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Matthew Lester: Investing local is still lekker

Date Released: Wed, 8 October 2014 09:43 +0200

There are many disturbing images of our beautiful country. My mate, photographer Obie Oberholzer, calls South Africa ‘the happy sad land’. And he has sold many books that picture the stark contrasts.

The images that dominate the press today of President Jacob Zuma, Oscar Pistorius, Gaza, the Ukraine, and others are enough to put me on a cocktail of Prozac and Imodium. It has got so bad that I have stopped working with a news channel in the background. And Abba is getting a bit lame, even for me.

In spite of all this there are two frightening images that cannot be ignored in the context of financial planning. Neither will necessarily bite us today, but in the long term they almost inevitably will. And any financial plan must contain carefully considered measures to counteract the consequences.

Growth rates

Accelerated growth rates of above 3% were the primary driver of the massive increase in tax collections between 1998 and 2008.

In 2010 the financial gurus said the 2008 financial crisis was just a V and recovery would be a matter of perhaps two or three years. ‘In five years’ time the financial crisis will just be a blip on the radar screen,’ they said.

By 2011 the V had changed to a W. And the financial gurus said recovery would take a bit longer.

Today the analogy has changed to the ‘bathtub’. But the end of the bathtub still cannot be predicted and the plug is still missing. Given developments in Europe in recent weeks, the bathtub is now as long as a feeding trough.

Since the financial crisis, tax collections have only been increasing at slightly above the inflation rate. Only when tax collections increase will South Africa start containing the national deficit that has already grown by R1,2 trillion since 2008. After that, South Africa may contain the criticisms of the sovereign debt-rating agencies.

One wonders what news will emerge come new Finance Minister Nhlanhla Nene’s first medium-term budget policy statement at the end of October 2014. Are tax collections on track? Or could we be facing a tax increase in the National Budget Speech in February 2015? These are difficult times.

In the five years that Pravin Gordhan was finance minister (2009 to 2014) there were no tax increases. South African fiscal strategy was simply to wait for the economy to recover. Will Nene change this approach?

At best South Africa’s current tax base cannot grow by much unless growth rates exceed 4%. This must create the strong possibility of tax increases in years to come.

The threat of tax increases on financial planning is very difficult to predict. Even if the top marginal rate of personal income tax is increased it will not have much effect. Substantial tax increases will have to come from other sources:

    The war against aggressive tax structuring will continue unabated. The result may be that tax-aggressive structures of the past may rebound on the investor of the future.
    The carbon tax proposals will probably be postponed indefinitely. But this does not mean that stealth taxation will diminish. Increased taxes on fuel and electricity coupled with a possible increase in the VAT rate could well be on the cards.
    Non-compliance and understatement penalties and interest charges will be imposed more stringently than ever.

Financial planning of the future must be totally tax-compliant and achieved at a reasonable cost. Aggressive tax structuring may keep ahead of tax amendments, but will the costs of implementation justify the outcome?

Lifestyle choice is becoming increasingly important in the context of financial planning. In the past ‘living on capital in retirement’ had little tax consequence. This is fast changing. In the future the more one spends, the higher the overall tax exposure will be.

But even if tax exposure can be contained, a second problem emerges.

The currency issue

In financial planning considerations Reserve Bank Governor Gill Marcus is just as important as Nene. So the second disturbing image becomes the state of the balance of payments current account.

Gone are the days of institutional money flowing into South Africa due to South Africa’s favourable interest rates. Since 2011 there has been a net outflow of foreign institutional money invested from South Africa in short-term markets.

South Africa’s dependence on the mining sector tax receipts has gradually diminished over the past 20 years. Today only 10% of tax collections are directly related to mining. But in the long term this is not the end of the mining issue. Today 50% of South Africa’s foreign earnings remain directly attributable to the mining sector.

Hopefully South Africa will recover from the Marikane tragedy and be able to contain the labour issues within the mining sector. But that may well not be sufficient to contain South Africa’s currency problem.

South Africa’s mines are reaching the end of their life. And with the growing environmental concerns export opportunities for coal may well diminish.

In the long term this must create the question ‘where does South Africa find the foreign exchange earnings to replace the declining mining sector earnings?’ And what is the future of the rand given that South Africa is becoming increasingly dependent on imported oil and food.

Some financial plans do recognise the vulnerability inherent to the rand by making use of the offshore investment allowance of R4 million per taxpayer of good standing. And there are some articles in the press promoting the view that any portfolio should contain at least 50% exposure to offshore investments.

But there is a problem inherent to directly held offshore investments: they are acquired out of after-tax income and returns within the offshore portfolio are subject to capital gains tax and dividend tax.

On the other hand, investment in a retirement annuity fund is tax-deductible. Income tax is deferred until withdrawal and dividend tax is avoided.

This leaves the taxpayer in a quandary. Yes, offshore investment is desirable, but the tax profile ranks well behind the retirement annuity fund.

The JSE obviously has a component of obvious rand hedge shares. But it goes further than that. There is an obvious correlation between a decline in rand exchange rates and an increase in the JSE all-share index. Yes, Top 100 JSE shares are truly an international investment.

In short, a retirement annuity fund inherently contains a hedge against the decline of the rand simply by virtue of the underlying listed investments. This should be factored into the equation in determining the offshore component of a portfolio. Thus the retirement annuity fund can to some extent be viewed as the tax-deductible international investment.

One must never lose sight of other issues:

    The increased cost of holding direct foreign investments. These costs are substantially higher than retirement annuity funds.
    The complexity inherent to reporting foreign investments in the personal tax return.

This leaves the issue being ‘is it better to acquire a direct offshore investment or an indirect foreign investment that is tax-subsidised by up to 40%?’

The same logic needs to be applied in determining a financial plan’s exposure to cash. Logic dictates a cash counter. But then Regulation 28 of the Pension Funds Act dictates a 25% minimum cash requirement for a retirement fund. Many investors do not realise that the cash component of their portfolio is inherently achieved through their retirement savings.

Conclusion

In these troubled times investors get frightened and sometimes overreact by repositioning portfolios to cash and foreign currency. If one truly believes that South Africa is facing a meltdown scenario, perhaps there is some merit to this.

But ask the question ‘what are fund managers doing with their time?’ The answer is that they are consistently taking measures to protect investments against risk. Some risks are more obvious than others.

A correctly administered fund already has the checks and balances in place in a manner that caters for far more than the obvious threats South Africa faces today.

So, unless one truly believes in the meltdown scenario, a local fund with a tax incentive is, for me, a far safer prospect.

Article by: Matthew Lester.
Article Source: Biz News

Source:Biz News