Using a local endowment to invest offshore

by Laura du Preez         

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Investing directly in offshore unit trust funds denominated in a foreign currency has, at present, two distinct disadvantages over using rand-denominated foreign funds: you may incur tax that you would not pay on local investments and you create an offshore estate that may cause problems for your family after your death.

Life assurance or endowment policies issued by a South African life assurer with an offshore branch enable you to invest in foreign currency offshore unit trusts without these problems, local asset manager Marriott says.

Unit-linked offshore endowment policies have become popular, because they do not create an offshore estate and have enabled you to avoid the tax problems associated with investing offshore, although this advantage may become less of an issue in future if proposed tax law changes are approved. Currently, the tax advantage is that the local assurer is registered for tax in South Africa and can pay tax on your behalf if you invest in an endowment policy, Simon Pearse, the chief executive of Marriott, says.

Cobus Kruger, the head of product and investment at Glacier International, a division of Glacier in the Sanlam group, says local life assurers Sanlam, Old Mutual and Momentum are the biggest providers of offshore endowments from a foreign branch.

Momentum’s offshore policies are issued through RMB International from Guernsey.

Old Mutual’s offshore branch is in Guernsey but will soon relocate to the Isle of Man. It operates in South Africa under the name of Old Mutual International. Its policies enable you to access funds through offshore life assurance company Skandia International.

Glacier International offers offshore policies from its Bermuda office.

Kruger says other players include Discovery Life, Absa Life, Hollard, Investec Global and Sygnia.

Pearse says investors who use their R4-million offshore allowance to invest directly offshore typically invest in offshore unit trust funds that are registered with the Financial Services Board (FSB) in terms of the Collective Investment Schemes Control Act (Cisca) as funds that can be marketed to South Africans. These funds are domiciled offshore and are denominated in foreign currencies.

In order to be registered with the FSB, offshore funds must comply with Cisca and its regulations, and this requirement has to some extent limited the range of FSB-registered funds on offer to South African investors.

As an investor, you are free to invest in any offshore fund. But if you invest in an FSB-registered fund, you can take some comfort that the company with which you are investing is represented in South Africa and adheres to the same investment rules as do local funds. However, the local rules are out of step with those in other well-regulated parts of the world, particularly those for funds registered in European Union countries, and some funds registered there are unable to register here.

Local life assurers that offer offshore endowment policies can offer underlying investments in FSB-registered foreign-domiciled unit trust funds, as well as funds that are not registered with the FSB.

Kruger says life assurers are regulated by the Long Term Insurance Act rather than Cisca. Long-term insurers, as institutional investors, can create investment products. When it comes to international markets, this typically requires enhanced due diligence by the assurer, he says.

You must obtain clearance from the South African Revenue Service (SARS) before you may invest in any offshore funds directly (whether FSB-approved or not) or through an offshore endowment policy.

In the case of an offshore endowment policy, your investment is paid to the offshore office of the local life assurer in the relevant foreign currency and it is then invested in the underlying foreign unit trusts.

The big three providers of offshore endowments offer the funds from a range of companies and not only the funds of their associated asset managers.

Although the endowment policy may add a layer of costs, a big advantage is that you do not create an offshore estate. A second benefit of using these policies is their tax advantages, but this may become less of an issue with tax law amendments due to become effective next year.

Tax advantage

As a South African resident, you pay tax on the income you earn and the capital gains you make anywhere in the world. This means that you have to declare and pay tax on dividends earned from overseas shares and on interest income earned in an offshore fund. You also have to pay tax on any capital gains you have made on your investment when you cash it in.

Currently, dividends and interest are taxed differently, depending on whether it is of local or foreign origin. While dividends earned from local shares are tax-free and interest earned locally is exempt up to R22 800 a year (in the 2010/11 tax year), or R33 000 a year for investors over the age of 65, both foreign interest and dividends are taxable, and you can use only R3 700 of your annual interest exemption against your foreign dividends and interest.

If you invest in an offshore endowment policy offered by a local life assurer that is registered for tax in South Africa, the assurer pays tax on your behalf and the proceeds are tax-free in your hands.

Life assurers pay tax at 30 percent on all the foreign dividends and interest income in the policy. Any capital gains made in the policy are taxed at 7.5 percent.

This is a favourable rate if you have exhausted your annual interest exemption and your marginal tax rate is higher than 30 percent, because you would then be paying tax at a higher rate on the interest income earned and your capital gains tax (CGT) rate would be higher than 7.5 percent. Your CGT rate is a quarter of your marginal tax rate, because CGT is levied on only 25 percent of the taxable capital gain.

Legislation has been introduced to change secondary tax on companies, currently paid by local companies on dividends declared at a rate of 10 percent, into a dividends tax paid by shareholders (but withheld by companies from dividends paid) at the same rate. National Treasury expects that dividends tax will be effective from April next year.

In June this year, the treasury published draft legislation to introduce parity between the tax treatment of local and foreign dividends. The draft amendments propose that from next year only a quarter of your foreign dividends be included in your taxable income – so taxed at a maximum effective rate of 10 percent for those on the top marginal tax rate of 40 percent, but less for those on lower rates – and the R3 700 exemption will no longer apply.

A formula for companies, including life companies, has been proposed that will result in a similar effective tax rate (10 percent) for foreign dividends earned by companies or life assurers. If approved, the tax advantage on the dividends earned when using an endowment to invest in foreign funds will fall away, but the CGT advantage remains.

Investors in foreign funds who are liable for tax in the country in which their funds are registered will continue to be able to offset tax paid in that country against what is owed here where there are double taxation agreements between this country and the countries in which funds are domiciled.

Pearse says that to avoid tax on foreign dividends and interest, South Africans are often offered offshore roll-up funds, which do not declare any taxable income but use any interest earned to issue you with new units. However, these investments incur CGT when the units are realised.

He says SARS has some concerns about roll-up funds and may ask you to declare the income earned and the capital gains made. If you are unable to do so (because the fund was a roll-up one and does not report the income as income), the entire growth in the investment may be taxed as income, he says.

While offshore endowment policies offered by local life assurers registered for tax in South Africa have at least a five-year term, partial surrenders of the policy are allowed. These will incur CGT paid on your behalf by the assurer, Pearse says, and are limited by the Long Term Insurance Act to the original premium plus five percent a year during the initial five-year term of the policy.

Only one withdrawal or one loan is allowed against the policy in the first five years, Kruger says. Thereafter, withdrawals are unrestricted, but the policies may stipulate a minimum withdrawal amount.

No offshore estate

The second major advantage of using an offshore endowment policy is that it can overcome the problems that often arise after your death when you have an offshore estate. These problems occur because many overseas jurisdictions do not recognise your South African will, Pearse says.

In terms of probate, which is the legal process that takes place after you die, your will must be proved to be valid, your property must be identified and appraised, your outstanding debts and taxes must be paid, and your property must be distributed according to your will or state law, he says.

If your South African will is not recognised in an overseas jurisdiction, your heirs may have a problem with distributing your offshore investments.

Many South Africans with offshore investments go to the trouble of having an offshore will drawn up, but the consequence is that your estate will need an offshore executor - and that will make things far more complicated after your death, Pearse says.

Kruger says that in Guernsey and Jersey you cannot wind up an estate until you have followed certain procedures. You have to apply for probate using an advocate of the High Court, he says.

Both Kruger and Pearse say that offshore life wrappers from local assurers can be used to obviate the problems that otherwise arise with offshore assets, because the proceeds of the policy will be paid out to the beneficiary or beneficiaries you name in the policy or into your local estate.

Pearse says that, according to legal opinion obtained by Marriott, you can nominate an offshore beneficiary and have the policy proceeds paid to that beneficiary in a foreign currency.

Marriott's lawyers are of the view that, as long as you comply with South Africa's exchange control regulations when you take out a policy invested in foreign markets, you or your estate will not be obliged to repatriate the proceeds of the policy either when the policy matures or on your death. The proceeds can be paid in any currency or country and to any person agreed on by you and the life assurer, Pearse says.

Navin Ramparsad, the head of legal at Momentum Wealth, says that if you do not nominate a beneficiary, the policy proceeds will be paid into your estate and your estate will need a grant of probate.

He says this does not equate to the creation of an offshore estate. “It is simply a process in terms of which the South African executor appointment and process is validated by the offshore jurisdiction. Once the grant of probate is obtained, the proceeds are paid into the local estate,” he says.

Other benefits

Momentum points out that if you nominate a beneficiary, the proceeds of the policy will be paid directly to that beneficiary and your estate will avoid paying executor’s fees on the proceeds.

Kruger says another benefit of an offshore endowment policy is that it usually allows you to make cost-effective switches between the underlying unit trust funds – in effect, this is a similar benefit to the one you derive by using a linked-investment services provider. Providers appear to offer either all switches at no charge or four free switches a year. There may be minimum amounts that must be switched.

Another advantage is that you receive consolidated reports that will enable you to know the value of your offshore funds without having to check the individual fund statements, Kruger says.

Momentum says investors can choose the reporting currency for its offshore policies.

The assets in your policy will typically be held by an offshore custodian.

Kruger says that following the recent global financial crisis, most financial services companies are using custodians to hold their clients’ assets. In terms of Guernsey law, for example, a life company must hold 90 percent of its clients’ assets with an independent third party. Sanlam has decided to hold 100 percent of its assets with a custodian, he says.

Estate duty advantage

If you nominate a beneficiary and stipulate that the proceeds are to be paid outside of South Africa, the policy will not be classified as a domestic one for estate duty purposes and will therefore be excluded from your estate, Pearse says. This could save your heirs paying estate duty of 20 percent on the proceeds of the policy, he says.

In effect, Pearse says, the offshore policy achieves the benefits of an offshore trust without the cost of that structure.

But Kruger and Ramparsad disagree with Pearse, as do Tiny Carroll, Glacier’s estate planning expert, and Wayne Sorour, the head of sales for Old Mutual International.

Carroll says an endowment is property you own directly that should be included in your estate, because the Estate Duty Act defines property as any right in or to property, movable or immovable, corporeal or incorporeal (not composed of matter).

The Estate Duty Act distinguishes between a domestic and a foreign policy only in the case of deemed assets, Carroll says.

Deemed assets are those that you do not own directly but which can be included in your estate for estate duty purposes. Examples of deemed property are: the proceeds of certain domestic policies; property donated by the deceased that was exempt from donations tax; property controlled by the deceased before his or her death; and claims in terms of the Matrimonial Property Act.

In Old Mutual’s opinion the assets in the policy are property in your estate from day one and will therefore attract estate duty, Sorour says.

Ramparsad says that Momentum is also of the view that even if the proceeds are paid to an offshore resident, the policy is property in your estate.

If the proceeds of the policy are paid in South Africa, he says, the policy will be regarded as a domestic one. There is some debate over whether the endowment policy should be treated as property or deemed property, Ramparsad says.

What does it cost?

Remember that the offshore endowment policy will result in your paying fees in addition to those charged on the underlying funds.

You may have to pay an initial fee to the offshore branch of the local life assurer, to your financial adviser and on the underlying unit trust funds.

You will pay an annual fee to the life assurer, the asset manager, the trustee and the custodian.

You may have to pay an annual fee to your financial adviser.

Most unit trust companies no longer charge an initial fee. Their ongoing management fees are usually between one and three percent, and they may also charge a performance fee (all the fees quoted in this article exclude VAT).

Discovery Invest’s offshore endowment policy, for example, has an annual fee of 0.5 percent for the life assurer and between 0.35 and 0.5 percent for the trustee or custodian, depending on the size of your investment. Discovery gives its life policyholders an additional 10 percent allocation upfront, which it says offsets these fees.

Discovery Invest says the financial adviser fees can be up to four percent initial and 1.5 percent ongoing.

The offshore endowment policies issued by Glacier International have an ongoing administration fee that depends on the value of the policy. The financial adviser fees are up to three percent initial and one percent ongoing.

Momentum charges no initial administration fee but has an ongoing administration fee of one percent.

Financial advisers can charge an initial fee of between zero and four percent and an ongoing fee of up to 1.5 percent on Momentum policies, with the total financial adviser fee not exceeding 7.5 percent over the first five years of the policy term.

Old Mutual’s Life Account, the policy issued by Old Mutual International, has a tiered annual contract fee, with rates from 0.9 to 0.3 percent applying to the accumulated value of your underlying investments in bands. For example, the 0.9 percent rate applies to the amount up to £30 000 and the 0.55 percent to the amount between £30 000 and £100 000.

Old Mutual spreads the adviser’s initial fee over three years. A portion of the fee accumulates each month against your investment, and one percent of the three-percent fee is deducted each year for the first three years of the contract. This means that most of your initial investment is allocated to the underlying funds, and the amount allocated does not start off minus the initial fee, Sorour says.

However, if you withdraw funds from your policy, the outstanding initial fee will still be recouped, and different formulae are used to determine the applicable fees in these cases.

There may also be charges for switching the underlying funds. Old Mutual International and Momentum do not charge for any switches, while Glacier International and Discovery Invest do not charge for the first four switches (each of which allow multiple switches to rebalance your portfolio) in a year. After the first four switches, Discovery charges 0.25 percent of the switched amount.

After the first four switch forms, Glacier has the right to charge US$50, €50 or £50 per switch.

Investment choice

All the providers that personal finance canvassed have what is known as open architecture and offer not only their own funds but funds from other asset management houses as well.

Old Mutual International offers access to about 140 funds, including managed funds from Skandia Investment Group, funds chosen by Skandia on a best-of-breed basis and funds in a range selected by Old Mutual International including Ashburton, Jupiter, Blackrock, Investec, Coronation, HSBC and Templeton, Sorour says. There is only one Old Mutual fund, Old Mutual Japanese Select, he says.

The global equity fund on the Old Mutual International platform is a JP Morgan fund, while the European equity fund is an Invesco one, he says.

The fund list extends to funds that are not registered with the FSB for marketing in South Africa, but Sorour says that all the funds on Old Mutual International’s platform are traded daily and are liquid. There are no hedge funds in the offering.

Discovery Invest offers both FSB-registered and non-registered funds. Its list of funds extends to BlackRock, PNB Paribas, Deutsche Bank, Goldman Sachs, Franklin Templeton, Credit Suisse and Fidelity.

Momentum offers a choice of 1 380 funds from both local and offshore providers, FSB-registered and not, through RMB Investment Services. Of these 1 380 funds, six are RMB Investment Services funds.

The external fund managers on the RMB Investment Services platform include: Ashburton, Aurum, BNY Mellon, Investec, JP Morgan, Sarasin, Stenham, Aviva, Barclays, BJM, Blackrock, CAM, Castlestone, Coronation, Fidelity, Franklin Templeton, Goldman Sachs, Harmony and HSBC.

Sanlam’s Glacier International offers a choice of more than 300 underlying funds on its offshore endowment policy.

These funds include SIM’s Dublin-based funds, as well as funds – those that are FSB-registered and those that are not – from 30 other asset managers, including Ashburton, Alliance Bernstein, Aviva, BlackRock, Coronation, Franklin Templeton, Investec, JP Morgan, Nedgroup, Pimco, Pictet and Sarasin.

Glacier investors can also invest in a share portfolio through Pictet, a Swiss private bank.

Investment minimums

There may be minimum investment amounts, some of which are quite high. For example, Momentum’s minimum is US$25 000 or the equivalent in euros or pounds. Discovery Invest, as a newer entrant to the market, accepts more manageable minimums of R100 000, US$10 000, £7 500, €10 000 and ¥1 million.

Sanlam’s Glacier policies accept €25 000, US$25 000 or £25 000. Old Mutual’s minimums are £20 000, US$30 000 and €30 000.

Additional investments may also have to meet certain minimum amounts.

Foreign assurers

Don’t confuse offshore endowments from foreign branches of local assurers with those offered by foreign life assurers not registered with SARS for tax, as the taxation of these policies differs from that of offshore endowment policies offered by local assurers.

In fact, the taxation of policies issued by foreign assurers is something of a grey area. Last year, SARS issued an advance tax ruling stating that it would not tax the income or dividends earned within the policy but only the capital gains made when the policy matured. But Kruger says that this ruling has been withdrawn and that a new one will apparently be issued.

Harry Joffe, Discovery Life’s senior legal adviser, says he is aware that a tax practitioner has obtained an advance tax ruling from SARS that will overturn the one issued last year. In terms of this yet-to-be-published ruling, investors will have to declare the income and dividends earned within the policy each year and the capital gains will be taxed when the policy matures, he says.

Kruger says an advance tax ruling provides an insight into SARS's thinking, but it is not law, and tax law currently does not deal with offshore policies issued by foreign life assurers. His view is that SARS will ask you to prove what income and capital gains you have earned from your investment each tax year.

In addition, be wary of foreign assurers operating illegally without offices in South Africa and be aware that some local investors have had bad experiences with investments in endowment policies offered by offshore life assurers. For example, some investors who were exposed to certain funds via Skandia’s endowment policies in 2000 found themselves the victims of fraud when one of the underlying funds went belly-up.

Sorour says the fund in question was put on the platform at the request of clients, and it was accessed by investors on an execution-only mandate – that is, without due diligence by the life assurance company.

Funds available on the Skandia platform now have been subject to a due diligence, but the life assurer is not responsible for the performance of the fund.

This article was first published in the third-quarter 2011 edition of Personal Finance magazine.