Rich get off tax-free with offshore investment
25 June 2012
Posted by: SAIT Technical
By Bruce Cameron (Business Report)
Two principles of taxation are that it should be fair and that the wealthy should pay more tax than the less affluent, particularly the poor.
Everyone has the right to organise their finances in such a way as to reduce any tax commitment. For example, you can save money by investing in a retirement annuity fund, rather than directly in a unit trust fund, to gain tax advantages.
The question is how far you can go in organising your affairs to reduce your tax commitment.
Three terms are used to describe the structuring of your financial affairs to minimise tax. They are:
* Tax evasion, which is plain tax fraud;
* Tax avoidance, which is legal structuring to reduce your tax commitment; and
* Tax "evoision”. Although it is not a real word or a legal term, "evoision” has come to mean dubious or creative ways to avoid tax by finding loopholes in the Income Tax Act that are not meant to be used.
Recently, I was surprised by a media release from Old Mutual promoting an offshore investment product that Old Mutual claimed was free of tax.
That piqued my interest for two reasons:
* Two years ago, Old Mutual extensively advertised a savings product aimed at lower- to middle-income groups claiming it was tax-free”. When Personal Finance had a close look at the product, we found that it, in fact, was not tax-free. It was a life assurance endowment policy. In terms of current tax law, life assurers must annually pay tax on your behalf on endowment policies at an income tax rate of 30 percent on interest, net rental and foreign dividends; and capital gains tax at an effective rate of 10 percent on any profits made on the sale of underlying investments in a portfolio.
So taxable they were. In fact, for anyone on a marginal rate of less than 30 percent, Old Mutual was creating a tax liability the consumer probably would not have had if he or she had invested directly in a unit trust fund. And even people on a marginal rate of more than 30 percent would probably pay more tax, because the individual tax exemptions on interest and capital gains do not apply.
* Foreign investment using your once-off R4-million exchange control allowance is really only something for the wealthy. Most people simply do not have sufficient wealth to take money offshore because of the costs involved.
So here was something structured for the wealthy so that they could avoid paying tax on their offshore holdings. (See "How Old Mutual's tax-free product works”, below.)
Old Mutual has used a gap in insurance and tax law to advantage the wealthy, to the eventual disadvantage of the poor, which (along with other life companies) it already disadvantages with products that create needless tax consequences.
I am quite sure the legislature never intended that the reinsurance loophole used by Old Mutual should be used in this way. National Treasury says it is not aware of the structure.
The consequence of this tax-free structure for the rich is that everyone else has to pay more tax, while those people who can afford to pay tax are finding ways around paying their fair share via a company that should know better.
While this loophole may be legal at the moment, in my view it most definitely shows no indication of tax morality.
Incidentally, the structure was effectively banned in the United Kingdom some years ago by the imputation of a tax on the life assurance portfolio.
Seeing as these investments are for a minimum five years I would suggest that investors establish with Old Mutual what will happen if the South African tax authorities also impute a tax liability on Old Mutual Life Assurance Company South Africa and whether this tax obligation will be passed on to investors!
Old Mutual replies:
The tax structure used to allow wealthy clients to avoid tax is legal, says Old Mutual. Old Mutual's senior media consultant, Lisette Lombard, says: "I would like to reiterate that we designed the structure to provide our clients access to offshore assets while at the same time provide optimal policyholder protection and pricing efficiencies, all within the laws of South Africa and the Isle of Man. In order to achieve this we used a reinsurance structure which is often used with multinational insurance groups to bring similar risk and investment styles together in one place so that the group can manage the risk resulting in cost reduction and capital utilisation benefits; as well as leverage off the group's buying power with investment providers.”
How Old Mutual's tax-free product works
The Old Mutual's "tax-free” offshore product, which requires a minimum investment of £100 000, is complex. This, in simple terms, is how it works:
1. To invest in the product, you give Old Mutual money you have offshore or have transferred offshore using your once-off foreign investment allowance of R4 million.
2. You decide on the underlying investments, which must be foreign assets, such as shares listed on a foreign stock exchange.
3. Old Mutual sells you what is called a sinking fund policy in South Africa. This means that the investment may only be paid out after the end of the five-year investment term or at any time during the lifetime of this policy, which may last for up to 99 years. Normal South African endowment policies have a minimum investment term of five years or death, whichever occurs earlier.
4. The policy is issued by Old Mutual Life Assurance Company South Africa (Omlacsa), a wholly owned subsidiary of Old Mutual plc, which has its main listing on the London Stock Exchange and its group headquarters in London.
5. The policy, however, is issued through an Omlacsa branch on the Isle of Man (a branch that was established some years ago). The reason the Isle of Man is used is because the Old Mutual group has a substantial business presence there that it uses to reduce costs. The jurisdiction does not levy any tax on investment returns.
6. Your investment is immediately paid over to a reinsurance company called Royal Skandia Life Assurance Limited, Isle of Man, which is also owned by Old Mutual plc in London.
This is where it gets a bit complicated. When you invest money or buy a risk policy with a life assurance company, you are in effect buying a promise. The promise may be to pay out a certain amount if you die or are disabled or, with an investment, to give you a return linked to some asset or group of assets.
In the case of an investment, the life assurance company does not actually have to invest in the assets you nominate, but it normally does.
But because it does not actually have to invest in something, particularly when it sells you risk life assurance, it is placing itself at risk. As a result, the life assurance company will lay off (share) this risk with others. In effect, it is buying assurance for itself. This assurance is normally bought from a reinsurance company, in this case an Old Mutual plc reinsurance company.
In this case your full investment is the reinsurance premium, with the promise from Royal Skandia that it will pay Omlacsa an amount equal to the returns of your selected assets.
7. Your investment policy, even though you invested your foreign allowance, is issued by a South African life assurance company and is subject to South African tax law.
If you invest in an individual investment (endowment) policy in South Africa, the investment returns are normally subject to tax in the hands of the life assurer on an annual basis, as explained above.
8. When your policy matures, Omlacsa makes a "claim” against Royal Skandia, which has invested your money according to your selected investment choices. Royal Skandia pays the amount your investment earned less costs.
Reinsurance "claims” paid by a reinsurance company to a life assurance company are not subject to tax in the hands of the life assurance company that "bought” the reinsurance in terms of the Income Tax Act.
The reinsurance company – in this case Royal Skandia – is also not paying any tax on your investment returns, because it is based in a tax-friendly offshore jurisdiction.