It's not surprising that billions of rands are pouring into dividend income funds: they convert taxable interest into non-taxable dividends. But why do asset managers clam up when asked to explain the specifics of how their funds do this? And is the taxman prepared to continue to forgo the revenue?
Dividend income funds, which were launched in South Africa in July 2002, have been under the beady eye of the tax authorities for the past two years. They are now attracting even greater attention as investors' money pours into the funds' coffers, denying the taxman up to R2 billion a year.
The regulators and the taxman are increasingly concerned about the risks of dividend income funds and whether they enable investors to sidestep tax. An investigation is under way into dividend income funds, under the auspices of the National Treasury.
Dividend income funds, which fall in the domestic fixed-interest varied specialist sub-category, had attracted more than R51.3 billion by the end of the June 2009 reporting quarter.
In effect, some of the funds seem to convert taxable interest into non-taxable dividend income, using some very opaque structures that involve the creation of preference shares.
Preference shares can be listed or unlisted shares, issued by companies, that pay a fixed dividend rather than a variable dividend, which may not be declared, based on the profits of a company. The payment of preference share dividends is normally given priority over the payment of any other dividend.
There are four dividend income funds in South Africa, and the Financial Services Board (FSB) has declined applications for licences for more funds. The reason is that the FSB requires a tax ruling from the South African Revenue Service (SARS) before it will register a fund, but SARS has discontinued the practice of issuing tax rulings.
In order of size by assets under management, the managers of the dividend income funds are: Prudential, with R23.2 billion; Absa Investments Unit Trusts, with R14.8 billion; Stanlib, with R7.9 billion; and Sanlam, with R5.7 billion.
Initially, dividend income funds were created mainly for wealthy individuals with a tax problem. But, with more than R51.3 billion sitting in these funds, it appears that corporates are using dividend income funds to park spare cash and avoid tax.
Apart from the tax issues, the FSB is concerned that the risk of dividend income funds is not easy to quantify, because, in the case of at least three funds, the source of the income that generates the dividend income is not always easy to identify.
Mike Galloway, the head of Stanlib Collective Investments, says Stanlib's experience has been that its dividend income fund initially invested primarily in listed ordinary shares that had a high dividend yield and in listed preference shares, with a small investment in money market instruments.
The funds produced an attractive income yield, but their capital value fluctuated with the market price of the relevant shares on the JSE. This made dividend income funds less attractive to investors than money market unit trust funds.
Dividend income funds also faced the problem that preference shares listed on the JSE were scarce and not very liquid, while the pool of listed ordinary shares that paid high dividends was very small.
On the advice of various financial services companies, asset managers have apparently devised different ways to create the preference shares that make up their investment portfolios. Most of the structures that are used to provide a ready flow of preference shares are very opaque and complex.
John Kinsley, the chief operating officer of Prudential Portfolio Managers, which has the biggest dividend income fund as measured by assets under management, says the Prudential fund is different from the others, as "it does not make use of preference share structures at all. The underlying instruments are all money market instruments managed according to normal money market regulations. Hence the credit and capital risk is exactly the same as that of our existing Prudential Money Market Fund.
"We use the cash flow from the underlying instruments to buy ordinary equity dividends on a weekly basis. These dividends are then distributed to investors on a monthly basis, being the cash flow from the fund."
And what is more, he says, the structure used by Prudential has been approved by SARS. (SARS, however, says that it does not endorse products.)
The "created" preference shares used by the other asset managers, and which now dominate the underlying investments in most dividend income funds, are unlisted.
In terms of the Collective Investment Schemes Control Act (Cisca) and its subordinate regulations, non-equity funds may hold only listed securities or non-listed securities that have been rated by approved credit rating agencies. In terms of Cisca, there are limits on what a collective investment scheme may hold in "non-equity securities". These limits are in turn based on the specific issuer and the risk ratings attributed to the securities.
The unit trust management companies say all the structures involved have been disclosed fully to the tax authorities, the National Treasury, the FSB and the industry association, the Association for Savings & Investment South Africa. But the National Treasury, SARS and the FSB have told Personal Finance that they are concerned about dividend income funds from both a tax and a regulatory point of view.
And when it comes to public disclosure, an iron curtain slams down on how the dividend flow is actually created in the preference share structures. All that the fund managers are prepared to disclose is that they invest in preference shares, which pay dividends, issued by what are called special purpose vehicle (SPV) companies. They will not disclose how these companies actually generate their income.
Kinsley says the information on how the tax issue is dealt with is "proprietary".
Martin Rabe, the middle office executive at Stanlib, says bluntly that where the income actually comes from in its highly complex structure, designed by Australian-based investment bank Macquarie, is intellectual property to which not even the fund managers are entitled.
Stanlib says it has obtained independent advice that indicates there is no tax risk.
That there are risks is borne out by the National Treasury-led investigation, particularly into the funds that "create" the preference shares in co-operation with others.
It is interesting that Marriott, the Old Mutual subsidiary that sells itself as being the best at offering unit trust funds structured to provide an income, does not have a dividend income fund.
Chief executive Simon Pearse says Marriott has never contemplated launching a dividend income fund, because it is difficult to ascertain all the risks that would be passed on to investors.
Mike Ronald, the head of investments at Marriott, has looked long and hard at the complex and opaque structures used to "create" preference shares. He says a typical dividend income fund may consist of a number of structures, and it would be managed both by a unit trust fund manager and a structured finance manager.
The entire scheme would comprise four parts:
- The unit trust fund in which you invest;
- An intermediary set of companies in which the fund invests through preference shares;
- An underlying SPV into which the intermediary companies invest and that provides dividend income, which is paid to the dividend income fund; and
- An arrangement of agreements held by a company and collateral managed by the company that gives capital security to the scheme as a whole, as well as providing the ultimate source of income.
Ronald says the core portfolio of the dividend income fund would consist of unlisted preference shares that are rated by a credit rating agency and issued by special purpose vehicles (SPVPrefs).
A spread of SPVPrefs would be used to satisfy the requirements of Cisca.
"The SPVPrefs own preference shares issued by an underlying investment vehicle, say Investbox, whose assets may or may not be on the balance sheet of a financial institution (Fininst) but which would be managed by Fininst.
"Protecting the capital values of the preference shares issued is a set of call and put options held by an SPV company (Comp-secure), which would be managed by Fininst. Collateral as security for the scheme would be held by Fininst."
In practice how all this works is that you buy units from your selected fund manager. Your money is used to purchase preference shares from the intermediary SPVPrefs. The SPVPrefs then purchase preference shares in the Investbox.
The underlying funds then received by the Investbox would be held by the Fininst as collateral outside of the entity as deposits held with major banking institutions.
It now gets more complex, as derivative instruments enter the structure.
What are called pledged call options over the preference shares are issued by both the Investbox and the SPVPrefs that are held by the Compsecure. Pledged put options are written on the collateral and held by the SPVPrefs and the CISPref. The effect of the combined put and call options is to neutralise any gain in value of the scheme or loss sustained by the collapse of the SPVPref, the Investbox or the CISPref.
Income earned from the investments held by the Investbox is paid by way of a preference dividend to the SPVPref, which would declare a dividend to the dividend income fund, CISPref.
Cash is held in the CISPref scheme to accommodate investors who make new investments or who cash in investments in the dividend income fund. Returns on the cash are used to defray the expenses of the CISPref scheme to minimise taxable income.
Ronald says he has a number of concerns about these structures. They include:
The existence of, and the content of, the SPV that issues the preference shares (Investbox) is not ordinarily disclosed to investors. Hence the investor (and sometimes even the manager of the collective investment scheme) is unable to assess the level of risk within the scheme and the possibility that the options would need to be used. "This contradicts the transparency that has historically been considered a benefit of collective investments," Ronald says.
Ronald says although a series of intermediary companies is used to provide ostensible diversification in investments, ultimately the dividend income fund and you, the investor, are exposed to one vehicle managed by one issuer. He says this contradicts the requirements in terms of Cisca to provide investors with diversification by not exposing the portfolio to one issuer or one company.
The scheme is complex and its capital stability relies on tailored hedge contracts. Should the scheme suddenly come under stress, the mechanisms in place may not be able to operate fast enough for the turnaround times expected within a collective investment scheme. These mechanisms are unique to each scheme and have yet to be tested.
Ronald says there is a danger that collateral provided as security may be considered to be assets of the financial institution that manages the background investments, not those of the scheme. The reason is that the collateral is not controlled by the trustees of the dividend income fund.
The fund also does not benefit from the income derived from the collateral.
The collective investment scheme may suffer loss should a curator of a failed scheme claim the collateral for the ordinary creditors of the scheme.
Ronald says a scheme that converts taxable interest income into tax-free preference share income must, at some stage, be questioned by either SARS or the National Treasury, as tax is being avoided.
When action is taken, there is a risk to investors that, at best, the cash will be returned to them or, at worst, that the scheme will be liquidated suddenly, with unforeseen costs not covered by the hedge agreements that the investors would have to bear.
This article was first published in Personal Finance magazine, 4th Quarter 2009. See what's in our latest issue