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## Capital Gains Tax, Inflation And Amnesia

Tuesday, 12 November 2013   (1 Comments)
Posted by: Author: Ben Strauss

Author: Ben Strauss (Cliffe Dekker Hofmeyr)

The South African capital gains tax (CGT) regime does not provide for indexation: it does not take into account the effect that inflation may have on capital profits over time.

Consider the following example: A company bought an asset on 1 January 2002 for R1 000. The company sold the asset on 1 January 2013. The inflation rate during that period was, for example, 6% compounded annually. The company realised a return of, for example, 10% compounded annually, that is, a return of 4% above inflation compounded annually. Accordingly, the company sold the asset for an amount of R2 853. The company realised a nominal profit of R1 853 (R2 853 – R1 000). But, taking into account the effect of inflation, the company achieved a real profit of R539 (R1 539 – R1 000).

The company distributed the nominal profit of R1 853 to its shareholders who are natural persons.

The total amount of tax payable effectively borne by the shareholders, the ultimate investors, is determined as follows:

Step 1 – Determine CGT in the hands of the company:

 Proceeds R 2 853 Base cost (R 1 000) Capital gain R 1 853 Apply inclusion rate (66,6%) R 1 243 Apply corporate tax rate (28%) R 346

The CGT amounts to R 346

Step 2 - Determine dividends tax in the hands of the shareholders:

 Profit before CGT R 1 853 CGT (R 346) Profit after CGT R 1 508 Apply dividends tax rate (15%) R 226

The dividends tax amounts to R226.

The total tax effectively borne by the shareholders amounts to R572 (R346 + R226).

As mentioned above, the real net profit after taking into account the effect of inflation is R539. In other words, in real terms, the shareholders are paying more to the taxman (R572) than they are actually realising on their investment (R539).

When CGT was introduced in 2001, the National Treasury considered the issue of whether or not CGT should provide for indexation, that is, take into account the effect of inflation.

In a document entitled "Briefing by the National Treasury's Tax Policy Chief Directorate to the Portfolio and Select Committees on Finance Wednesday, 24 January 2001" the National Treasury considered the issue in detail. Among other things, it made the following statements:

• "The combined benefits of the 'low inclusion rate' and deferring accrued capital gains until realisation should more than compensate for the effects of inflation in a moderate-inflation environment".
• "…[T]he potential impact of inflation was one of a number of considerations (though not the primary factor) that informed the decisions to have moderate (low) 'inclusion rates' of capital gains in taxable income, thereby partially adjusting for inflation".
• "Assuming a constant pre-tax real return, constant inflation and constant inclusion rate, the effective tax rate would fall over time. This suggests that inflation compensation arising from a constantly low inclusion rate would increase with time" (emphasis added).
The "low" inclusion rate was only one of the reasons why the National Treasury did not provide for indexation. Notably, "administrative complexity" was one of the motivations.

When CGT was introduced with effect from 1 October 2001, generally speaking, the inclusion rate was set at 25% for natural persons and at 50% for other persons. However, with effect from years of assessment starting on or after 1 March 2012, the inclusion rate was increased to 33,3% and 66,6%, respectively

In the Budget Speech of 22 February 2012 it was stated that the increase of the inclusion rate was necessary to "reduce the scope for tax arbitrage and broaden the tax base further". The 2012 Budget Tax Proposals stated (at page 3) that CGT: "was introduced in 2001 at relatively modest rates and has remained unchanged for the past 10 years. This reform has helped to ensure the integrity and progressive nature of the tax system. To enhance equity, effective capital gains tax rates will be increased." It appears that no substantive reasons were given for the change

At the time, most commentators were surprised by the increase in the inclusion rates but there was not much resistance against the increase at the time.

It would appear that the inclusion rate was increased simply to collect more tax. The increase certainly had nothing to do with "equity". As noted above, in fact, when CGT was introduced the National Treasury implied that the inclusion rate was set at a 'low' rate for reasons of equity: to compensate for the effects of inflation. Further, it said that the inflation compensation would increase over time as a result of a constantly low inclusion rate, suggesting that the compensation would only work over a long period of time if the inclusion rate was kept steady. (It is noted that the corporate tax rate at the time was 30% compared to the current rate of 28%, but this does not materially affect the principle.)

When the inclusion rates were increased in 2012, the National Treasury seems to have conveniently forgotten what it had said before about keeping the rates constant. The effect of the increase of the inclusion rate is of course exacerbated by the recent replacement of secondary tax on companies with the dividends tax and the increase of the rate from 10% to 15%.

It is manifestly apparent that the high rate of CGT combined with the dividends tax is eroding the real returns of investors, and is not encouraging taxpayers to invest and save. It is submitted that, to compensate for inflation, the National Treasury should at a minimum either reduce the CGT inclusion rates or provide for indexation.