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Offshore investment portfolios: discretionary vs tax efficient structures

Ruan Breed

We all know the saying ‘Give the Caesar what belongs to the Caesar.’ If you don’t you will pay the price.

Without a doubt, all of us would like to stay on the right side of the Caesar and his law as far as possible, otherwise, you will pay the (financial) price if you fail to do so.

What one would however like to achieve is to channel one’s portfolio so that there is as little as possible leakage to Caesar, especially with direct offshore investments.

What I have seen far too often come across my desk, is investors with direct offshore investment portfolios in simple discretionary structures, with no tax or succession planning mechanisms built into the structure.

This simply means that even though you might be invested in a well-diversified portfolio with an extremely successful track record of historical returns, you are most likely to end up giving a big percentage of these gains back unnecessarily to the Caesar.

Trusts have been the ‘go-to’ solution from a structural perspective for many wealthy SA families over the last couple of decades. However, the scenario has changed to a great extent over the last couple of years due to a couple of factors:

  • Certain tax benefits of trusts have been diminished by various changes in law and legislation.
  • ‘Globalization’ of families. Gone are the days when it is ‘traditional’ for a family of four to attend school, and university and then work in the same jurisdiction over their entire lifetime.
  • The ‘reach’ of SA trusts is limited to a large extent, especially with the focus on direct offshore investments. Offshore property portfolios, and direct shares in offshore companies just to name a few are all without reach for SA trusts.

Assuming the fact that trusts were used as the structure of choice by wealthy South Africans to accrue assets and wealth, capital gains are the issue at hand when any moves are considered within the trust.

Opting for any other option and making changes within the trust will trigger capital gains events, leading to tax problems.

Scenario:

A trust invested in JSE-listed companies in March 2022. R300 000 capital invested, split in an equal-weighted portfolio across Sasol, Nedbank, Shoprite) would have accrued to the value of R4m today. (Annualized return of 13%).

To get out of this investment and consider any alternatives with this capital, CGT of R1.33m would have been payable to the Caesar.

Using the conduit principle of SA trusts, income and capital gains can be transferred from the trust through to the beneficiaries and be taxed in a personal individual capacity as opposed to within the trust, which is far less favourable.

One must keep in mind that the primary objective of using the trust was to preserve and accumulate wealth over a long period of time for future generations, so by distributing all capital and earnings from the trust to the said individuals, proved to be the opposite outcome of what was initially set as the main objective of the trust.

A family trust’s primary objective is wealth accumulation – preserving the capital within the trust to build generational wealth where it is safely managed by the trustees and not exposed to the opinions of various individuals.

Furthermore, when these distributions are made from the trust to affluent individuals, it will simply increase their personal marginal tax rates and therefore most of the tax efficiency is foregone either way and now the capital has been externalized from the trust.

Now, this capital is also exposed to estate duty as opposed to where the capital was held within the trust. The Caesar is smiling all the way by now….

Alternative? The sinking fund

A SA trust could opt to invest the capital into a sinking fund. This structure is very similar to an endowment policy, with the exception that a sinking fund does not require life assured.

The investment therefore can live into perpetuity without the requirement for trustees and/or advisors having to appoint new life assureds. With an endowment, the policy is realized if the last life assured passes away.

The structure itself (sinking fund) is liable in its own right for the tax consequences of the investment, therefore the earnings are not taxed in the trust. Income is taxed at a flat rate of 30% and CGT at a mere 12%.

A trust’s income is taxed at a flat rate of 45% and the capital gains at 36%, as opposed to the sinking fund’s income being taxed at 30% and CGT at 12%.

Keeping in mind that the primary objective of trusts is to accumulate generational wealth (meaning it is normally large amounts of capital), this discrepancy between the two CGT rates of 45% and 12%, will make a HUGE impact on the net assets within the trust over the long term. We have seen this play out.

SA trusts are not able to make direct offshore investments, which is a big drawback for wealthier South African families and investors, especially considering that these families normally live and spend in global terms.

The sinking fund also addresses this issue in the sense that the capital can be up to 100% exposed to offshore markets. Although not in a direct offshore jurisdiction, the investor is able to get exposure to the biggest global names, such as the FAANG (Facebook (now Meta Platforms), Amazon, Apple, Netflix and Google (now Alphabet)) stocks, global indices, etc.

This also provides a very strong rand hedge for the capital within the trust, whereby the trust is not only exposed to offshore companies but also protected against the ever-weakening rand.

Given the way that the modern wealthy family lives and spends their money, this is a generational wealth-building mechanism that simply cannot be ignored!

If generational wealth building is the primary objective of your SA trust capital, this is a very important factor to consider.

Ruan Breed is a financial advisor at Brenthurst Wealth Stellenbosch and you can contact him here.

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