Dividend income fund structures may be legal, but what about the morality?
In last week’s column I dealt with how, in structuring the controversial dividend income unit trust funds, taxable interest income appears to be converted into non-taxable dividend income.
I calculated that this bolt hole could be costing the taxman about R2 billion a year.
In the column I said that the underlying investments of dividend income funds were preference shares and that these preferences shares were created artificially by using some very complex and opaque structures.
Dividend income funds are currently the subject of a joint investigation by the South African Revenue Service (SARS), the Financial Services Board and the National Treasury.
Money continues to pour into the funds; at last count, they had R51 billion under management.
I raise this matter again because John Kinsley, the chief operating officer of Prudential, which has the biggest of the four dividend income funds, says I got it wrong with his fund.
Kinsley says his fund converts taxable interest into non-taxable dividends without using complex, opaque structures. Kinsley’s fund works as follows:
The R23 billion or so in the fund is invested in money market instruments that earn interest;
The interest is used to buy dividends from shareholders; and
The interest earned by the fund does not attract tax, because collective investments, including unit trust funds, are taxed according to the conduit principle. This means that a fund manager can trade merrily without the tax consequences that would affect you and me if we did likewise. Tax comes into effect only when you cash in your unit trusts. So the purchase of the dividends is a non-taxable event.
Very neat, but I doubt the National Treasury, SARS or Parliament had this in mind when they approved the conduit principle.
TAX BREAKS FOR THE WEALTHY
The main point of last week’s column was not the methodology; it was the morality of the financial services industry taking advantage of gaps in the law to give tax breaks to the wealthy and corporates.
Although dividend income funds have smaller investors, investments of R51 billion mean some pretty big players must be getting the tax breaks.
Anyway, Kinsley’s request for a correction got me thinking.
The question for me is who is selling the dividends? They must come from really big shareholders. The big shareholders are life assurers and retirement funds, the money of which is managed by asset managers.
If the dividends were coming from retirement funds only and the dividend income funds had been set up after March 2007, when the tax on interest in retirement funds was scrapped, things would not be so bad. It would simply be a case of utilising another tax loophole, possibly but not necessarily to the advantage of retirement fund members.
Post 2007, there would be no tax consequence in taking interest income on board, and if you sold something, you would do so at a profit. However, the problems are:
The Prudential fund was launched in 2005, two years before retirement fund tax was scrapped, so, depending on how the swap was treated, it could have been subject to income tax. It would not have been subject to capital gains tax (CGT), as retirement funds have always been exempt from CGT.
Life assurance portfolios and other equity unit trust funds could be providing the dividends. The unit trust funds would be okay, because of the conduit principle. But life assurance companies pay tax at a rate of 30 percent on interest income, as well as CGT. Policyholders would be none the wiser.
Remember the secret profits scandal in which retirement fund administrators and others made secret profits from bulking retirement fund bank accounts? That was not the only way in which secret profits were made, and one wonders whether retirement fund trustees whose funds may be affected have been informed of the significant trade in dividends and how much money is being made from it. One also wonders whether the trustees have given their approval to the trade. I would suggest every retirement fund trustee starts asking questions.
Kinsley, after much prodding, says the trade is conducted through the major banks, so he cannot say exactly from where the dividends emanate.
He also states that what is being done is perfectly legal. I am sure it is. I have not said otherwise. It is the morality of the issue that worries.
It is not the first time that the financial services industry has created tax schemes. Some years ago, it created what are called blackhole endowment policies that allowed the wealthy to take advantage of tax breaks.
The policies were closed down by Gill Marcus, then the Deputy Minister of Finance, who simply told the financial services industry: “No way.”
What is more worrying is that Kinsley says: “Our fund has been approved by SARS and scrutinised by the treasury, therefore we certainly don’t regard anything about the fund as immoral. Without this approval, we would certainly not have gone ahead.”
Vlok Symmington at SARS commented on Kinsley’s statement as follows: “I am not sure what he means by ‘approved by SARS’. We don’t ‘approve’ products.”
The point of all this is that if the wealthy pay R2 billion less in tax than they should because of loopholes, someone else has to pay more.
Although every taxpayer has the right to use every legal means to minimise his or her tax burden, it is repugnant for the financial services industry to create tax bolt holes, even if they are legal.