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Why You Should Keep Shares For at Least Three Years

28 April 2010   (0 Comments)
Posted by: Author: David Warneke
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Why You Should Keep Shares For at Least Three Years

The tax consequences of not doing so could prove extremely costly

It is common knowledge that investing takes time and patience,and that the chances of a good return are increased the longer the investment horison.From an income tax perspective, there's also an incentive to hold shares for at least three years before selling them.

This is because of the ‘safe haven’ tax rules in Section 9C of the Income Tax Act, which provide that the proceeds from the sale of shares (with certain exceptions) are automatically deemed to be capital if held by the taxpayer for at least three years.

This essentially means that the more favourable capital gains tax rate (a maximum rate of 10%, as opposed to the income tax rate of a maximum of 40%) will apply to profits made on shares that are held for three years or more.

Where shares are held for less than three years, the normal rules governing capital gains versus income gains must be applied to determine whether the gain is capital or income in nature. If the gain is capital in nature, the capital gains tax rate will apply; and if it is income in nature, the income tax rate will apply.

There is a large volume of legal precedent governing the distinction between capital and income gains,and the approach of the courts has been to place a high emphasis on the intention with which the taxpayer acquired the shares—was the dominant purpose for investment (capital) or was it for speculation (income)?

Speculation concerns the subsequent sale of the shares at an increased price, whilst investment is the holding of the shares more or less ‘for keeps’ in order to earn dividend income.However, a potential problem that a taxpayer faces with regard to the argument that he acquired shares in order to earn dividend income is that the dividend yields of shares on the JSE are generally extremely low,and it is therefore often difficult to argue that this is a rational investment strategy.

Our strongest case law on this issue, much of which was decided in a time when dividends were relatively higher, would certainly not prove helpful to a taxpayer who, in addition to earning dividend income, sought to bolster the performance of the portfolio by selling at a profit to any meaningful degree.

Two cases in point: In the case of Tod, which was decided in the Natal Provincial Division of the High Court in 1983, the taxpayer was retired and lived almost entirely on the dividends from his shares. Tod had embarked on a plan in order to increase his annual dividends, whereby he would purchase a share on which a dividend was imminent, and as soon as the dividend had been declared, he would sell the share,usually at a profit.

The court held that in order for profits on the sale of shares not to be subject to income tax, the taxpayer must have a dominant purpose of maximising dividend income, and that any selling of shares must be ‘purely incidental’ to this objective.Tod's share transactions were held not to be purely incidental to the objective of maximising dividend income, and the proceeds were subject to income tax.

In Nussbaum's case, which was decided in the Appellate Division of the High Court in 1996, Nussbaum was a retired schoolteacher who had inherited a substantial share portfolio.He testified that he always acquired shares for the earning of dividend income, and that he had never bought a share for profitable resale;however, his modus operandi was to sell a share if the dividend yield had fallen to unacceptable levels.

Since a fall in the dividend yield was generally caused by an increase in the price of a share, Nussbaum generally made profits,and the court found that even though he had the primary purpose of earning dividend income, there was a ‘secondary purpose’ of dealing in shares, which rendered profits subject to income tax.

Market conditions aside, it is therefore wisest from a tax perspective to wait a minimum of three years before selling shares.

Source: By David Warneke (Tax breaks)


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