Print Page   |   Report Abuse
News & Press: TaxTalk

The Tax Implications of Currency Gains made on Foreign Investments

26 September 2016   (0 Comments)
Posted by: Author: Pieter van der Zwan
Share |

Author: Pieter van der Zwan (Pieter van der Zwan and Associates)

Investing offshore. Beware: the amount of capital gains tax that you need to pay will differ greatly depending on the what type of investment structure you make use of.

The current economic conditions in South Africa have led many to invest in non-South African Rand (ZAR) denominated instruments. Many of these instruments provide investors with exposure to investment growth opportunities in foreign markets and economies. They also serve as a hedge against depreciation in the ZAR. 

Only time will tell whether this investment strategy reaps rewards as economic events and conditions in other countries pose their own challenges, for example, the implications of Brexit. This article is intended to provide an overview of some tax implications of these investment strategies rather than offer any insight as to the value of such investments. 

Investment options considered in this article

The analysis in this article assumes that the majority of South African investors who invest abroad are high income earners or high net worth individuals who are either employed or owners of businesses, whether large or small, or persons with interests in such businesses. These high net worth individuals are assumed to have access to advisors who would assist them in structuring their business interests and income streams in an efficient manner taking into account various factors such as asset protection as well as wealth and estate planning.

In light of these assumptions, the funds invested abroad may be located in structures involving companies and trusts or they could be held in their personal capacity. 

The remainder of this article considers the implications that the choice of investment vehicle may have on the tax implications arising from currency gains (or losses) made on these foreign currency denominated investments. The tax implications of the yield on the investment (interest, dividends or capital growth other than currency gains) are not considered.

The relevant legislative framework

Section 24I of the Income Tax Act[1] deals with gains or losses on foreign exchange transactions. This provision requires that certain taxpayers, discussed below, include or deduct from their income the exchange differences arising from exchange items. This entails that these exchange gains or losses be taken into account for tax purposes, whether it has realised or not, and be taxed at the normal rate of tax at which any other income is taxed. The concept of an exchange item is defined as foreign currency, foreign denominated debt (for example, bonds), forward exchange contracts (FEC) and foreign currency option contracts (FCOC). Section 24I does not deal with the foreign currency gain or loss elements of instruments such as shares or units in collective investment portfolios.

It is important to note that the scope of section 24I does not include all taxpayers and their exchange items. Any company that holds an exchange item is required to apply section 24I to all its exchange items, as described above. Trading trusts are similarly required to apply section 24I to all exchange items. Trusts that do not carry on a trade are however only subject to section 24I on currency derivatives covered by section 24I, namely FECs and FCOCs.

Natural persons, similarly to non-trading trusts, are only required to apply section 24I to their currency derivatives. In relation to units of foreign currency and foreign debt instruments a natural person is only required to apply section 24I if these items are held as trading stock (in an investment context, with a speculative intention). This means that the exchange gains a natural person make on a foreign debt instrument, for example, a US dollar (USD) bond, will not be taxed under section 24I. It is however important to note that this does not necessarily mean that it is not taxed at all, as this is still a capital investment that may attract capital gains tax. As indicated earlier it also does also not mean that the yield, in this case interest, will not be taxed. The USD interest should in principle still be taxed in South Africa if the investor is a South African tax resident.

The Two Methods of Determining Tax on Capital gains 

When a taxpayer sells any asset, in this case a long investment rather than a speculative investment, this triggers a disposal which is subject to capital gains tax. The capital gain or loss is calculated as the difference between the proceeds received and the base cost incurred to acquire the asset.

In economic terms, this gain or loss will reflect both the gain or loss on the intrinsic value of investment instrument as well as any exchange gains or losses made due to the fact that the investment was made in a foreign currency.

If an investment were to be purchased and sold in ZAR, no currency conversions would be required to determine the taxable capital gain or loss. However, if the investment is acquired or disposed of in a foreign currency, paragraph 43 of the Eighth Schedule provides the rules on how the conversion from the foreign currency should be done. 

Paragraph 43(1) determines that where a natural person or non-trading trust disposes of an asset in the same foreign currency that it acquired the asset, the gain or loss should be determined in that foreign currency and be converted to ZAR by applying the average exchange rate for the year of assessment in which that asset was disposed of or by applying the spot rate on the date of disposal of that asset. SARS describes this method of calculating the capital gain or loss in the foreign currency and the converting such gain or loss to ZAR as the “simple conversion method”.

In any other case (in other words, not natural person or non-trading trust, or proceeds denominated in a different currency from the base cost), the proceeds should be converted to ZAR at the spot rate on the disposal date or the average rate for the year in which the disposal took place. The expenditure included in base cost should be converted at the spot rate on the date of disposal or the average rate for the year when the expenditure was incurred. This is referred to by SARS in the Comprehensive Guide to CGT as the “comprehensive method of conversion”.

A relevant example 

Assume that two South African persons, a natural person and a company, purchased a share in Apple Inc on the NASDAQ exchange in 2012 for USD 60 per share and sold it in 2016 for USD 100. Lets’ further assume that the exchange rate on the purchase date was R7,5: USD1 and in 2016 when the share is sold this the exchange rate is R15:USD1. In both cases, the investor would benefit from two elements namely the increase in the Apple Inc share price of USD40 as well as the fact that the ZAR has depreciated by ZAR7,5 to USD1 over the period of three and a half years. The overall gain in ZAR is R1 050 (being USD100 x ZAR15 - USD60 x ZAR7,5).

The capital gain subject to capital gains tax under the mechanism in paragraph 43 in the case of each investor is:

 

This significant difference arises from the fact that the simple method effectively uplifts the base cost to the depreciated ZAR exchange rate at the time of the disposal, which eliminates currency depreciation from the capital gain. This outcome is acknowledged by SARS in the Comprehensive Guide to CGT. The converse would however also be true: taxpayers who have to apply the simple method are likely to be at a disadvantage when the ZAR appreciates.

Practical implications

Where a taxpayer has set up a structure where a family trust holds shares in operating companies that generate business profits, which will ultimately be distributed to the trust as dividends and that can then be retained or distributed to beneficiaries, the foreign investment can, in theory, be made either at the level of the company, the level of the trust or by a natural person. Many factors other than tax, for example, risk exposure and wealth planning, should play a role in this decision.

The analysis in this article however shows it may have a significant tax impact in terms of capital gains at which level an investment is made. 

If the investment is made at the level of the company, exchange differences on foreign debt investments would be taxed under section 24I. The full gain, including currency elements, on equity type of investments would be subject to capital gains tax under paragraph 43(1A).

If the investment is however made at the level of the trust (assuming it is not a trading trust), section 24I will not apply to exchange gains made on foreign debt investments held as long-term investments. These persons may benefit from the simple method of determining capital gains on both debt and equity investments. In the type of structure described above, this would however mean that the funds available for investment would be reduced by the dividends tax at 15% when the funds are extracted by the trust from the company. This automatically shrinks the investment base, which may have a significant impact if one considers that the effect of this lower investment base could be exponential taking into account the principle of compounded growth.

In the context of natural persons or non-trading trusts, the provisions of paragraph 43 may also result in a significant difference as to whether the person invests directly in foreign denominated instruments or through a South African instrument, denominated in ZAR, of which the value tracks the foreign currency or markets. The former would fall under paragraph 43 while the latter is unlikely to do so. As such, this provision could impact on the choice of investment instrument.

These choices may leave investors with some difficult decisions. As is often the case with many transactions, the answer would probably to a large extent lie in what makes sense from a non-tax perspective as decisions in this regard that are driven only by the above tax implications could be driven by pure speculation on what the currency will do.


 [1] Any reference to a section in this article refers to a section of the Income Tax Act unless indicated otherwise.

Please click here to do the quiz.

This article first appeared on the September/October 2016 edition on Tax Talk.


WHY REGISTER WITH SAIT?

Section 240A of the Tax Administration Act, 2011 (as amended) requires that all tax practitioners register with a recognized controlling body before 1 July 2013. It is a criminal offense to not register with both a recognized controlling body and SARS.

MINIMUM REQUIREMENTS TO REGISTER

The Act requires that a minimum academic and practical requirments be set to register with a controlling body. Click here for the minimum requirements of SAIT.

Membership Management Software Powered by YourMembership  ::  Legal