A decision based solely on tax considerations is likely to be the wrong one.
“I HATE tax!” These were the words spoken by a director of one of the clients of the audit firm with whom I served articles. Whilst many would agree with this sentiment towards the tax-man, this particular individual’s zeal in devising schemes to pay as little tax as possible was legendary in our firm.
Being a somewhat conservative lot, our policy as a firm was to generally steer clear of exotic tax planning schemes, with the focus centred largely on compliance. Whilst we did assist our clients in tax planning, we made sure that any advice given would withstand any scrutiny from the revenue authorities.
I’m not sure when this particular director had his ‘road to Damascus’ experience as far as tax was concerned, but suddenly, he was no longer so vehemently anti-tax. On the contrary, he was quite keen to pay tax. Lots of it. He had come to the realisation that tax was a by-product of the success of his business. Therefore, he figured, if he was paying lots of tax, he must be making lots of money!
This change of heart set him and his business free. By concentrating on running his business to maximise profit, and taking his focus away from tax all the time, his profits exploded. Sure, he paid a lot more tax as a result, and it was our job to ensure that he did not pay more than what was legally due, but his focus was now in the right place.
Clearly, then, it can be seen that people make investment or business decisions based on a perceived tax benefit, rather than a holistic view of the merits thereof.
This incident was brought back to mind by a query that once came my way.
When you retire from a pension or retirement annuity fund, you are entitled to take up to one-third of the fund as a lump sum. This lump sum is taxed favourably, with a portion thereof being completely tax-free, whilst the balance thereof is taxed at preferential tax rates which are often (but not always) at a lower rate than your marginal rate.
You are, however, required by law to utilise the remaining two-thirds* to purchase a pension. With most companies outsourcing their pension fund administration nowadays, you are normally entitled to purchase your pension from a wide array of financial institutions, and these institutions have a number of different forms of annuities to cater for your pension requirements. These are collectively known as compulsory purchase annuities, and it was such an annuity that was the subject of the query.
Pensioners are no different to the rest of us when it comes to a desire to minimise our tax liability, and a scheme that had become popular about 20 years was for an annuity to be structured in such a manner as to pay the pension annually in arrears.
My first thought around such a scheme would be to question the benefits of such an arrangement. If I had to wait a year for my first pension payment, I would firstly need other resources on which to live—since, being retired, I would no longer be receiving a salary. Secondly, I would want a benefit that would significantly exceed that which I would be enjoying if I had elected to receive my pension monthly.
The main reason touted for schemes of this nature was the deferral of tax. The argument was that if the pension is only received a year later, the tax is only payable then. However, the revenue authorities quickly jumped on this, with SARS issuing Practice Note RF 1/2004 some time back.
The principle outlined in the practice note is that since the gross income definition contained in Section 1 of the Income Tax Act refers to an amount in cash or otherwise that has been “received or accrued”, and the general principle is that pensions accrue monthly, PAYE must be accounted for accordingly.
The example given in the query relates to an annuitant signing a contract on 1 January, whereby pension payments will be made in arrears on 31 December each year. In this case, the annuitant would have to account for the portion of the annuity that would accrue for the months of January and February, i.e., 2/12 of the gross amount of the annuity represented by the payment that takes place in December.
The consequence of this is that 2/12 of the December annuity payment would be taxed in the current tax year, whilst 10/12 of this annuity payment (and 2/12 of the next payment made the following December) will be taxed in the following tax year.
The practice note also refers to Section 104 of the Income Tax Act. This section deals with offences and penalties that would arise from false statements in a person’s income tax return. Given the context in which the practice note applies, failing to declare the proportionate share of the annuity in the correct tax year would be grounds for SARS to invoke this Section.
The cynic in me would want to know how the advisor’s remuneration structure is affected by schemes of this nature. This cynicism arises from a situation with someone I spoke to about six years ago who had purchased her annuity in an investment constructed along these lines.
Given the fact that she had no other source of income, it was quite clear that this investment was totally inappropriate from a cash flow perspective, and did not appear to provide any significant compensation in the form of increased returns by delaying physical payment.
Her reason for going into this investment? “It would have tax benefits.” Thanks to Practice Note RF 1/2004, this so-called ‘benefit’ that has masked what has effectively been poor advice has also been removed, showing such schemes up for what they really are—dud investments.
What can we learn from this? Here are some pointers:
-Do not base your decision solely on perceived tax benefits. Whilst I am not suggesting that you should ignore tax, since tax often has a significant influence on the overall return, tax should not be the sole determinant of your investment choice.
-Understand what you are investing in. Any investment that cannot be deciphered without the assistance of a PhD is probably inappropriate. How can you possibly gauge if your investment is doing what you expect it to do if you cannot decipher how it works? For an annuity, you need common-sense answers to the following questions:
How much will my pension be?
How often will I receive it?
Will it keep pace with inflation?
In what underlying portfolio is my capital invested?
Will I be able to leave a portion of my pension/capital to my heirs if I die earlier than expected?
-There is no such thing as a ‘one size fits all’ investment. The plan being proposed must fit your requirements, risk profile, and temperament.
-Examine the remuneration structure of the advisor. This is to make sure that the proposed investment is in your best interests, not the advisor’s. Many a poor investment has been sold based on the amount of commission that the advisor stands to earn. However, you must also accept that a good advisor is a professional who you should reasonably expect to remunerate accordingly.
Written by Steven Jones
This article is a general information sheet and should not be used or relied on as legal or other 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 adviser for specific and detailed advice. Errors and omissions excepted (E&OE).