By Andró Griessel
Be careful of the merry-go-round thought process with tax
The idea to defer tax, that will be payable at some point, for as long as possible, is grounded in the notion that there is an opportunity cost related to paying the tax immediately and therefore forgoing the future growth on that “lost” investment.
What happens in practice is that the fear of an ever-increasing capital gains tax wave, and the natural renunciation to pay this tax to the South Africa Revenue Service, inherently leads to bad decision making by investors, or might even lead to no decision making at all, which can both materially sabotage their wealth planning.
This principle usually presents a dilemma to investors who manage portfolios with a high concentration of shares or where a person or trust has held a specific unit trust for many years without rebalancing.
Many who read this article, might be in the position of having significant exposure to shares such as Richemont, Naspers, Capitec or some other stock which has performed well over the years and therefore led to an overweight position in their overall portfolio.
This merry-go-round thought process that follows sounds something like: “I cannot sell now, as the capital gains tax liability would be too big”. However, should the share price decline significantly, you would not want to sell “because it is too cheap now” (as could be the case for Naspers perhaps?)
If the share recovers again, the capital gains tax problem re-appears, and you tell yourself that “it would be foolish to sell now as the share has great momentum”. (Take Sasol as an example.)
You therefore become entangled in a circular argument that leads to indecisiveness. This leads to you retaining the share or unit trust in its highly concentrated format. What follows are a few thoughts that can assist in the decision-making process of when and whether it is worth it to take the CGT-blow.
As an example, let’s use a R5m investment which has a base cost of R2.5m.
Remember that the past is not a good predictor of the future and even the tallest trees stop growing at some stage.
A lot of academic literature will suggest that a highly concentrated portfolio is the only way to “quick” wealth creation. I can’t argue with this, but one must perhaps add that this approach might also potentially be the path that runs over a financial cliff.
It would benefit investors to remember that an investment is a marathon and not a sprint. The frontrunner after 10 years is not necessarily the winner after 15 years. Refer to the table below, which shows a few well-known examples (there are several others) where very high long-term average growth rates (longer than ten years) disappeared into thin air over the following consecutive years.
When investments start to trade at extreme valuations, it might be a good idea to rebalance (and to therefore take the CGT-blow on the chin), even if the decision appears to be the wrong one when the price continues to rise.
No share price moves in a straight line and the opportunity to buy a high-quality business at a more reasonable price will present itself again sometime in the future. Some may assume that rebalancing means you permanently sell out of a position, but that is not what I am trying to say here.
The long-term impact is smaller than you might think.
Going forward, assume a long-term average growth number of 10% on the original investment. To account for the “loss” in growth on the R442 800 in the example above, one would need the following additional growth to end up in the same position:
- Over ten years = 0.59% per annum;
- Over fifteen years = 0.50% per annum; and
- Over twenty years = 0.42% per annum.
Do the benefits of the rebalancing outweigh the negative impact of the premature CGT?
If the intention is to also transfer the asset to a trust or a more tax beneficial structure, then it is important to take the long-term impact of the reduction in other taxes, such as dividends- or estate duty tax, into account.
Assume for example that the R5 million is split between husband and wife (via a tax neutral donation) and then loaned to a trust where the future growth is pegged in their respective estates, then the full amount of future growth will be excluded from their estates.
Assume that it gets invested into two retirement annuities and the disallowed credits can be used over their lifetime, then the investment value is excluded from their estates and no dividend- or capital gains tax will apply.
Asset growth of 10% per year over a twenty-year period would result in the original R5 million growing to R33.6 million which, if we assume other assets absorb the section 4A estate duty deduction, translates into estate duty tax of roughly R6.9 million (no adjustments to the income tax brackets) versus the R1 million estate duty tax on the R5 million.
This example is very much over-simplified and actual values will differ based on the quality of the investment and the chosen investment vehicle, but the principle should be clear.
- In general, investment decisions should not be made based solely on tax considerations.
- Measure your investment decisions with a clean slate approach. If your portfolio would not be constructed in the same way if you started from scratch today, then there is usually not a good enough reason to keep your existing portfolio as is.
- Remember that CGT (especially in your personal capacity) cannot be deferred forever. When you pass away, it is automatically deemed as a selling event, which will trigger CGT.
- If you have a significant accumulated capital gain in your investment portfolio which leads to hesitant decision making, then you should investigate other alternatives by talking to a tax expert or a specialised wealth planner. This may include a section 42 asset transfer, the strategic use of annuities, etc.
Andró Griessel is a certified financial planner and managing director of Woodland Wealth (Previously ProVérte Wealth and Risk Management). Contact him at firstname.lastname@example.org.
Although all possible care was taken in the drafting of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone planning on taking any financial action based on this document, is strongly advised to first consult with their personal financial advisor. Woodland Wealth is an authorised financial service provider with FSP no. 5966.