Capital Gains Tax: hearings

Meeting report

FINANCE PORTFOLIO & SELECT COMMITTEE: JOINT MEETING
25 January 2001
DRAFT TAXATION LAWS AMENDMENT BILL: HEARINGS

Chairpersons: Ms B Hogan (Portfolio Committee); Ms D Mahlangu (Select Committee)

Documents handed out:
South African Chamber of Business submission
Afrikaanse Handelinstituut submission

SUMMARY
The South African Chamber of Business made it clear that they opposed the introduction of Capital Gains Tax but commended the exemption of retirement funds. They expressed concern at the lack of consultation regarding the desirability of this tax. They noted that there is a worldwide move away from Capital Gains Tax as the rate of this tax is being reduced in many countries. They argued that this tax has a low yield in terms of net revenue. They believe CGT is administratively complex. With regard to equity considerations, SACOB asserts that this tax will impact more heavily on those attempting to become wealthy as opposed to those who are already wealthy. As this tax becomes payable on the realisation of gains, people will be reluctant to realise their assets, thus resulting in a locking-in of capital. The 15% CGT rate, as opposed to the 12,5% Secondary Tax on Companies rate, will discourage entrepreneurship.

The Commissioner of the South African Revenue Service criticized SACOB’s presentation as being filled with innuendo that the government had been part of a "grand conspiracy" by failing to consult on this issue. This was an insult to the government who believed that the consultative process had been quite extensive.

Professor Rick Krever of Australia agreed that CGT is difficult to comprehend but said in the long term people can realize economic efficiency as a result of it. He commended South Africa for opening CGT for debate saying in most countries the CGT is just introduced without any discussion on it.

The Afrikaanse Handelinstituut said that although it supported the CGT, the government’s tax system was perceived as a political tool for redistribution purposes. It said it doubted the government’s capacity to administer this tax system and urged the government to postpone it. It asked the government to consider scrapping some of the capital tax systems, which made South Africa the only Commonwealth country with so many capital tax systems. Finally, the AHI proposed that the implementation date be extended to March 2002.

MINUTES
South African Chamber of Business (SACOB)
Advocate Meiring complimented the system of public hearings in dealing with issues of national importance. He stated that members of foreign parliaments, at a recent meeting including organised business, described the South African system of Portfolio Committees as serving as a model to which the rest of the world should strive. It is for this reason as well as the Committee’s role in building a democracy in South Africa that SACOB lends its support to the Portfolio Committees of Parliament.

He referred to the following recommendations made by SACOB previously to the Portfolio Committee on 2 March 2000:
1) That the Government appoint a subcommittee of the Katz Commission of Inquiry to investigate the pros and cons of the Capital Gains Tax for South Africa in a domestic and international context.
2) That the South African Revenue Service (SARS) do a full cost benefit analysis of the administrative and collection implications of the proposals currently on the table.
3) That, if Government were to implement Capital Gains Tax, the realisation of gains in approved retirement funds be exempt from this tax and that the current basis of taxing such funds be reassessed urgently.

Exemption of Retirement Funds
Mr Meiring commended the Committee on their stance taken in this regard in 2000. He stated that this stance undoubtedly influenced the National Treasury in their decision to exempt retirement funds from Capital Gains Tax (CGT) pending further investigation. It is important to send the right signals regarding personal savings, which low as it is in this country, is largely accounted for in the contractual savings in retirement funds.

Lack of proper consultation
The latest authoritative view on CGT for South Africa is the 1987 Margo Commission of Inquiry where the recommendation was against such a tax. One could not accept the unsubstantiated statements in the March 2000 SARS Guide as a substitute for the Commission of Inquiry findings. Although no work had been done by the Katz Commission since its Third Interim Report, it now transpires that there had been a group of "ten wise men" including Professor Thompson and other foreign experts who had been conducting further investigations on the matter. SACOB criticised the fact that no report had emerged from these investigations.

He referred to those advocating for the implementation of CGT as academics whose inputs are untested in the private sector. The paper published by the Treasury the previous day had been defensive in nature and had given them only 24 hours to consider their input. The public had not seen the detail of any investigation that may have been undertaken by SARS, nor have they had any feedback on submissions.

"International best practice"
A simplistic roll call of countries is useless in this regard unless one also has regard to the tax bases. In addition, although some countries may have some or other form of tax on capital gains, these could be restricted to certain assets only while rates could also vary from 5% to more than 50%. Within countries rules are also constantly changing. These factors therefore make it extremely difficult to determine what the international best practice is.

In addition, there is a trend away from CGT internationally:
The OPEC countries had been experiencing a move away from CGT
In Australia CGT has been adjusted from 100% to 50%
In African countries (for the period 1999-2000) the rate of CGT decreased in eleven countries and increased in only three countries.
In Asia nine countries experienced an decrease in the rate while five countries experienced an increase.
In the OPEC countries seven countries experienced a decrease while no countries experienced an increase.
In Europe seven countries experienced a decrease while four experienced an increase.
Adv Meiring however stressed that contrary to media reports it was not SACOB’s contention that CGT was being abolished worldwide. He concluded that though there was not much to emulate from CGT countries, there is a lot to learn from them.

He stated that the paper published by the Treasury on the previous day had been defensive in nature and had given members only 24 hours to consider their input.
He stated that they had not seen the detail of any investigation that may have been undertaken by SARS, nor had they any feedback on submissions. SACOB thus put the following issues on record:

Question: The Chair asked exactly what Adv Meiring meant by the assertion that countries were moving away from CGT. She referred to the fact that the rate was being reduced as the income tax rate was also being reduced in many countries. However this did not mean that there is a move away from income tax.

Adv Meiring replied that he was not just referring to countries experiencing a one to two percent decrease but to countries that had experienced decreases of up to 50%.
CGT has become a discredited tax, both as a revenue collection mechanism and as an economic instrument. Many countries would not introduce this tax if they had the luxury of tax redesign. However, removing CGT is extremely difficult once it has been entrenched - this is an important consideration to be taken into account.

Yield Efficiency
The Ministry of Finance has acknowledged that CGT is an inefficient generator of net revenue. The problem was that it could produce a negative yield once opportunity costs are factored in such as valuing and re-evaluating assets and fees of professional advisers. A cost benefit analysis should be conducted urgently.

Administrative Complexity
The administrative burden for SARS will include drafting complex legislation, systems changes, training staff and also dealing with avoidance and evasion. The complexity of administering CGT can be reduced by ignoring inflationary gain and the length of time for which assets were held. However, even such a simplified system would still be complex owing to the valuations and record keeping required.

This tax will be a heavy administrative burden in the winding up of deceased estates. The proposal that the deceased be treated as having disposed of all assets at market value will have serious consequences for estate administration and would impact more heavily on the ordinary middle class, small business owners and farmers.

SACOB has noted a vast improvement in administrative capacity at SARS over the past couple of years and believe that this momentum will be undermined by the introduction of this low yielding, administratively complex new tax.

Equity considerations
CGT is not a tax on wealth per se, but on the realisation of wealth. The wealthy can afford to have their wealth work for them without realising their gains, while the less wealthy are more likely to have to realise their assets in order to access their capital.
In addition, the person with an undiversified investment will be taxed if the investment succeeds, but get no tax benefits if it fails. Where the capital gain has been derived from savings which have been made out of taxed income, the taxpayer may perceive it to be unfair that they are taxed again. Thus CGT treats the less wealthy rather harshly as opposed to the wealthy.

The purpose of the 12,5% Secondary Tax on Companies (STC) had been to keep profits in the country and encourage people to build their companies by reinvesting their profits instead of paying out dividends. With CGT, the person who has built his business will now upon realisation have to pay a tax of 15%. Thus, he criticised the argument that CGT does not negatively affect entrepreneurs as weak.

In answer to Adv Meiring’s assertion that Professor Katz had presented his argument to the Committee as if he had been briefed to argue in favour of CGT, the Chair stated that she had given Katz no such brief and that Katz had been entitled to give his opinion. She warned Adv Meiring not to make such statements.

Locking-in effect
CGT is responsible for a locking-in effect as it is human nature not to realise assets that carry an inherent tax liability. This situation is undesirable because:
a) it affects the free flow of capital. The economy lose out while the fiscus does not gain anything;
b) it distorts equity shares and the property market as commercial decisions are distorted by tax considerations.

Effects on Entrepreneurship
In South Africa it is vital to encourage entrepreneurship as new and small business are the best generators of employment. This is only possible if the entrepeneur perceives the venture to be worth it in terms of capital gain. CGT has a negative effect on entrepeneuship and therefore on job creation.

Although tax is not the most important consideration for a potential foreign investor, the absence of CGT is seen as a distinct competitive advantage for entrepeneurs to set up business in this country.

Recommendations
SACOB recommends at the very least the exemption of CGT on small business growth and on the value of productive agricultural land by looking at international best practice.

It recommends that a sub-committee of the Katz Commission of Inquiry investigate the advantages and disadvantages of CGT for South Africa. The sub-committee should consider "international best practice" regarding CGT and if it is a widely accepted tax or a discredited tax.

The National Treasury should conduct a cost benefit analysis – focusing on yield efficiency in the light of administration, collection and opportunity costs.

As CGT clashes with government’s objectives of increased savings and direct investment in the economy, the Bill should be postponed at least until the publication and due consideration of a White Paper.

Discussion
Ms F B Marshoff (ANC) referred to SACOB’s view that the government further investigate CGT and asked what type of consultations they were recommending.

SACOB replied that it should be postponed at least until a White Paper had been published, following consultation. Government cannot simply come to the Committee to defend a viewpoint.

Ms Marshoff referred to the consultative process that has been taking place since March 2000. She wanted to know if that was not enough.

Adv Meiring responded that he had been part of this process, but that the process had merely been a consultation on a fait accompli and not on whether there should be a CGT or not.

The Chair argued that there have been extensive investigations and that government has to reach a decision at some point. It seemed to her as if SACOB were undermining the executive’s ability to make decisions. It surprised her that there was a lack of confidence that government had done its job. What was coming across was that business just did not want this tax to be introduced. She asked why SACOB felt this lack of confidence.

Adv Meiring responded that this had not been intended, as it was SACOB’s belief that what is good for the country is good for business. He referred to the consultative process and the input by the Treasury and the Margo and Katz Commissions and said that they had been impressed thus far, but wanted a detailed list of the pros and cons of CGT.

The Chair argued that the Katz Commission had already made such a list available after an extraordinary consultative process. She found it a cause for concern that business did not feel the same way.

Mr Martin Grote (National Treasury) clarified the "ten wise men" issue. They were a group of unbiased internationally acclaimed tax experts who in July 1999 had spent seven days discussing the issue and had subsequently presented government with a balanced view on the issue.

The Commissioner of SARS criticised Mr Meiring for the innuendoes which had implied that they had been part of a grand conspiracy by making decisions without consulting anyone. The Commissioner asked whether it was indeed SACOB’s view that they had been conspiring.

Without waiting for a reply, the Commissioner referred to the implication that that the ten wise men had decided the issue for the government and indicated that South Africans had to have confidence that the Minister would not give up his power to foreign experts. He found the innuendoes to be insulting.

Ms Fubbs (ANC) referred to the statement that CGT has a reputation for its low yield. She criticised the lack of evidence and asked how they had come to this conclusion.

Adv Meiring replied that even government has admitted to this. Further one had to take into account the cost of introducing and maintaining the system.

Ms.Fubbs observed that from her understanding it is those who have already accumulated wealth who will be most affected by the Bill.

Mr Kruger (SACOB) pointed out that although it will impact on these people, they will not be the only ones affected by the Bill as it will affect those wanting to accumulate wealth even more severely.

Dr G Koornhof (UDM) asked if the outcome of further enquiry is that CGT will be introduced, would SACOB support this. He also asked how many small businesses SACOB represents.

SACOB responded that they would not re-submit if further investigations show that CGT is good for South Africa. 80% of its members is small business. In addition, there is a move towards amalgamating with NAFCOC, its African counterpart. SACOB’s concern for small business has increased. While big business is able to voice its own concerns, small business needs SACOB to act on their behalf.

Mr M Lekgoro (ANC) asked if SARS rather than outsiders was not best suited to determine its own readiness to administer CGT.

Adv Meiring stated that he had no knowledge as to whether SARS is ready or not, but argued that SARS should not have to put up with the increased workload.

An ANC member asked what SACOB has done since the Minister’s announcement.

Adv Meiring replied that they had made several submissions. Mr Kruger added that although SACOB opposes the tax it does not mean that they just criticise it without providing suggestions. SACOB had a second document [attached to submission] which dealt with how they felt the Bill could be improved in order to assist the Committee.

The Chair stated that they had been unaware of such document, but thanked SACOB for its input in this regard.

Professor Rick Krever of Deakin University’s School of Law, Australia
Prof. Krever pointed out that his presentation is based on Capital Gains Tax in a developing country perspective. He posed the following questions:

Should we be guided by overseas examples or South Africa’s needs?
Prof. Krever said South Africa has to decide whether it is going to design its CGT system by looking at international models and lessons learnt from their successes and failures. Whatever the answer might be for South Africa, the fact is that it would come from South Africans themselves and not from overseas.

What are capital gains in South Africa?
It is important to understand that SA tax law is loosely based on English law. Prof Krever explained that in terms of our tax system a distinction needs to be made between capital gains and income gains. The capital can be likened to the tree and the income would be its fruit. The tree which is the income generator is currently not taxed but the fruit of such tree would be taxable. For example, rental from a warehouse where the property itself is not taxable but the rental income is. Due to this distinction many taxpayers tried to pass off income gains as capital gains so as to escape taxation. CGT would therefore prevent loopholes in our tax system.

We need to encourage economic growth.
History has shown that the most successful economic system is the free market economy. Prof Krever stressed the need for individuals to make business decisions based on market criteria and not on tax criteria. An individual’s decision to invest should not be affected by tax criteria. Not taxing capital gains would distort market forces as individuals would be making business decisions based on tax as opposed to market criteria. A country needs a good taxation system if it wants to allocate resources efficiently to its people.

The need to encourage riskier and more entrepreneurial investment
Prof Krever was convinced that taxing capital gains would encourage entrepeneurial investment. He stated that it would encourage risk taking because
- if both capital gains and income is taxed the same, individuals would make business decisions based on market criteria.
- CGT would also reduce the cost of capital as the tax base would be broadened
If CGT is in place and an individual makes a loss on an investment, he is in fact insured by government as SARS would offset his losses against his capital gains.
South Africa needs risk taking and entrepreneurial investment in order to confront the challenges of globalisation.

The need to encourage greater foreign portfolio and direct investment
Prof Krever distinguished between two types of capital investments:
Portfolio capital investment (foreigners investing in shares in SA companies)
Prof Krever was adamant that that the assertion that CGT would discourage foreigners from buying shares in SA companies is a misconception as CGT would not be applicable to portfolio capital.

Foreign direct investment (foreigners investing in capital assets in SA)
Rumours that CGT would discourage foreign direct investment are false as investors would be taxed on their capital gains in the country of investment or in their own countries. Either way, they would have to pay tax. Thus it is in SA’s interest to tax these foreigners, otherwise they would be forfeiting tax revenue to other countries.

Revenue yields – How much revenue
Prof Krever pointed out that much discussion had revolved around the administrative cost of CGT - that it would be greater than the revenue generated from it. He stated that revenue yields from CGT around the world were surprisingly high and that yields in Australia were ten times greater than expected. Prof Krever emphatically stated that the revenue yield from CGT would by far exceed its administrative cost.

Indexation
Indexation is difficult to administer. Prof Krever stated that the administrative burden of CGT would mainly fall on the ordinary person. He proposed the lessening of this burden by scrapping indexation. Prof Krever pointed out that even Australia had scrapped indexation in 1999. He felt that a better alternative would be to introduce incentives as the arguments for indexation do not hold much water.

In conclusion Prof. Krever stated that he is always baffled as to why paying of taxes is seen as being a burden. Rather, it should be seen as investing and contributing to the growth of one’s country.

Discussion
Ms Mahlangu (ANC) asked whether there are countries that no longer utilise CGT.

Prof Krever said the countries using the CGT system are mostly English speaking. He could not give specifics on which ones had abandoned it.

Mr K Andrew (DP) wanted clarity on preferential rates

Prof. Krever said if you want to make gains the tax should be neutral, there can be enormous gains if it’s like that. He added that some countries used the tapering system, that is, the longer you hold the asset there is a compensation for inflation. The government should determine how much tapering relief one should get.

An ANC MP asked what is the experience of insurance companies on the implementation of CGT?

Prof. Krever replied that insurance companies have two businesses: insurance and shares. It is only in South Africa that insurance companies can apply CGT.

Ms Joemat (ANC) asked if Australia’s system had pitfalls and could he mention any loopholes for South Africa.

Prof. Krever said the advantage of South Africa is that it has a progressive tax system and there is an equity aspect for CGT. CGT is great in this instance because it creates economic efficiency. Companies in South Africa are involved in lot of schemes that promote investment, South Africa shouldn’t face problems. The pressure will be that here in SA you have a lot of exemption for residence.

Dr DJ Rabie (NNP) noted that Prof Krever said that when CGT was introduced in 1985, initially it had a negative impact on small business. The main concern in SA is that we have much unemployment and we need to encourage small business.

Prof. Krever agreed that this was so at the initial stage, but added that in Australia most innovations have come from small businesses. Small business is an engine of growth for the economy and exports so there is no way that it can be left behind.

An ANC MP said the country has enormous disparities between the haves and the have-nots. What are the opportunity costs for this?

Prof. Krever responded that anytime you have tax differentials there are enormous costs. There is a loss of national income. But if you mitigate it everybody will be better off.

An ANC MP asked what was the position of formal business in Australia on CGT?

Prof. Krever replied that every business always want to maximise profits. They have been relatively indifferent, but lately they are fully supportive of the CGT.

Afrikaanse Handelinstituut (AHI)
Mr Boonzaaier said that the AHI believes that the tax system and tax reforms play an important part in making South Africa a winning nation. However, there is an increasing perception among South African taxpayers that the government’s main objective with tax reforms appears to be to use the tax system for political motives as a redistribution channel. One should not fall into the trap of attempting to rectify the inequalities of the past by placing too heavy a burden on a relatively small sector - economically active individuals who carry the largest part of the tax burden.

The AHI said that there was a perception that the SA law enforcement system is not effective with incidents of criminals escaping custody, police dockets disappearing, public prosecutors being dismissed for misconduct and a number of people escaping the tax net. Tax evasion must not be tolerated, and such misdemeanors should be widely publicised to serve as a warning to all.

The AHI said that it acknowledges the progress made to improve the administrative capacity of the South African Revenue Services (SARS), but as the Commissioner himself has acknowledged, there is still room for improvement. Hence the AHI felt very strongly that the introduction of the CGT should be postponed.

The AHI listed the arguments from the Katz Commission’s Report and the budget speech of 23 February 2000 for introducing the CGT:
- the absence of a CGT encourages taxpayers to convert otherwise taxable income into tax free capital gains;
- this has negative implications for the efficiency and overall equity of the tax system;
- the integrity of the personal and corporate tax system needs to be protected;
- a CGT is international best practice of our major trading partners; and
- a CGT makes the overall tax regime more efficient by limiting the benefit from transactions designed to convert income into capital.
The AHI, however, said that time will tell whether these results are achieved in South Africa.

By introducing the CGT, the AHI argued, South Africa will be the only Commonwealth country to have such a large number of capital type taxes, which are:
transfer duty, marketable securities tax, estate duty, donations tax, and now CGT.

The AHI urged the SARS and National Treasury to seriously consider scrapping some or all of these capital type taxes in lieu of a comprehensive CGT.

They have serious reservations about the introduction of the CGT now because:
- It is extremely difficult to judge the total impact CGT may have on a business from mere guidelines.
- The consultation period was too short with the release of the draft bill in mid December 2000 and the deadline on 10 January 2001. SARS has not had enough time to review comments it received and there is insufficient time for debate.
- It is not feasible to expect businesses to effect the required changes to computers and other administrative systems before 1 April 2001.
The AHI proposed that the implementation date be extended to 1 March 2002.

The AHI then proceeded to deal with some of the fundamental issues of the draft Bill:
- It cannot accept the arguments for not allowing for any form of inflation indexation;
- There is no logical reason to disregard interest expenses in determining the base cost of an asset for CGT purposes;
- The method for determining the tax rate is very harsh on taxpayers with a taxable income below the 42% marginal rate threshold and this exacerbates fiscal drag;
- There is no reason to treat closed investment companies differently to unit trusts for CGT purposes, especially in the light of South Africa’s dismal savings record;
- There is no justification for taxing a capital profit in respect of aircraft, boats, certain rights and interests and designated intangible assets, while disallowing any capital loss in respect of these assets; and
- There is no reason not to extend the same exemption from transfer duty afforded to a company or close corporation owning the primary residence of a taxpayer, to a trust, should the taxpayer wish to transfer this residence into his/her name.
- A major impediment to economic growth in SA is the lack of job creation. To this end heavy reliance has to be placed on entrepreneurs. To subject small business assets to CGT will negatively impact economic growth
- The exemption of R500 000 in respect of small business assets disposed of after age 55 is insignificant and should be extended to 50% of gain with a minimum of R500 000 and a maximum of R2,5m.

Ms Marshoff (ANC) commented that the AHI had said that it was not aware of tax evasion mechanisms within the current tax system. She pointed out that the current practice of characterising income as capital to avoid paying tax was a form of tax evasion. She said that the intention of CGT was to curb such tax evasion schemes.

The AHI concluded that they trusted that their comments will be viewed in a serious light to make SA not only a destination for foreign investment but a winning country for all its citizens. Mr Boonzaier noted that closed investment companies was an issue of vested importance to his organisation. Further the AHI commented that personal use assets which fall within the CGT system may be taxed on a capital gain but that losses on these assets would not be allowed as a deduction. This was
‘’inequitable’’ because if one wants to tax the profit then one must allow the loss.

Professor Keith Engel of the National Treasury said that personal use assets almost always sell at a loss therefore losses are not allowed to be deducted. Only the bigger assets sometimes sell at a profit therefore the gain on this is taxed. He noted that a capital loss cannot offset an ordinary gain. This would amount to a mismatch.

Mr Boonzaaier responded that in this particular instance a capital loss could also not set off a capital gain. This was the disparity.

Mr Andrew (DP) commented that if there is a market value for antique boats then why not apply that same principle to items such as Persian carpets which are quite expensive. If they were in the system - which inclusion rate would be used?

Professor Krever said that the value of boats and planes can go up but they can also decrease in value through use. When it decreases in value because of consumption then this amounts to a capital loss. He said that picking assets in this regard is a ‘’judgement call’’.

Mr Grote said that the National Treasury would look at this issue and respond to it.