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In recent years, offshore investments have gained traction due to factors like South Africa's weakening fiscal situation, stagnant local market growth, and the ease of investing internationally. Investors now have a plethora of options for offshore exposure through various products and platforms. This article explores the considerations and tax implications of investing via a unit trust feeder fund (asset swap) or directly into an offshore unit trust.
Direct Offshore Investing: The Basics
Direct offshore investing involves converting Rands into foreign currency and transferring funds to an offshore investment account in your name. This means your funds are physically moved out of South Africa. South African tax residents can invest up to R11 million annually offshore, including a Single Discretionary Allowance (SDA) of R1 million and a Foreign Investment Allowance (FIA) of R10 million. Tax clearance is required for the FIA but not for the SDA. It's crucial to stay within these limits to avoid penalties ranging from 20% to 40% for exceeding the allowance.
When to Consider Direct Offshore Investing
This option is ideal for those planning to use their capital abroad, such as for emigration, overseas education, or extended travel. It offers access to foreign currency and can help meet liabilities in other countries.
Tax Implications of Direct Offshore Investing
Disposing of offshore investments triggers a capital gains tax (CGT) event, with the gain calculated based on the sale value and the purchase's base cost. It's essential to calculate any potential CGT liability before selling assets to avoid unnecessary taxes. South African tax residents must declare their direct offshore investments and pay income tax on interest and dividends earned.
Indirect Offshore Investing: A Simpler Approach
Indirect offshore investing allows you to invest in foreign assets without converting your money into another currency. You can invest through a local LISP platform with a mandate to invest in foreign assets, using the platform's foreign exchange capacity for asset swap investments. There's no limit to how much you can invest indirectly, and it's a cost-effective and convenient option with lower barriers to entry.
When Indirect Offshore Investing Makes Sense
Indirect offshore investing is suitable for creating diversity in your investment portfolio without physically moving your money abroad. It's especially relevant for those invested in approved retirement funds, where offshore exposure is limited by Regulation 28 of the Pension Funds Act.
Tax Implications of Indirect Offshore Investing
Like direct offshore investing, you'll be taxed on the income earned from your investments. Disposing of units triggers a capital gain, so careful tax planning is necessary before making any decisions to realize part of your investment.
Performance Comparison: Let’s look at the numbers
When comparing the performance of World MSCI Index feeder fund in ZAR to that of a direct offshore investment fund in the World MSCI in USD, the performance between 2014-2024 was as follows:
When evaluating the performance of the feeder fund against a direct offshore investment fund over the past decade, it initially seems like the feeder fund has outperformed the direct offshore investment. However, this analysis doesn’t yet consider the impact of taxes and currency fluctuations.
Tax Illustration with Currency Fluctuations
If someone invested in a direct fund, they would have changed their South African Rand (ZAR) to US Dollars (USD) when they started investing in 2014. They would only pay capital gains tax (CGT) on the increase in value of their USD investment. For this type of investment, changes in the exchange rate over the investment period are not considered for tax. However, if someone invested in a feeder fund, gains from changes in the exchange rate are included when calculating CGT.
Let’s take a closer look by using an example investment of R1,000,000. We’ll use the average Rand/Dollar exchange rate for January 2014 (R10.84) and for January 2024 (R18.81).
After accounting for tax differences and the depreciation of the Rand, it becomes evident that the direct offshore investment ultimately outperforms the feeder fund. Despite the feeder fund’s seemingly better initial performance, the tax treatment and currency changes significantly impact the final outcome, highlighting the importance of considering these factors in investment decisions.
A feeder fund provides an avenue for global diversification, acts as a hedge against the depreciation of the rand, and offers a straightforward method for investors to incorporate an offshore component into their portfolio, requiring a lower initial investment compared to direct investments. However, it's important to note that feeder funds typically incur higher costs and may result in a more burdensome tax liability (especially if the currency weakens) compared to direct offshore funds. As always, it is imperative that investment strategies are tailored to the individual's specific needs and objectives. I strongly advise consulting with a qualified financial adviser to ensure that your investment strategy aligns with your financial goals.