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Preference shares - Tax amendments

26 August 2011   (0 Comments)
Posted by: SAIT Technical
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Preference shares - Tax amendments

Business Day - Gareth Stobie

If you are on the hunt for higher income yields and tax relief, listed preference shares (prefs) should be on your list. Regrettably, confusion caused by pending changes to tax legislation is causing many investors to steer clear of prefs.

Two tax amendments due to come into force on April 1 2012 are at play. One is the removal of secondary tax on companies (STC), which will make dividends taxable in the hands of the investor. The second is the crackdown on structured finance arrangements using prefs, which finance minister Pravin Gordhan has termed "dividend schemes”.

Neither of these two issues will have an impact on funds that invest directly in prefs , says Gareth Stobie, manager of Grindrod Diversified Preference Share Fund. At present dividends are tax-free in the hands of the investor and the company paying the dividend is liable for 10% STC on the dividend payment. Under the new regime a 10% tax on dividends will be payable by shareholders, though in practice it will be a withholding tax which companies will pay on their behalf. Stobie explains that to compensate for the 10% withholding tax, companies will increase dividends on their prefs , leaving prefs investors with the same income as they get now.

The crackdown on dividend schemes, however, is more complex and targets structured products that convert taxable interest into tax-exempt dividends. The closure of one unit trust using these products, Prudential Dividend Yield Fund, has already been announced. The fate of two others, Absa ’s and Stanlib’s dividend income funds, remains to be seen. But it’s all systems go for Grindrod’s fund and two others that invest in prefs: PSG Preference Share Fund and Coronation Preference Share Fund. Stobie says there are 18 listed prefs of significance, 10 issued by banks and eight by nonbanks. The weighted average yield of prefs in Grindrod’s fund is 7,25%, he adds. This is a big improvement on money market fund yields of about 5,5% and also comes with a tax advantage.

For a taxpayer paying a 40% marginal tax rate, a 7,25% yield provides an effective pretax yield of 12,1%. Listed prefs pay dividends coupled to the prime overdraft rate (prime). A change in prime triggers a corresponding change in the dividend paid.

But there are risks. Pref share prices and yields vary with changes in investor demand and risk appetite. Coronation Fund Managers CIO Karl Leinberger notes in a recent study that in the mid-2000s a stampede into prefs drove their yields down to unrealistically low levels. For example, the yield on the oldest pref in issue, Nedbank ’s, issued in late 2002, fell from 75% of prime in 2003 to well below 60% of prime in 2006. A derating of prefs followed, driving their prices down sharply and seriously denting investor confidence. "This fear and loathing has created a buying opportunity for the investor who is prepared to put emotion aside and focus on the fundamentals,” says Leinberger. The fundamentals are positive. Prefs of the big banks are trading at about 75% of prime compared to a long-term mean, based on the Nedbank pref, of about 70%. For investors who shun price volatility, an alternative is Sanlam Alternative Income Fund, which invests in unlisted but otherwise conventional redeemable prefs issued by the five big banks and Sanlam.

Unlisted prefs remove potential price volatility associated with listed prefs, says Sanlam Collective Investments CEO San- Marie Greeff. The fund’s price is fixed at R1/unit, but lower risk comes with a lower yield, now 4,6%, or an effective pretax yield of 7,2%. Prefs are not the asset class for investors aiming for big capital gains. But, as Leinberger advises, they have the makings of a great buy for tax-sensitive investors.


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