Interest tax exemption limitations: What are your options?
The draft Taxation Laws Amendment Bill 2010 (released on May 10) has created some concern amongst investors and financial advisers. At issue is the proposed change to exemptions from income tax on interest income afforded to South African residents and non-residents respectively.
Presently, the first R22 300 of interest received by a South African resident individual under the age of 65 is exempt from income tax. For individuals over 65, this exemption increases to R32 000. Furthermore, all South African sourced interest received by a non-resident is exempt.
These exemptions have provided tax planning opportunities, typically involving loans between related or connected persons or closely held companies - the borrower obtains a tax deduction for interest incurred, and the individual recipient benefits from exempt interest income.
In its efforts to curtail tax avoidance, National Treasury has now limited the scope of the exemptions. However, there should be very little cause for concern amongst bona fide investors.
For residents and non-residents alike, the form of interest will affect the application of the exemption. Only interest from government bonds, listed debt instruments, bank deposits, benefit funds, stock broking accounts and unit trusts will be exempt for years of assessment ending on or after January 1 2010. A "listed debt instrument" includes listed bonds, debentures and other similar instruments. Listed corporate and parastatal debt instruments, including debentures, fall within the ambit of this definition.
From a fund management perspective, it is clear that most local investors will not have to alter their portfolios in anticipation of the proposed legislation. This is because very few investors will have interest sources other than those exempted. Certainly, the proposed changes should not prompt any alteration in an ordinary local investor's portfolio.
Non-residents should only have concern about the narrowing of the instruments qualifying for the interest exemption if they have established internal structures to maximise the remittance of interest offshore. Interest remittance was typically prioritised as it is presently permitted in terms of the exchange control regulations. For example, non-resident investors may have loaned funds to South African residents such as companies or trusts at high rates of interest (typically at prime plus 2%) so as not to fall foul of other tax and exchange control provisions. It is these structures that are adversely affected by the proposed legislation as the SA-sourced interest income on these loans will now no longer be exempt from SA income tax in the hands of non-residents.
With money market interest rates hovering around 7% per annum, an individual under 65 could invest some R318 000 before receiving interest that would be subject to tax. But in many instances, this may be a disproportionately large component of a portfolio. For non-residents, a 7% yield may not be sufficiently attractive to justify a continued investment.
High-yielding listed debt instruments offer the tax exemption advantages which local and non-residents seek.
*Darron West of Foord Asset Management is also a senior lecturer in the Department of Finance, UCT