WORDS ON WEALTH
After my column last week on using Treasury’s RSA Retail Savings Bonds to provide a retirement income, a reader emailed me asking whether there was capital gains tax (CGT) to pay on the capital gain in an inflation-linked bond, which is adjusted for inflation each year for the term of the bond. My subsequent investigations into tax payable put something of a dampener on using the inflation-linked bonds for this purpose.
I knew that interest-bearing investments do not attract CGT, but that you do pay income tax on interest earned. However, it was not clear to me what happened in this case, where you have a product on which you receive interest (4.5% a year on the 10-year bond), and in addition your capital increases by the inflation rate. If you didn’t pay CGT on the inflation-based gain, would SARS treat it as part of your interest earned?
Dale Cridlan, director at Norton Rose Fulbright Tax services, was very helpful in providing answers to these questions.
The answer to the first one, as I expected, was an unequivocal “no”. You do not pay CGT on a capital gain in an inflation-linked bond.
The answer to the second was “yes”: the gain is taxed as interest. Cridlan explains further: “An Inflation Linked RSA Retail Savings Bond is regarded as a ‘variable rate instrument’ for purposes of section 24J of the Income Tax Act. This means that any adjustments for inflation made to such bonds will be regarded as interest rather than capital gains in the bond holder’s hands. All interest earned on RSA Retail Savings Bonds will be subject to the provisions of the Income Tax Act that apply to interest. As a general rule, bond holders treat interest received as ordinary revenue for purposes of income tax. Bond holders who are natural persons may be entitled to the tax exemption of a portion of or all of the interest. The quantum of the tax exemption available will depend on the personal circumstances and age group of the bond holder.”
Let’s try an example, simplifying things slightly by assuming capital is adjusted for inflation once a year instead of twice, according to the terms of the bonds. Also, I distinguish between “living income”, which is the income in rands you receive from the bond on which to live, and “interest income”, which refers to all your interest including the inflation-related gain on your capital.
Say you are 65 years of age and have R5 million in a 10-year inflation-linked bond, currently offering 4.5%. In the first year you earn interest of 4.5% and your capital increases by inflation, at a rate of 5.5%. Your annual living income will be R225 000 and your capital will have increased by R275 000, totalling R500 000 in interest income. At age 65, you have an exemption of R34 500 (for under-65s the exemption is R23 800). So your taxable interest income before deductions, assuming no other sources of income, would be R465 500.
Compare this with the fixed-rate bond, which is offering 9.25% on the five-year product. Your interest in the first year (and each subsequent year) would be R462 500. With the exemption of R34 500, this would bring your annual taxable income, before deductions, to R428 000. However, because your living income is almost double what you’d receive on an inflation-linked bond, the proportion of it going to SARS would be a lot lower.
Assuming no deductions or credits (which is somewhat unrealistic, considering there are generous credits for pensioners on medical expenses), according to the 2022/23 income tax table, on an inflation-linked bond you would pay tax of R83 145, taking into account the primary and secondary rebates totalling R25 425. This would reduce your living income by 37%, from R225 000 to R141 855.
The fixed-rate bondholder would pay tax of R71 520 (after primary and secondary rebates) on his or her living income of R462 500, reducing it by 15%. But the buying power of the R5 million capital would decrease by 5.5%, or R275 000.
One thing I forgot to mention last week when comparing the fixed-rate and inflation-linked RSA Retail Savings Bonds was that on the fixed-rate bond you have the option to restart your bond after a year if the interest rate rises. This can be highly advantageous in a rising-interest-rate environment, such as we’re looking at for the next few years. If, for example, you take out a five-year bond, currently offering 9.25%, and after a year, with rising inflation and correlated rising interest rates, the bond rate rose to 10%, you can restart your bond for a fresh five-year term at the 10% rate.
PERSONAL FINANCE