6th Report - BENEFIT FUNDS CHAPTER 1 - INTRODUCTION 1.1 The Income Tax Act recognises three categories of benefit fund. These are: (a) Friendly Societies; (b) Registered Medical Schemes; and (c) an omnibus category - often referred to as "para (c) benefit funds" - which depend for their recognition on approval by the Commissioner, and are described in more detail in section 5 of this Report. 1.2 Benefit funds have an income tax regime of their own. Its nature may be summarised under four headings:- (i) taxation of the fund itself; (ii) tax treatment of contributions by employers; (iii) tax treatment of contributions by members, who are usually (but not always) employees; and (iv) the tax status (i.e. "capital" or "income") of benefits received from a fund, and their tax treatment if regarded as income. An introductory discussion of these matters occupies the rest of this section. 1.3 The fund itself: Benefit funds are exempt from income tax. This exemption extends to contributions received and to investment income earned on amounts accumulated - the so-called "roll-up". Tax-exemption has certain other advantages, not least being access to the "untaxed policyholder funds" of long-term insurers. This normally allows members to enjoy insurance cover on terms more favourable than would otherwise be available to them. 1.4 Contributions by employers: Employers may claim deduction of contributions made on behalf of their employees, subject to certain limits. These limits are: (i) expressed as a percentage of each individual employee's "approved remuneration"; (ii) largely within the discretion of the Commissioner, except where they do not exceed 10%; and (iii) calculated, for each employee separately, by lumping together the contributions made on his or her behalf in respect of benefit and retirement funds - although retirement funds are not themselves regarded as benefit funds for any purpose other than seeing whether or not the limit has been exceeded. 1.5 Provided they are within the approved limits employer contributions to benefit funds do not create fringe benefits that are subject to tax in the hands of the employee. That is the position in terms of current practice. The Commission expresses no view on the correct interpretation of the law as it stands. 1.6 Employer contributions that are repaid on the withdrawal of a member are taxed in the employer's hands to the extent that they represent a "recoupment" of expenditure previously allowed as a deduction. To the extent that they exceed that amount (either because some deductions were disallowed or because the fund rules allow the employer to claim a share of the investment roll-up), they are received tax-free. Partly for this reason, the Commissioner has in recent years declined to approve para (c) funds that have such rules. 1.7 Contributions by members: Subject to two exceptions, noted briefly below, member contributions to benefit funds do not rank for deduction from income subject to tax. They must be made out of after-tax income. 1.8 The first exception relates to contributions to registered medical schemes made by the elderly; and by those of working age who have had to incur medical expenses exceeding the greater of R1000 and 5% of income. They may claim a deduction. The dispensation for handicapped persons is slightly more generous. 1.9 The second exception relates to contributions to benefit funds that provide disability benefits in the form of income-replacement policies. As the benefit (usually in the form of an annuity) is fully taxed as income, contributions to cover the premiums are deductible on ordinary tax rules as "expenses in the production of income." 1.10 Benefits received by members: The tax treatment of benefits is not entirely straightforward. The examples to be given are intended to do no more than indicate the degree of complexity. It has just been noted that a benefit received as an annuity is taxed as income. On the other hand, payments by a registered medical scheme to or on behalf of its members, to indemnify them against medical expenses actually incurred, have no tax consequences. The status of lump sum payments is less clear-cut. 1.11 Lump sum proceeds of insurance policies giving protection against the occurrence of a "stated event" such as accident or illness are normally regarded as capital receipts, and not taxed. If in due course used to meet medical expenses they may (from an income tax point of view) do even better than that, and give rise to a deduction. 1.12 However, lump sum payments whose receipt coincides with the termination of employment (whether because of withdrawal, retrenchment, ill-health, old age or death) may be regarded as falling within the definition of "gross income" and taxed at marginal rates to the extent that they exceed three years' earnings. Up to that level they may be taxed at a concessionary average rate; and in addition the taxpayer may qualify for a one-off tax-free allowance of R30,000. 6th Report - BENEFIT FUNDS CHAPTER 2 - THE NEED FOR REFORM 2.1 The tax regime applicable to benefit funds, sketched in the last section, was not designed as a coherent whole. It has developed piecemeal over a number of years. It is complex. It contains anomalies. It is open to abuse. A view on the extent to which it is in fact abused cannot be formed until each of the three categories of fund has been examined in more detail. That will be done in the sections that follow. This section concentrates on some of the more obvious matters that require attention. 2.2 Salary sacrifice: Any regime that grants tax deductibility in respect of contributions made by the employer, but denies it to the employee, opens the door to salary sacrifice schemes. Their operation is simple. The employee accepts a lower salary but in return expects the employer to spend an equivalent amount in meeting the cost of contributions to this or that benefit fund of the employee's choice. The employee gets fund membership without having to purchase it out of after-tax income, and at no net cost to the employer. Obviously, this is attractive only to employees paying significant tax. Salary sacrifice is of no interest to those earning low incomes. Obviously, too, salary manipulation is a device unavailable to the self-employed, who have neither salaries to sacrifice nor employers to make tax deductible contributions on their behalf. 2.3 In the example just given the employer is left in a neutral position, the new salary plus benefit fund contribution being just equal to the old salary - and both being fully deductible. More typically the amount gained by the employee at the expense of the fiscus is shared between the parties. 2.4 Salary sacrifice schemes are common to all income tax systems where deductibility rules are asymmetrical, and attractive to all employees whose marginal tax rates are high. It is possible to attack the schemes directly, but much simpler to amend the rules. The Commission's recommendations will follow the latter course. 2.5 Deductibility limits: The present deductibility limits are largely discretionary and their application to employees on an individual basis, rather than as a group working for one employer, is administratively cumbersome. The lumping together of contributions to benefit and retirement funds in determining the limits is essentially inappropriate, given the differing tax regimes to which the benefits are subjected. All three matters require attention. 2.6 Employers whose contributions exceed whatever limits have been set by the Commissioner may, if taxpayers, attempt to deduct the excess as "expenses in the production of income" under the normal tax rules. In most cases they are unlikely to succeed, in view of a recent amendment to the Act. This is, however, not a sanction likely to inhibit employers who are outside the tax system (e.g. municipalities, para-statals and most N.G.O's) from doing as they please. 2.7 It would appear to be necessary to amend the Act's Fourth and Seventh Schedules (which deal with these matters) to provide that employer contributions to benefit funds in excess of the approved limits be allocated to individual employees on a basis satisfactory to the Commissioner and taxed as income in their hands through the PAYE and SITE systems. The Commission recommends accordingly. Acceptance of the recommendation will go a long way towards securing compliance by both taxpaying and non-taxpaying entities. 2.8 In paragraph 8.7.10 of its Third Interim Report the Commission recommended that separate deductibility limits be set for retirement and benefit funds. Further consideration has persuaded it that each of the three categories of benefit funds should be treated separately. This is done in the individual sections dealing with those categories. 2.9 The views put forward in paras 2.5 and 2.8 above, run contrary to those embodied in section 11(l) of the Income Tax Act, which is the one dealing with the limits to be placed on employer contributions to benefit funds. It is recommended that it be repealed and replaced by one based on the approach adopted in this Report. 2.10 The tax-free roll-up: In chapter 8 of its Third Interim Report the Commission drew attention to the use of retirement funds as tax shelters and emphasised the crucial part played by the tax-free status of their investment roll-up. It was the sheer size of the funds administered by the industry and the fact that they could be used on a massive scale to shelter non-retirement income that caused the Commission to recommend remedial action.