Investigation into Dividend Income Funds by the FSB

The Financial Services Board (FSB) has announced that it is currently conducting an investigation into Dividend Income unit trust funds. These funds are under review as some of them use opaque structures to convert taxable interest income into tax-free dividends. Pending the outcome of the FSB investigation, some funds may be closed.

The FSB is concerned that some of the underlying holdings of dividend income funds may have undisclosed risk and tax issues.

According to a briefing from Stanlib, the use and application of Dividend Income type investment products in South Africa has increased tremendously over the past five years to over R80 billion in assets under management.

The FSB, in the recently issued CISCA Circular No. 11, has stated it will continue with the approval process for new applications for Dividend Income Funds, on the basis that these fully comply with the requirements of the Collective Investment Schemes Control Act (CISCA).

The investigation could affect certain of the underlying investments in such portfolios, and therefore have adverse tax consequences for certain of the instruments. The outcome could require amendments to existing legislation.

Most dividend income funds invest in rated unlisted preference shares, with the aim of consistent capital preservation.

According to Stanlib, the credit risk of these preference shares is therefore similar to the credit risk in most Money Market portfolios.

Some fund managers have written to us to explain that their dividend income funds are exempt from ongoing investigations on the grounds that their underlying holdings are a combination of preference shares and cash, and do not include ‘tax structuring, ‘SPV’ s’ or any other opaque instruments.

A note from PSG explains that preference shares are largely unknown and misunderstood financial instruments, plus they were miss sold when the first listings took place – many clients thought they were going into “secure” type investments, which is not the case, as preference shares are subject to market influences even if only at smaller movements. 

Preference shares are issued to raise capital and finance business development, and holders of preference shares rank before ordinary shareholders, but after ordinary creditors. 

There are many different types of prefs available (convertible vs. non-convertible, cumulative vs. non-cumulative, etc, etc) and the instruments should be seen as a long-term investment opportunity for clients seeking tax efficient income.  The current market capitalisation of preference shares is around R25 billion with 18 listed issuers. 

It is therefore clear that if the market cap of pref shares is R25 billion and the combined value of the Dividend Income Funds is R80 billion, other instruments and holdings must have been used to make up the balance in value.

Dividend Income Funds are attractive to income seekers who are fully invested in interest bearing instruments and have utilised their tax exemptions and are seeking some tax shelter on their returns.

The FSB has instructed fund managers to warn investors by February 28 of the possible dangers and to provide the FSB with an "exit strategy" for the closure of a fund.

At EFS we will monitor news by managers of these funds and alert investors accordingly.