Capital Gains Tax: Some questions answered.

Many unit trust investors, already smarting about the introduction of Capital Gains Tax are concerned that the base evaluation of their units will not be fair because of the recent fall in the markets. The timing for the introduction of Capital Gains Tax on unit trusts could not have come at a worse time.

Capital gains tax is a tax that is levied on the difference between the base or starting price of an investment and the price at which the investment is eventually sold. It stands to reason that the higher the base price, the less the tax, and that investors benefit if their investments are valued from a relatively high base cost.

Recent market turmoil has prompted SARS (South African Receiver of Revenue) to open the door to the possibility of different valuation methods of shares, as many investors may have shares in their portfolios that would be valued at less than their acquisition prices. Share traders have the option of using the original buy price to calculate their base costs, which also applies to unit trusts.

The situation is more complicated in the case of unit trust investors, where administration systems for the calculation of the base cost have been designed to use the last five trading days. According to Colin Woodin, Chief Executive Officer of the AUT, the onus is on the individual unit trust investor to decide on which method to use for evaluating the base cost.

"There are four different methods whereby unit trust investors can establish their base costs," he said. The base cost calculation on valuation date (1st October 2001) should be explained first. The base price is the average of the sell prices over the last five working days prior to 1 October 2001 (21, 25, 26, 27, 28 September 2001). This valuation date base cost price will be published in the Gazette and would apply to any of the first three methods of valuing the gain, i.e. weighted average, specific identification or first-in first-out.

"The first is the weighted average method. This method recalculates the base cost for every additional purchase of units on or after October 1st. The existing number of units is multiplied by the existing base cost of the units and the resultant value is added to the total cost(at buy price of the new units). The new value is the divided by the total number of units held after the purchase. When the units are sold the gain for that transaction would be the difference between the weighted average base cost at that time and the sell price multiplied by the number of units sold. Most unit trust investors will probably use this method, and unit trusts companies and linked product companies have designed their systems to calculate and report capital gains tax on this basis," he said.

"The second is the specific identification method. To calculate capital gains or losses, unit trust investors would select specific units, bought at a specific price on a particular day, as those they wish to sell. The capital gain or loss would be calculated on each transaction.

"The third is the "First in First out" method. This method assumes that when units are sold the gain is calculated by subtracting the base cost of the units bought first in a particular fund from the market value of the units sold, i.e. the units that were held for the longest time are sold first.

The time apportionment method gives the unit holder the opportunity to spread the gain over the entire period that the units were held and apportioning the gain over the periods prior to 1 October and post 1 October 2001.

A simple example of the time apportionment method is as follows:

A unit holder purchased R50,000.00 worth of units on 1 April 1993 and sells these units on 1 December 2001 for R160,000.00. The gain would be R110,000.00 (R160,000.00 less R50,000.00). The gain would be apportioned over the total number of year or part thereof in the proportion of the years held prior to 1 October 2001 and after 1 October 2001. The total period is 9 years of which 8 where prior to and 1 after 1 October 2001. Thus the taxable gain would be R110,000.00 X 1 / 9 = R12,222.22

Unfortunately, once a unit trust investor selects one method of valuation, all future transactions have to be consistent with this method for that particular unit trust fund account. The legislation specifically precludes a scenario whereby one method is used to calculate the base cost and another used for future valuation, as this could lead to anti-selection.

Woodin also clarified which fees and expenses could be included in the calculation of the base and sell costs.

"The base cost of unit trusts on valuation date will be calculated on the sell price, which excludes the initial fee and other expenses. This applies only to units held prior to 1 October 2001.

"All units bought subsequently will use have the buy price as their cost. When the asset is sold, the value of the unit trust will be based on the buy price, which will include the initial fee and the broker's fees," he said.

At Equinox we opposed to capital gains tax. We believe that the inflows or proceeds due to the SARS will be less than the cost of collection. In addition we are concerned that there is no benchmark against which capital gains should be applied. Capital gains are all very well in a low-inflationary environment, but in a scenario of high inflation, according to present legislation, it would be possible to pay capital gains on zero or negative real growth.