Whether you are a share trader or a long-term investor, when you make a profit, SARS will want its slice of the pie
Ever since biblical times, there has been a tug-of-war between governments trying to extract as much as possible from their citizens in the form of taxes, and individuals trying to keep as much of their income and wealth away from those very same governments. In South Africa, owners of shares have not historically needed to worry too much about the tax man—especially if they considered themselves to be long-term investors. This is because any profits made when shares held over long periods of time were eventually sold, were completely tax-free (as were all so-called ‘capital’ profits), while dividends have also for quite some time been tax-free in the hands of shareholders. However, on 1 October 2001, the way South Africans think about tax was changed forever, for this was the day on which Capital Gains Tax (CGT) came into effect.
Share investors’ panic over CGT
Markets can be seen as a fascinating study of human behaviour, and this can be seen most clearly in how markets often tend to overreact to news. This tendency to overreact can also be seen in how people respond to even the very thought that SARS has its minions lurking behind every bush, just waiting to pounce on unsuspecting taxpayers and seeking to shovel every last cent they possibly can into the State’s coffers. But first, a warning: While tax is an important aspect to consider when deciding what to do with your share investments, there is a real danger of allowing tax to so completely dominate your thinking that you end up making the wrong investment decisions as a result. For example, at the time of writing, MTN Group was trading at R135.95 per share. However, although it is significantly down on its 11 March 2022 peak of R202.00, it was not too long ago—about two years, in fact—that this particular share was trading at about R69.00, just over half of its current price. Now suppose that you had bought 1 000 MTN Group shares at R69.00, and were thinking about selling them at the current price of R135.95. Although you should have ideally got out in March 2022, by selling them now you would have still just about doubled your money in two years. Not too shabby, Nige! But assuming that SARS accepts the premise that these shares are part of a long-term investment portfolio, you will still be liable for CGT on the profits made—in this case, give or take a couple of rands, a profit of around R66 500. Now I have actually heard people make the comment that they shouldn’t sell in this case for fear of having to pay CGT—so let’s look at the following scenario to illustrate the folly of allowing tax to dominate your decision.
Suppose that you believe that the market may fall further, so you sell the shares, realise the profit of R65 000, and now have to account to SARS for the CGT. Assuming that you have no other taxable capital gains, and your marginal rate of tax is 45%, your CGT liability is calculated as follows:
Capital gain on sale of the shares: R66 500
Less: Annual amount of capital gains that are exempt: R40 000
Taxable capital gain: R26 500
40% of the capital gain to be included in taxable income: R10 600
Tax thereon at 45%: R4 770
After taking the CGT into account, you would still be left with a net gain of R62 180—a 90% gain on your initial investment.
Now imagine that you become so paralysed by fear of having to pay SARS some money that you decide not to sell, even though you do actually believe that the market is likely to fall even further. In actual fact, the share price only has to decline by a mere 3.5% for its value to drop by more than what you would have paid in CGT if you had sold them at the price of R135.95—something that can happen in a matter of minutes in a volatile market! While you should never ignore the effects of tax on your investments—and the purpose of this series is to outline exactly that—the old adage, “if I am paying lots of tax, I must be making lots of money”, holds equally true for share investments.
So to kick off the series, let’s examine what we mean when we talk about ‘capital’ and ‘revenue when it comes to share investments—and why this distinction is important.
The concepts of ‘capital’ and ‘revenue’
The distinction between revenue and capital is important mainly because CGT is effectively levied at a far lower rate of tax than that levied on normal income. The other reason why the distinction is so important is that while revenue losses may be set off against both revenue earnings and capital gains, losses of a capital nature may only be set off against future capital gains. Before CGT was introduced on 1 October 2001, capital profits were completely exempt from tax. So it was obviously beneficial if one could have a particular gain or profit declared as being of a capital nature, rather than as revenue. However, even though capital profits are now taxed, the tax rate applied is lower than that applied to trading or revenue profits. For individual taxpayers, the effective rate of CGT will be 40% of their marginal rate of tax, while for all other taxpayers, the effective rate is 80% of the applicable tax rate. But what do we mean by the terms ‘revenue’ and ‘capital’? In simple terms, ‘revenue’ refers to the income that you earn from buying and selling goods, rendering services, rent, and interest. On the other hand, ‘capital’ refers to the structure that is used to earn income. Distinguishing between the two concepts can best be understood by applying the ‘tree and fruit’ analogy, which was first discussed in the Commissioner for Inland Revenue v Visser [1937 TPD 77, 8 SATC 271] court case. The tree would represent part of the capital structure from which income is earned, while the fruit would be what you would sell to generate income.
Applying this analogy to shares, the share investment itself would be like the tree, whereas the dividends received are like the fruit. The problem with this approach is that not all share investors are the same. One investor may decide to build up a portfolio over many years with the intention of maximising their dividend income. Many such investors have in fact managed to retire on their dividends. On the other hand, there are others who are looking for gains from the movements in the underlying share price. Such investors could end up being classified as traders.
Intention, backed up by actions
Whether a particular share disposal transaction is classified as either revenue or capital will also depend on a number of factors, such as the underlying intention when purchasing the shares, the period for which a share is held before disposal thereof, and the frequency of similar transactions. Most of our court decisions concerning the determination of an amount as capital has revolved around the intention of the taxpayer. The question is asked: “When you originally bought this asset, what did you intend to do with it?” In the case of shares, if the intention was for a long-term dividend, you will have no problem. In such a case, your share portfolio represents a fixed, capital investment in that it is acquired “for better or for worse”, or “for keeps”, and you are only likely to dispose of a share if some unusual, unexpected, or special circumstance warrants such disposal (Barnato Holdings Ltd v Secretary for Inland Revenue [1978(2) SA 440 (A), 40 SATC 75]).
Certain share disposals are automatically regarded as capital after specific periods
There are however special provisions in the Income Tax Act whereby the proceeds of certain so-called ‘affected shares’ are automatically regarded as being of a capital nature, provided that they have been held for longer than a specific period. If you sold your shares on or before 30 September 2007, Section 9B would have applied. Under this Section, you can elect to have the proceeds of listed shares sold to be deemed as capital, as long as you have held them for five years or more. If you decided to make such an election, the burden of proving that the disposal is of a capital nature falls away. However, the downside is that once you have made such an election, it became binding on all future disposals of so-called ‘affected shares’. Section 9B also applied only to listed shares, and did not include shares in private companies or members’ interests in close corporations.
From 1 October 2007, a new Section 9C came into effect. This Section provides that the proceeds of shares held for three years or longer would automatically be regarded as capital once sold. There is no longer any requirement to make an election, as was the case under the old Section 9B. The new Section was also expanded to include all domestic and foreign listed shares on the JSE, private company shares, interests in close corporations, as well as certain collective investment schemes where the underlying investments are in shares. However, the definition excludes hybrid instruments such as shares with both equity and debt features; shares involved in former Section 24A rollover schemes; interests in share block companies; and unlisted foreign companies.
WRITTEN BY STEVEN JONES
Steven Jones is a registered SARS tax practitioner, a practicing member of the South African Institute of Professional Accountants, and the editor of Personal Finance and Tax Breaks.
This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)