FEATURE: SA providers take stock of tax changes as RDR looms

South Africa’s National Treasury has published the draft Notice and Regulations required to allow the introduction of tax-free savings accounts in the country from March 1, 2015 under the Taxation Laws Amendment Bill (TLAB), 2014.

The draft Notice lists the service providers that may offer tax-free savings and investments and administer those accounts on behalf of retail savers/investors, while the draft Regulations specify the products that will qualify as “tax-free investments” to be included in tax-free savings accounts.

“The tax-free savings regulations per se are silent on structured products and it comes as no surprise given the dominance of unit trusts on the local scene here,” Ryan Sydow, head of retail distribution at Absa Capital, told SRP. “Worryingly, though, they do mention derivatives and that their use is limited.”

According to Sydow, a UK retail distribution review (RDR)-type regulation is on the country’s horizon, along with reforms in the retirement industry. “I think twinned with these initiatives it would be hard to not include structured products into the universe of allowable products,” he said. “As part of the Barclays group, [we are] well positioned on the structured products side of things given we’ve adopted the global retail distribution policy which was partly formed in response to RDR and the FSA review of structured products in the UK.”

New opportunities
The stated objective of the tax-free saving accounts is “to encourage individuals to save, which would reduce their financial vulnerability and reliance on debt when there are unexpected shocks to their normal income or sudden large expenditures”.

According to Andrew Wolfson, multi-asset solutions strategist at Ashburton Investments, the intention behind the new rules is to address the levels of debt in South Africa’s households and issues around boom/bust cycles. “At this stage this will have no impact in the domestic structured products market because banks will propose simple products such as single cash products,” he said. “However, there is scope for change and I believe this could evolve and open up the market for index solutions or medium-term investments with some capital protection and exposure to equity upside.”

Once approved, the TLAB will include a new section that will define a "tax-free investment" as a savings product, financial instrument or insurance policy that must comply with the regulations.

According to Sydow, the mention of derivatives on the draft and the requirement that these can only be used “for the purpose of reducing risk of loss or reducing cost (without any increase in risk of loss)” brings up questions around the use of structured products.

“Now it can be argued that purchasing a call option on the Top 40 Index is a more cost-effective way of gaining access than purchasing all 40 stocks in the requisite weightings and as such structured products would be allowable, but I’d prefer clarity from the Financial Services Board (FSB) and specific inclusion of structured products as an allowable product type in the guidance notes,” said Sydow. “The JSE has a manner/check list to identify these products and their 'DNA' so using the same list would make them easy to identify and leave issuers with no doubt as to what they were issuing was or was not a structured product.”

Sydow said that Absa Capital would agree to a guideline clarifying that structured products would be allowed “provided the risk to the saver/investor is no greater than if they had bought the underlying shares in the index directly”.

Suitability
On the suitability front, said Sydow, and taking into account the whole initiative is there to “encourage individuals to save, which would reduce their financial vulnerability”, an ideal product is one with explicit capital protection (or contingent capital protection) to allow savers to move from cash safe havens where real returns are negative to something that will indeed more often than not provide above inflation returns over five years or more.

“The term-based nature of structured products should not be confused with zero liquidity – the liquidity (and pricing) is daily. The fact that the capital protection only applies if held to term should be seen as a positive to ward off investors from knee jerk withdrawals/redemptions when markets fall – numerous studies prove that this is a primary destroyer of wealth,” he said. “In the worst case, banks will lend upwards of 80% to desperate investors who hold these products and need the cash to avoid them having to cash in products that might be out of the money.”

Under the new rules, products may not restrict when returns are paid or the level of returns paid to the individual, while products with performance fees will not qualify either as tax-free investments.

In a similar obligation to that imposed on collective investment schemes (CIS), products that expose an investor to an “excessive” level of market risk are excluded. Products must enable individuals to access their savings and investment within seven business days upon request.

The new TLAB guidelines also state that all returns from such products will be tax-free in the hands of the individual who owns them. An individual may contribute up to ZAR30,000 ($2,700) per year in tax-free savings and investments, with a lifetime contribution limit of ZAR500,000 ($44,775).

Taxation
In the current set-up, said Wolfson, callable structures are taxed as interest income and not as capital gains tax because they can be called early.

“So most people are staying away,” he said. “Retail investors are going to look for those products that offer a better return and provide some sort of tax certainty, such as government bonds as they have no fees, no complexity in their structure and favourable taxation.”

Wolfson also said that in time banks will issue two-in-one types of investments with one half paying some kind of fixed yield for a period of time and the other giving an equity-linked return with capital protection.

“We could see more types of structured (premium) deposits being provided where the client has potential for a defined return with a low risk of getting no yield,” he said. “Structured deposits may also get some traction over structured notes as many people might not want to pay for advice on a R30k ($2,700) investment.”

Complexity
The draft regulations also state that products that qualify as tax-free savings and investments should be “simple to understand, transparent in their disclosure and suitable for the majority of individuals making use of such savings and investment products”.

“Structured products speak very much to the key principles of being simple, transparent and suitable,” added Sydow. “To be clear, a structured product is no more than a combination of the zero coupon bond issued by the bank (which provides the capital protection element) and an option referencing an index (more often than not a call option to provide upside growth potential), packaged together into one neat single product. Structured products are by their very nature simple and transparent.”

According to Sydow, structured products providers will need to seek clarity on the point around derivatives and their use with packaged structured solutions. Wolfson in the meantime said the new rules will take time to get to final offering, and will evolve in time.

“If you take the UK, it started favouring only single fund managers,” he said. “The UK model took over 15 years to evolve to where it is today but we see it as a good move that may bring new opportunities in future.”

According to the new regulation, licensed banks, long-term insurance companies, managers of registered collective investment schemes, authorised users, linked investment service providers and the government will be able to offer tax-free savings accounts.

Click here to read the full TLAB draft.