Switching an offshore discretionary investment into an endowment wrapper can offer estate planning advantages, but the outcome depends heavily on the size of the embedded capital gain and the investor’s broader tax profile, according to a recent webinar presented by Allan Gray.
Guané Coetzer, manager: IFA proposition at Allan Gray, said investors often assume endowments are automatically more tax-efficient, particularly for individuals in higher tax brackets. However, transferring an existing investment into an endowment triggers an immediate capital gains tax (CGT) event.
“The real question isn’t whether an endowment is better,” Coetzer said. “The question is: at what level of capital gain does switching no longer make financial sense?”
Structural differences between the two vehicles
Coetzer compared two offshore investment structures using Allan Gray’s offshore discretionary investment platform and its offshore endowment policy as illustrative vehicles.
In a discretionary offshore investment, tax is paid in the hands of the investor at their marginal tax rate. For high-income investors, this can reach 45% on income, translating into an effective CGT rate of 18%.
At death, South African tax rules treat the investment as a deemed disposal, triggering CGT in the deceased estate. The asset forms part of the estate administration process, meaning the executor must give instructions on how the investment should be distributed. In the case of discretionary investments on Allan Gray’s offshore platform, the firm acts on the instructions of the South African executor, meaning probate is not required in the foreign jurisdiction of the underlying funds.
An offshore endowment, by contrast, is taxed within the product itself. Income is taxed at a flat rate of 30%, while capital gains are taxed at 12%.
Although the policy still forms part of the estate for estate duty purposes, nominated beneficiaries can receive the proceeds directly from the policy without executor involvement in the distribution process. Both structures remain subject to estate duty, although the spousal exemption means no estate duty applies where the surviving spouse inherits.
Where ownership of the policy transfers to a beneficiary rather than being paid out in cash, the CGT liability can be deferred until the policy is eventually surrendered or disposed of.
How the structures operate at death
Coetzer examined how the two structures operate when the investor dies, highlighting how executor involvement and CGT treatment can influence the outcome.
Under a discretionary investment, executor involvement is unavoidable because the asset forms part of the deceased estate. Beneficiaries may receive a cash payment, a transfer of the underlying investment, or a combination of the two.
If a surviving spouse receives the investment through a unit transfer, spousal rollover relief can apply, allowing the CGT liability to be deferred. However, executor’s fees would still apply because the asset must pass through the estate administration process.
An endowment allows the policyholder to nominate beneficiaries directly. The beneficiary may either receive the proceeds as cash or take ownership of the policy.
If the beneficiary elects to take ownership of the policy, no CGT is triggered at death, and the tax liability is deferred. If the benefit is paid out in cash, CGT is triggered within the product at the applicable endowment tax rate.
Non-spouse beneficiaries
The differences become more pronounced when the beneficiary is not a spouse, such as adult children.
In a discretionary structure, death triggers a deemed disposal, and CGT is calculated at the deceased’s marginal rate with no rollover relief. Estate duty and executor’s fees also apply.
In an endowment, ownership of the policy can transfer to the nominated beneficiary without triggering CGT at death, meaning the gain is deferred until the policy is eventually disposed of. Executor’s fees are avoided entirely, although estate duty still applies.
Illustrative modelling
To illustrate the trade-off, Coetzer presented a scenario based on an investor holding $100 000 on Allan Gray’s offshore discretionary investment platform.
The decision ultimately hinges on the trade-off between paying CGT immediately and potentially saving tax and executor’s costs later.
The modelling used the following assumptions:
- Embedded capital gain of approximately 97%.
- Investor taxed at the maximum marginal rate of 45%.
- Effective CGT rate of 18%.
- 20-year investment horizon.
- 7% annual return in US dollars.
- 2% annual rand depreciation.
- Executor fees of 3.5% plus VAT.
In the example, the CGT liability is assumed to be paid from the discretionary investment itself, permanently reducing the capital available for compounding.
If the investment were transferred into Allan Gray’s offshore endowment, the CGT triggered on transfer would reduce the amount available for reinvestment to roughly $82 000.
The illustrative scenario assumes the surviving spouse receives the benefit as a cash payout rather than taking ownership of the policy.
Under these assumptions, Allan Gray’s modelling produced broadly equivalent outcomes under the stated assumptions once CGT and executor’s fees were taken into account at death. Although the discretionary investment began with a higher capital base, those additional costs narrowed the difference between the two structures.
Coetzer emphasised that the scenario was intended to illustrate the mechanics of the decision rather than provide a universal switching threshold.
A break-even point under the assumptions
Under the assumptions used in the illustrative scenario, the outcomes converged when the embedded capital gain in the portfolio reached roughly 97%. This threshold is specific to the assumptions used in the scenario, including the highest marginal tax rate now and at death, a 20-year investment horizon, a spouse beneficiary receiving cash, 7% annual returns, and maximum executor’s fees.
Below that level, switching into an endowment produced a higher final value in the modelling. Above it, the upfront CGT cost became large enough that remaining in the discretionary investment structure produced the better outcome.
Coetzer emphasised that the break-even point is highly sensitive to the assumptions used in the analysis.
For example, if an investor expects their marginal tax rate to fall later in life, paying CGT today could be less attractive than deferring the tax event until death. Higher expected returns increase the opportunity cost of paying tax upfront, because more growth is lost on the capital that is no longer compounding.
Shorter investment horizons can have the opposite effect, because avoiding executor’s fees becomes relatively more valuable when there are fewer years for the discretionary investment to recover the initial tax payment.
Tax residency considerations
Coetzer also highlighted the potential impact of tax residency.
Tax within an endowment is deducted within the policy and paid to the South African Revenue Service regardless of where the investor or beneficiary resides. For investors who later become non-resident, this may create additional tax implications in another jurisdiction and could require further tax advice.
Discretionary investments, by contrast, are taxed in the hands of the investor according to the rules of their country of tax residence.
Case-specific analysis required
Coetzer’s presentation highlights that there is no universal threshold at which switching structures becomes advantageous. The outcome depends on a combination of factors, including the size of the embedded capital gain, the investor’s marginal tax rate now and at death, the investment horizon, expected returns, and the level of executor’s fees.
Disclaimer: This article is a general summary of the webinar and does not constitute financial, tax, or investment advice. Investors should consult their financial adviser and tax practitioner for advice tailored to their personal circumstances.
