The case for en­dow­ments

In­vestors are of­ten scep­ti­cal of en­dow­ments, but high-in­come earn­ers could ben­e­fit from the lower tax rates levied on these prod­ucts.

Finweek English Edition - - MARKET PLACE - Ed­i­to­rial@fin­week.co.za Schalk Louw is a port­fo­lio man­ager at PSG Wealth.

un­til very re­cently, the one job I would have avoided at all cost was that of a crane op­er­a­tor. If you had to mea­sure my fear of heights on a scale of 1 to 5, it would prob­a­bly rate closer to 45. In all hon­esty, though, if the gov­ern­ment of­fered me the job of min­is­ter of fi­nance to­day, you would have a tough time keep­ing up with me as I rush up the lad­der to get to work.

In ad­di­tion to the nor­mal day-to-day dan­gers of los­ing his job, our cur­rent min­is­ter of fi­nance, Pravin Gord­han, re­cently had the un­pleas­ant task of in­form­ing us, as tax­pay­ers, that the South African Rev­enue Ser­vice (Sars) re­ported a short­fall of R30.4bn for the 2016/17 fi­nan­cial year – the largest short­fall since 2009/10.

This re­sulted in two ma­jor shocks: an in­crease in div­i­dends tax by a third from 15% to 20%, and an in­come tax rate of 45% for in­di­vid­u­als earn­ing in ex­cess of R1.5m a year. By the time this ar­ti­cle is pub­lished, count­less econ­o­mists and tax ex­perts would have placed the new Bud­get un­der a mi­cro­scope and most read­ers would have al­ready de­cided whether it is good, bad or ugly.

This week, how­ever, I would like to ex­plore a pos­si­ble so­lu­tion avail­able to an in­di­vid­ual earn­ing more than R1.5m a year and who is cur­rently con­sid­er­ing mak­ing an in­vest­ment.

In the 2015/16 Bud­get, cap­i­tal gains tax cap­tured the spot­light af­ter in­clu­sion rates for in­di­vid­u­als were in­creased to 40% and to 80% for le­gal en­ti­ties. In my col­umn Cap­i­tal gains tax: Change your mind­set dated 17 March 2016, I pointed out just how ben­e­fi­cial an en­dow­ment can be for a trust that only has nat­u­ral per­sons as de­pen­dents/ ben­e­fi­cia­ries. (An en­dow­ment is an in­surance prod­uct that is de­signed to pay out a lump sum af­ter a spe­cific term.)

The prob­lem, how­ever, was that it didn’t nec­es­sar­ily of­fer the same ben­e­fits for in­di­vid­u­als. Al­though this may not be the only rea­son why in­vestors would in­vest via an en­dow­ment, the tax ad­van­tages at­tached to it cer­tainly re­main one of the big­gest fac­tors to con­sider it as an in­vest­ment op­tion.

What this means is that a per­son earn­ing R240 000 a year at an av­er­age in­come tax rate of 14% won’t re­ally en­joy the full ben­e­fits of 30% in­come tax and 12% cap­i­tal gains tax on en­dow­ment of­fers. (See ta­ble be­low.)

The big ques­tion now is whether the higher-in­come groups, which will be largely af­fected by Gord­han’s re­cent an­nounce­ments, won’t be able to ben­e­fit more from a tax per­spec­tive by in­vest­ing via en­dow­ments.

Let’s sug­gest that a per­son who earns R2.4m a year would like to in­vest R2.5m ei­ther di­rectly or via an en­dow­ment. For the pur­pose of this il­lus­tra­tion, let’s use a 6.5% pre-taxed money-mar­ket rate, a 12% growth rate on their in­vest­ments and in both cases, prof­its will only be re­alised af­ter 10 years with a bal­anced cap­i­tal distri­bu­tion of 75% to growth as­sets and the re­main­ing 25% al­lo­cated to money mar­ket.

By tak­ing the new tax leg­is­la­tion into con­sid­er­a­tion, while ev­ery­thing else re­mains un­changed, this per­son’s in­vest­ment should be worth R6 044 939 af­ter taxes in 10 years’ time if in­vested di­rectly in their per­sonal ca­pac­ity. Had they in­vested their cap­i­tal via an en­dow­ment at an av­er­age en­dow­ment cost of 0.42% a year, the same in­vest­ment would have a net worth of R6 135 946. If tax rates re­main un­changed, you can add 1.5% in value to your in­vest­ment by sim­ply us­ing the right in­vest­ment ve­hi­cle, which in this case is an en­dow­ment.

The trust still reaps the most ben­e­fits from this type of in­vest­ment. With the max­i­mum tax rates in­creased from 41% to 45%, it also means that trusts’ cap­i­tal gains tax rates have been in­creased from an al­ready high level of 32.8% to 36%, and their in­come tax rates to 45%.

By us­ing the same ex­am­ple as above, the same R2.5m in­vest­ment would have had a net worth of only R5 290 051 af­ter 10 years if in­vested di­rectly. At cur­rent tax rates, a trust that did not ap­ply the look-through prin­ci­ple (with only nat­u­ral per­sons as de­pen­dents/ben­e­fi­cia­ries), that in­vested via an en­dow­ment, how­ever, ac­cord­ing to the five-fund ap­proach, would have paid only 12% cap­i­tal gains tax and only 30% in­come tax. Not only would that have meant a mas­sive R846 000 more in rand terms, but also an in­cred­i­ble 16% more in terms of per­for­mance.

If you, like many in­vestors out there, still be­lieve that en­dow­ments are worth­less in­vest­ment prod­ucts that only add ex­tra costs to your in­vest­ments, think again. Not only as a trustee, but as an in­di­vid­ual in­vestor as well.

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