clients.

The main benefit of using wrap funds is the ease of executing investment decisions across a range of client portfolios. Moving all client portfolios from one fund into another requires just one trade instruction, instead of a switch form for every individual client. This process of automatic rebalancing bears no transaction costs and ensures that all clients are treated in the exact same manner. By significantly reducing the administrative burden, it gives the adviser more time to focus on servicing their clients.

Wrap funds also allow financial advisers to offer a distinctive, exclusive solution to their clients. The administration of wrap funds must be done by a category II Financial Services Provider (like Graviton Financial Partners which holds the necessary FSB licence to manage assets on behalf of clients). Having an experienced and trustworthy asset manager managing the wrap fund can decrease the time spent by financial advisers on researching funds for client portfolios. In some cases wraps can be custom branded, and management fees are flexible.

The one drawback of wrap funds or the initial move to them, is the Capital Gains Tax (CGT) event that such a switch would incur. In general, wrap funds do not have a significant amount of portfolio turnover; however, certain trading activity could impact investors. If you are an investor or a financial intermediary who recognises the many benefits that wrap funds offer as discretionary retail investment products, but you are concerned about the CGT implications of moving to wrap funds, current market conditions may benefit you.

What constitutes a CGT event?

A capital gain is the profit that arises from the disposal or deemed disposal of assets in the year of assessment.  When units are sold in an investment portfolio, a CGT event is triggered.  This happens when switching between collective investment funds (except if the switch occurs between underlying investments within a fund of funds), when repurchasing units (such as when a withdrawal is made), when an investment is transferred between different entities (natural person and trust for example) or to an endowment, and at the death, sequestration or emigration of a unit holder. (The CGT death exclusion is R300 000).

Understanding CGT implications within a wrap fund

Investors are normally concerned with CGT liabilities when considering switching from Discretionary Savings Plans to Discretionary Wrap funds; however, many clients actually have limited liabilities. This is especially true for clients with lower risk profiles. To understand the capital gains tax one has to pay when making investments, there are three things to consider: the two types of returns on the investment that an investor can earn, i.e. income and capital growth, as well as the annual exclusion.

Income

Income can be received in the form of interest and dividends and can be paid out or reinvested. The interest earned is included in an investor’s gross income for a year of assessment, after which the available exemption under Section 10 of the Income Tax Act is applied and then the investor’s taxable income will be taxed at marginal tax rates.

Dividends declared by South African companies will be included in the gross income of the investor, but are also totally exempted in terms of Section 10 of the Income Tax Act. This means that local dividends are not taxed directly in the hands of the investor; however, they are still subject to Dividend Withholding Tax (DWT).

Dividends declared by non-South African companies will be included in the gross income of the investor and only a portion of the value will be exempted, as determined by a formula contained in Section 10. This means that foreign dividends will be taxed directly in the hands of the investor.

Capital growth

When an investor disposes of an asset, the amount received over and above the base cost is called the net capital gain. Net capital gain is reduced by the annual exclusion (R40 000) and thereafter multiplied with the applicable inclusion rate. This amount is the taxable capital gain that is included in the taxable income of the taxpayer. See illustration below for a visual representation of the calculation:

Considering the annual exclusion granted by SARS, an investor should use this to their advantage and
switch to wraps either by using a phased approach or a full switch. Having more investors switch over to wraps also makes it easier to manage and rebalance all portfolios from a central point, ensuring all investors are treated equally.

Practical examples

1. Below is an unrealised CGT statement (intermediaries can get these on the website or from the Client Communication Centre).

In the above example the unrealised CGT is R97 374.59.  This amount is indicative of the CGT that would be realised if the client had to withdraw or switch part of his investment.  If only a portion of the investment is realised, then the CGT will only realise on that particular portion (see example 2).

  • R97 374.59 – R40 000 (annual exclusion) = R57 374.59 capital gain
  • 40% of the gain will be included when calculating the tax:
  • R57 374.59 x 40% = R22 949.84
  • The investor in the example has a 45% marginal tax rate:
  • R22 949.84 x 45% = R10 327.43 (potential CGT to be paid)

2. Should the client want to switch or realise 50% of each of the following four funds (Coronation Optimum Growth, Foord Flexible, Truffle Flexible and the PSG Flexible) in the portfolio, then the gains will realise proportionally across all four funds:

  • Coronation Optimum Growth: 50% x R20 599.06 = R10 299.53 realised capital gain
  • Foord Flexible: 50% x R45 731.48 = R22 865.74 realised capital gain
  • Truffle Flexible: 50% x R12 022.68 = R6 011.34 realised capital gain
  • PSG Flexible: 50% x R11 629.15 = R5 814.58 realised capital gain

Total capital gain realised = R10 299.53 + R22 865.74 + R6 011.34 + R5 814.58 = R44 991.19

  • R44 991.19 – R40 000 (annual exclusion) = R4 991.19 capital gain
  • 40% of the gain will be included when calculating the tax:
  • R4 991.19 x 40% = R1 996.48
  • The investor in the example has a 45% marginal tax rate:
  • R1 996.48 x 45% = R898.42 (potential CGT to be paid)

Conclusion

If the capital gains tax implications have caused hesitation to move to wrap funds in the past, now could be the time to make that move. No longer having large capital gains means that the switch into wrap funds can now be done with a smaller tax bill. If you do decide to make use of this tax advantage created by the current market crisis, remember
the following:

  • CGT liabilities are a valid concern, but many clients have limited tax liabilities.
  • This is especially true for clients with a lower risk profile (they will typically have a lower exposure to equities and therefore potentially lower CGT liabilities).
  • Use the annual exclusion granted by SARS to the client’s advantage.
  • Consider the role of an intermediary to help achieve maximum after-tax returns.

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