LIFE OFFICES ASSOCIATION

Proposed introduction of Capital Gains Tax (CGT): Draft Taxation Laws Amendment Bill, 2001

1. Introduction
1.1 Subsequent to the announcement by the Minister of Finance of the intention to introduce Capital Gains Tax (CGT), the LOA made written submissions to SARS in which industry specific issues were raised. Representatives of the LOA also had discussions with SARS and Ministry of Finance officials to highlight some of these issues. We believe that the draft legislation does not deal sufficiently, if at all, with the issues raised. Since the LOA did not receive any official feedback, we believe the LOA was denied the opportunity to debate these issues. The LOA remains uninformed of SARS’ response to its representations.

1.2 It is our view that the draft legislation in its current format has several unacceptable shortcomings that should be properly dealt with through a process of constructive debate.

2. The appropriateness of CGT in South Africa
2.1 As an industry, the LOA has questioned the reasons given for introducing such a tax in South Africa. We urge Government to facilitate a proper process of debate on the appropriateness of introducing such a complicated tax for our country at this stage of its development. However, in the meantime the LOA has decided to approach the issue in a positive manner to ensure that the tax, if introduced, contains appropriate and practical provisions. The comments set out below on the draft legislation should be considered in this context.

2.2 The LOA believes that too little time has been set aside to debate, formulate and implement this new tax in order to ensure a credible system without the double and even multiple taxation of gains included in the present draft legislation. As will be seen later on in this document, the long-term insurance industry must have systems ready on the date of implementation. This requires certainty on the exact basis for calculation of CGT – which in our view can only be achieved once complete legislation has been accepted by Parliament - well before the effective date.

The draft in question was released on 12 December 2000 with the requirement that comment be submitted on or before 10 January 2001. Clearly, this period falls in the middle of a peak holiday season when many of the individuals who would want to study and comment are not available. This creates the unfortunate impression that Government is not committed to the consultation process that is essential to the creation and implementation of a well-designed tax of such a complex and controversial nature. This impression is strengthened by the fact that, although the LOA made submissions to SARS, there was no process of constructive debate.

2.3 The draft legislation does not provide sufficient clarity on a number of significant issues to allow this industry to commence with the detailed design of accounting, policyholder administration and actuarial valuation systems. We are therefore convinced that it will not be possible for the industry to introduce CGT on 1 April 2001 in an orderly fashion. We recommend that the implementation date should be set at least six months after the date on which the necessary legislation is completed (including the necessary amendments to other sections of the Income Tax Act, i.e. section 29A and after proper consultation.) We estimate that this would result in an implementation date of 1 March 2002, at the earliest.

3. Specific issues for long-term insurance companies
3.1 Double taxation 3.1.1 The problem of double (or even multiple) taxation has been somewhat relieved by the fact that unit trusts will not pay CGT, that unit trust holders are taxed on their capital gains and by the fact that policyholder funds will pay CGT in the case of long-term assurers, while the policyholders themselves will then not be taxed on their policy gains. If similar arrangements are not made for investors in the shares of Investment Trusts and Private Equity Funds, it would be blatantly unfair and may lead to the demise of such investment vehicles which we believe have an important role to play in gathering funds for investment.

To a slightly lesser degree the same applies to investors investing in the shares of long-term insurers, short-term insurers, banks and any other financial institutions. Their capital holdings can be compared to that of an investment trust. The largest component of the market capitalisation of most life offices is represented by the net asset value of their capital (or the corporate fund), which is directly comparable to the assets of e.g. an investment trust. The next three paragraphs explain this further.

3.1.2 Sound financial discipline and regulatory prescriptions require a minimum capital base for financial institutions. The level of this capital not only serves as security for such institution’s depositors/policyholders, but also for growing its business.

3.1.3 Traditionally the capital is invested in equities, bonds and property and any growth in this capital will be subject to either a realised or an unrealised CGT liability if the proposed taxation is accepted. Given the fact that the market capitalisation of such an institution is largely represented by the underlying capital, it could lead to an enormous double taxation effect, and could make investments in financial institutions with large capital bases unattractive if the institutions have to pay tax on such gains while their shareholders will again pay tax on the consequent gain in the share price. This, in turn, could lead to capital reductions. In our opinion it could have serious consequences for the financial markets should tax considerations lead to such steps. This fact is exacerbated by the further layer of CGT if nothing is done in respect of investment holding subsidiaries (see 3.2).

3.1.4 The LOA has made recommendations to SARS in this regard and would like to take part in further discussions to ensure that CGT does not negatively impact on financial institutions.

3.2 Intermediate investment holding subsidiaries
3.2.1 The explanatory memorandum to the draft legislation acknowledges the negative impact of group company structures and inter-group transactions. In the case of long-term insurance companies, where investment holding subsidiaries (holding investments in respect of policyholder funds) will pay CGT at normal company rates and not at the rates applicable to the different policyholder funds, CGT will be a big deterrent for the continued holding of policyholder assets through separate investment holding subsidiaries as well as for joint ventures and special purpose vehicles which have been used for empowerment transactions in the recent past. Not only will CGT be charged at the incorrect rates, but it may be taxed twice – in the subsidiary and by the policyholder fund holding the shares in the subsidiary.

3.2.2 Without allowing for some basis of relief, the interim exemption of the untaxed policyholder fund of long-term insurers could effectively be nullified in so far as untaxed policyholder funds hold assets via investment holding companies. An indirect tax liability for such fund would arise to the extent that part of its assets are held within a separate entity.

3.2.3 Given that SARS has indicated a desire to investigate this further, we would welcome the opportunity to take part in any initiative to address this anomaly. In submissions to SARS we suggested either a "see-through"-approach or a proper "credit system" for CGT paid by these subsidiaries. It seems to us that it would be appropriate to adopt an approach similar to that applied to controlled foreign entities for companies that are accepted as intermediate investment companies by the Financial Services Board. In this way, if an intermediate investment company were owned partly by each of the policyholder funds, an appropriate portion of the entity’s gains would be attributed to each policyholder fund where it would be taxed at appropriate rates.

3.2.4 The need to investigate these proposals further justifies a deferral of the implementation date.

3.3 Modifications to Section 29A of the Income Tax Act
Due to time constraints we are not in a position to supply you with detailed comments on the wording of the legislation, but our initial views are that some of the definitions and the wording of section 43 will need further attention. Also, the current draft legislation does not contain any proposed amendment or reference to section 29A. We are of the opinion that important issues have not been attended to, i.e.
3.3.1 revision of the weighting factors in the expense ratio formula in section 29A(11)(a). This formula is intended to deny deductions for expenses where they relate to assets that are likely to produce investment income in a non-taxable form. If capital gains become taxable it is clear that adjustments are required to this formula.

3.3.2 The treatment of "sales" between funds and the establishment of base costs in the transferee funds has not been dealt with;

3.3.3 The treatment of compulsory transfers between different tax funds must be dealt with;

3.3.4 The status of provisions for CGT on unrealised gains in the policyholder funds must be dealt with. Generally accepted accounting practice requires that a provision is raised for CGT on unrealised gains. For accounting purposes, each policyholder fund would raise its own provision. These provisions should be recognised as falling within the term "value of liabilities" as defined in section 29A(1).

3.4 Implementation of CGT proposals
3.4.1 It is important to bear in mind that a life office is contractually required to calculate correct "unit prices", often on a daily basis, to ensure that each policyholder or policyholders of a specific class are treated fairly. For example, linked policies, participating policies and policies with benefits based on marked related performance all require an internal unit pricing mechanism. Since policyholders make contributions and receive benefits throughout a year, long-term insurers’ systems will have to be ready on the effective date in order to implement CGT. (SARS mentioned in the media that they would have one year of grace to get their systems changed. Unfortunately no periods of grace is currently allowed for the industries affected.)

3.4.2 Given the inherent complexities of CGT and the lack of certainty on unresolved issues, the long-term insurance industry will not be ready to implement the CGT proposals on 1 April 2001.

3.4.3 The impact of CGT on systems (and investment management and valuation systems in particular) is enormous and due to a lack of information, no work has yet been done that we know of. Some assurers also pool assets in so-called unitised portfolios (one portfolio of assets for the different tax funds - similar, conceptually but not in form, to the basis on which unit trust funds operate). Compliance with the legislation will require a lot of adjustments to existing systems, and could result, in certain situations, in a complete revisit of existing administrative procedures and processes.

3.4.4 It is also worth mentioning that the changes to tax legislation over the past few years have placed an enormous burden on the administration systems within asset management businesses and CGT would add to this burden.

3.4.5 These administrative difficulties require a delay in the implementation date to ensure proper understanding of the requirements of the legislation and allow for testing of amended systems to be able to comply on the effective date.

3.5 Second-hand policies
3.5.1 The LOA has made a comprehensive proposal on this issue in its written submission and has not been informed of the reasons for limiting the exemption for insurance payouts to the original beneficial owner.

3.5.2 Currently, in line with the trustee principle, no distinction is made within the assurance company with regards to the nature of ownership other than for purpose of classifying it for tax purposes in a particular fund. Therefore, the proceeds on the underlying assets of all policies of a similar class are taxed on the same basis and any deviation from these principles will lead to further double taxation.

3.5.3 We are very concerned with regards to the economic consequences for the industry as a whole should the legislation be accepted in its current format. We are concerned that subjecting second hand policy proceeds to CGT will cause significant withdrawals from the long-term insurance industry. We would therefore like to address SARS’ concerns in such a manner that this block of savings is retained within the insurance industry.

3.6 Annual exclusion for natural persons
3.6.1 The draft legislation has increased the annual exclusion of a natural person’s aggregate capital gain or loss to R10 000, which is substantially more than the R1000 initially proposed and is in addition to the existing annual interest exemption of R3 000 for individuals. We welcome the increased exclusion but believe that the impact of this relief to individuals should also be given effect to in the Individual Policyholder Funds of long-term insurers.

3.6.2 SARS has accepted the trustee principle for taxing long-term insurance companies and to ensure that this principle is given effect to equitably, some comparable relief should be given to the Individual Policyholder Fund (IPF) of a long-term insurer. This could be achieved either by making only 20% of gains subject to CGT or by reducing the IPF tax rate from 30% to 25%.

3.7 Removal of subjective rules
We thought that together with the introduction of CGT, the Income Tax Act would have been amended to give more certainty with regards to the nature of certain profits. We understood that Section 9B would be broadened to encompass assets other than shares listed on the JSE and that the time period would be reduced to three years. We believe that such changes are necessary and should be implemented at the same time as CGT, if CGT is implemented.

4. Retirement Industry implications
We appreciate the decision to defer introducing CGT on retirement funds to allow time to further investigate the taxation of the retirement industry. We look forward to assisting SARS in its investigation. It is clearly very important that a team be brought together with clear instructions and reporting deadlines.

However, except for the issues raised in this letter, certain changes to the draft legislation are necessary to make it clear that retirement funds are exempt for the interim and also to prevent any additional compliance by these funds. We therefore recommend further debate with the LOA and the Institute of Retirement Funds to ensure that the legislation addresses all concerns.

From the aforementioned summary it is clear to us that not enough time has been set aside to address important issues and for implementation of the final decisions as far as life offices are concerned.

The LOA is committed to continuing discussions with SARS to address the issues raised in this submission to ensure complete and comprehensive legislation, accepted by Parliament, by the time CGT becomes effective. In our opinion this could only be attained if the implementation of CGT is postponed until 1 March 2002, at the earliest.

10 January 2001

Appendix:
LIFE OFFICES' ASSOCIATION
SYSTEMS CONCERNS WITH THE INTRODUCTION OF CAPITAL GAINS TAX

Introduction
We wish to express concern over the timing of the implementation of CGT. The purpose of this document is to provide our considered estimate of the impact and timing the proposed CGT might have on systems and processes. However, due to the unique circumstances of each Life Office, Asset Manager and related administration support service, as well as time constraints, it is difficult to generalise the issue of implementation and the specific difficulties each of the role-players might experience.

A fundamental requirement for any change to a system and process₁ is absolute certainty as to exactly what it entails. Add to that the high cost associated with amending existing systems and processes and everybody will wait until complete and comprehensive details are available - the proverbial phrase of "the devil lies in the detail", is appropriate under these circumstances. Our expectation was therefore always that affected parties would have a reasonable period of time to respond and implement from the date the final legislation is published.

A variety of systems would require consequential amendments which might involve other software suppliers. This contributes to the complexity of the task at hand. The availability of software suppliers for enhancements has become an issue at this late stage and will depend on final legislation and specifications.

The unique nature of our business requires that we are ready and fully operational on the date the legislation becomes effective. It is our respectful opinion that it is impractical at this stage to assume that affected parties and especially Life Offices, would be able to meet the target date of 1 April 2001.

What has been done to date?
It is important to remember that the only information available until 12 December 2000 was the Guide on Capital Gains Tax that was issued when CGT was announced in February 2000. Although some time has gone into evaluating the overall impact CGT might have on systems and processes, the Guide was silent on a lot of important detailed information - information that is essential for the development of changes to systems and processes. In addition the LOA also raised important issues, that have not been resolved at this stage and which have added to the uncertainty. The initial indication was also that draft legislation might become available as early as September 2000. All of this has lead to an approach of wait until more information becomes available.

Inquiries made to the user group for one of the systems available in South Africa, revealed that some discussions on CGT took place as early as September 2000. Preliminary specifications, based on the Guide, were given to the software support supplier, but due to the nature of the detail required, further specifications were put on hold at that time, until clarity could be obtained on important outstanding issues. Therefore, uncertainty on numerous issues relating to the law as it stands and the size of financial commitment required in enhancing systems to cope with CGT as at 1 April 2001 made it difficult to commit before 100% CGT certainty.

The different adjustments that could be required to determine or adjust "base cost" - a fundamental requirement for determining a capital gain/loss, (as set out in paragraph 23), is a typical example of the detail required. More details only became known on 12 December 2000 and these differed immensely from the information in the Guide. Looking at all the responses to that specific paragraph, it is also not certain at this stage that it will be accepted in its current format. This is but one example.

General systems impact
A fundamental requirement of CGT for Life Offices is the ability to determine and report on the exact capital gains and losses from the date of implementation. Current systems do not cater for the tracking and storing of the detailed information required to determine the gain or loss and to process accordingly. The system development that will be required is extensive and far reaching. As mentioned some affected parties are in the process of interpreting the draft legislation, but in many instances this process cannot be completed until final legislation becomes available.

In order to provide some insight into the extensive system development that will be required, the key systems that will have to be amended as well as the level of effort is as follows:
Fund Administration Very high
Client Service High
Benefit Payments High
Quotes Medium
New Business Medium
Policy Documents Medium
Valuations Low

It is important to note that aspects of the project are dependent on Third Party providers of software to enhance their proprietary packages before releasing to their customers for testing. Although the core of CGT enhancements might be uniform across some users within the industry, each and every set-up is unique and will require its own enhancements. One can assume that these providers will be under pressure to meet the demands of multiple customers within a short space of time.

If you consider that a generic system development life cycle will require user requirements and user testing, then it is clear that if the requirements are incomplete at this stage, the likelihood of delivery for April 2001 is not possible. In addition to all system development, the operational support processes to handle related customer queries will also have to be created and implemented.

The typical breakdown of the system development process, could be set out as follows. However, we have to point out that the nature of amendments required, taking into account the complexities of the four fund tax dispensation, could put pressure on the time allocated to the different elements of the process.
Analysis and design 1 to 2 months
Construction 2 to 3 months
System Testing 1 month
User Testing 1 month
Implementation 1 month
Should sufficient time not be set aside, not only will resources be stretched, but undue risk might be put on other business and development processes. Based on this process, we are still at preliminary specification stage and cannot progress to the next stage until certainty has been obtained on the law.

Summary:
Given the nature of unresolved issues, we are of the opinion that the level of systems development change required to comply fully with the legislation, justify a postponement of the introduction of CGT to at least 8 months after the legislation has been promulgated by Parliament. Certainty and the availability of software suppliers will go a long way in determining the date when we could be fully operational. The uncertainty that still prevails makes it difficult to commit investment in systems.

Your appreciation of our position on this matter, will be much appreciated.

The Life Offices' Association of SA 30 January 2001