Amid the tide of reports of doom and gloom for the local economy, supported recently by Moody’s official downgrade of South Africa to “junk bond” status, financial planners are faced with the dilemma of what to do with their clients’ long-term investments and savings.
One option that deserves attention and could benefit investors handsomely, is to diversify their portfolios into global markets. Many South African investors are, however, hesitant to approach offshore investing and consider the process intimidating.
One can’t predict what the future holds, but what we know for certain is that investing in international markets remains an important diversification building block in all investors’ portfolios. The good news is that you, as an investor, are spoilt for choice in your search for investments uncorrelated to the local economy.
Direct offshore investing
The purest form of investing offshore is physically moving your money out of South Africa by converting Rands into a foreign currency and then investing in the foreign currency. This can be as simple as holding cash in an offshore bank account or investing in funds domiciled outside of SA. Ireland and Luxembourg are the two most commonly used jurisdictions for offshore funds to be registered.
There are fund managers based all over the world who manage a wide range of offshore registered funds across the risk spectrum – funds with a high exposure to growth assets (listed equity and property) as well as income assets (cash and bonds).
Once you have converted your Rands into a foreign currency, the basic investment principles remain unchanged. Finding the balance between time, risk (both your tolerance and appetite) and return remains vital to successful investing.
How much can I take offshore?
As a South African taxpayer, you can take up to R1 million out of South Africa every tax year without applying for a tax clearance certificate. You can take up to an additional R10 million out of our borders, but you will have to apply for tax clearance from both the South African Revenue Services (SARS) and Treasury for anything over R1 million per tax year.
Even though this money has left the country, as a South African taxpayer you are still liable for tax on income and dividends earned, as well as any realized capital gains.
Keeping it local
Many investors don’t realise that they can gain exposure to global markets without having to use the offshore allowances mentioned above.
For example, numerous companies listed on the Johannesburg Stock Exchange (JSE) have very little exposure to our domestic economy as they earn the bulk of their revenue outside of South Africa. These companies are commonly referred to as ‘rand hedges’ and regarded as SA investments.
Some of the larger, well-known companies are Naspers, British American Tobacco, Richemont, Anglo American and AB InBev.
In addition, the South African Rand denominated unit trust industry offers offshore exposure options without needing tax clearance. Global feeder fund unit trusts directly “feed” your investment via asset swap capacity into a fund that is domiciled outside of South Africa.
Unlike when you invest directly offshore and use your natural person foreign allowance, when investing with Rand denominated global feeder funds, you will be using the foreign allowance of the MANCO itself.
Various single and multi-asset class funds exist that invest directly in offshore equity, listed property and fixed income markets.
It is important to consider the impact of the exchange rate when investing in a global feeder fund. If the underlying fund is USD-denominated, the USD/ZAR exchange rate is added to the feeder fund price every day. This can cause the fund’s price to go up or fall by an additional amount equal to the day’s currency move.
Understanding the tax implications when you invest offshore
Interest earned on offshore and local investments is taxable at your marginal income tax rate and offshore and local dividends are taxed at 20%.
Capital gains tax, on the other hand, is tricky as the exchange rate plays a different role in the calculation when you invest directly offshore versus gaining offshore exposure through Rand based investment vehicles. When you disinvest, the difference between the proceeds and base cost will be subject to capital gains tax (CGT).
- When you invest offshore, the taxable capital gain is affected by the growth earned on your foreign currency investment and the exchange rate on the day you realise the gain.
- When you obtain offshore exposure through a Rand based investment vehicle, your taxable capital gain is affected by the growth earned on your Rand denominated investment, which includes the exchange rate at the start and end of your investment period.
Let’s look at an example of how currency movement can affect your CGT liability:
Joe decides to invest R1.5m and can invest either into a US dollar denominated foreign fund OR a Rand denominated feeder fund. At the time of investing the Rand was trading at R15 to the dollar. This means that Joe gets an exposure of $100k invested across global markets, either by asset swap through the feeder funds or via one’s direct offshore allowance.
A year later, the US dollar fund that Joe was invested in returned 20%. He decides to fully disinvest his current market value of $120k (assume no other purchases or withdrawals made prior to sale of units).
Assuming the Rand strengthens
At the time of disinvestment, the Rand has strengthened and is trading at R13 to the dollar.
If Joe had invested offshore via his foreign allowance, the $20k capital gain will be converted at the current exchange rate of R13, which translates into a taxable capital gain of R260k ($20k x 13).
As Joe had invested in a rand denominated feeder fund, the strength of the currency largely offset the growth of the US dollar fund and one year later he has a capital gain of only R60k ($120k x 13 = R1.56m – remember his initial investment was R1.5m).
Summary
In periods of Rand strength, it is more tax efficient to realise capital gains from a Rand denominated investment vehicle than an offshore investment.
Assuming the Rand weakens
Let’s redo this example assuming that the Rand weakens to R18/$ over one year due to a risk-off environment for emerging markets.
- The $20k capital gain in the US dollar fund translates to a R360k capital taxable gain ($20k x 18).
- The equivalent Rand amount in the Rand denominated feeder fund is R2.4mil ($120k x 18 = R2.16m (versus initial investment of R1.5m) and translates to a R660k taxable gain.
Summary
In times of Rand weakness, it is more tax efficient to realise capital gains from a foreign currency denominated offshore investment vehicle.