Div­i­dend in­come fund struc­tures may be le­gal, but what about the moral­ity?

Weekend Argus (Saturday Edition) - - PERSONAL FINANCE -

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.


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.

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