1. Which investment structure results in paying the least amount of tax? 2. Which investment structure is more convenient to administer?

Transcription

1 22 July 2016

2 For many of us, there is nothing more tedious than learning the detail of prevailing tax policy on the investment returns of international assets. The majority of investors do not need to be tax experts, but simply want to know the answer to two central questions: 1. Which investment structure results in paying the least amount of tax? 2. Which investment structure is more convenient to administer? And therein lies the problem. When investing in international assets that are subject to the foreign investment fund (FIF 1 ) tax rules, you can choose between investment structures that deliver different benefits. Investing in FIF assets through a local investment structure, such a portfolio investment entity (PIE), delivers greater convenience at tax time. However, investing in FIF assets via non-pie structures, such as an Australian unit trust (AUT), will generally result in lower taxes over the long term. The international equity asset class covers approximately 40 countries and over 10,000 companies, and the best way to achieve cost effective diversification is often via a unit trust. With that in mind, what are the tax implications of the different types of unit trust structure you can choose? For the purposes of this paper, we are going to compare and contrast the expected outcomes when investing in FIF assets through a domestic PIE, versus investing in the same assets through an AUT. This structure is widely used by New Zealand domiciled unit trusts. Investors nominate a prescribed investor rate (PIR) based on recent income levels. The top PIR is 28%, which is attractive if you have a marginal tax rate of 33%. Within a PIE you effectively pay tax (accrued daily) at your PIR on 5% of the opening value of your FIF assets, regardless of whether markets go up or down. This assumed 5% return is called the fair dividend rate (FDR). As the tax is accrued and paid by the PIE on your behalf, then as long as you have selected the correct PIR to apply, you don t necessarily need to file a separate tax return. Unfortunately, if the investments in the PIE lose money you must still pay tax on an assumed 5% return. Losing money and still having to pay tax seems unfair, but that s the rule. 1 A FIF is a right in a foreign company, foreign superannuation scheme or foreign life insurance. This includes Australian unit trusts and UK investment trusts. 1

3 In this structure, investors get to choose between using the FDR method (described above), or taking into account actual gains and losses in their portfolio by using the comparative value (CV) method. Under a CV calculation you pay tax on your total return (including both realised and unrealised gains), but only if the total return is positive. The advantage here is that if your aggregate FIF investments lose money - and all will from time to time - you won t have to pay tax on those assets that year. However, if you invest through AUTs, you will need to file a tax return with the IRD. The major advantages and disadvantages of each structure can therefore be summarised as follows: Table 1: Summary of PIE and AUT advantages and disadvantages PIE AUT Advantages May not need to file a tax return. Maximum tax rate is 28%. Maximum tax is paid on an assumed 5% return. No tax is paid when aggregate returns are negative. Disadvantages Pay tax on an assumed 5% return even when the portfolio suffers a loss. Need to file a tax return. What are the estimated tax savings from using AUTs instead of PIEs? Let s consider a scenario where: Your international share investments lose10% You have a marginal tax rate of 33% (ie, a PIR of 28% for PIE investors) If you hold these assets in a PIE, you must pay tax (accrued daily) assuming a return of 5% per annum on the opening value of your investments, even though your investments lost money. Overall, your investment in the PIE lost 10%, plus you paid another 1.4% in tax (based on a 5% assumed return x PIR of 28%), for an overall result of -11.4%. Under this identical scenario, if you held these assets in an AUT and chose to apply the CV method, you would incur just the 10% market loss and pay no tax. On the flipside, if the investments gained 10% in value you would also pay PIE tax of 1.4%. However, in an AUT (in this example) you would pay a little more tax because you are taxed at your marginal rate of 33%, rather than the 28% a PIE investor would be taxed at. In this case, the AUT investor would choose an FDR calculation and pay 5% x marginal tax rate of 33%, which equals 1.65% in tax. 2

4 So, when FIF investments in aggregate lose money, our PIE investor in this example pays 1.4% more in tax than the same investor in an AUT. However, when aggregate FIF investments return more than 5%, because the marginal tax rate is higher than the PIR, the AUT investor pays 0.25% more. Therefore, the expected investment outcome clearly has a significant bearing on whether a long term investment in FIF assets held in a PIE should be considered more or less tax efficient than the same investments held in an AUT. How often should we expect diversified international FIF assets to lose money? If we take the last 25 years (to March 2016) as a guide, we calculate that a broad exposure to international equity and property assets has delivered negative returns in 24% of these tax years (six out of 25 years). An additional 8% of the time (two out of 25 years) the investments earned between 0% and 5%. In all of these years, it would have been beneficial for an AUT investor to select the CV tax calculation method rather than the FDR method that a PIE must apply. If we use these historical results as our best estimate of the future variability in foreign asset returns, then we can calculate the annual expected tax cost for PIEs (which must use an FDR calculation) and AUTs (which can choose either FDR or CV each year 2 ). Table 2: Estimated annual tax cost on FIF assets using a PIE or an AUT (for a 28%/33% taxpayer) Average tax paid in a PIE Average tax paid in an AUT Average tax benefit in an AUT Australian equity % 1.19% 0.10% International equity 1.40% 1.19% 0.21% International property 1.40% 1.19% 0.21% 2 When investing in FIF assets through AUTs, investors (limited to natural persons or trustees of a family trust) can choose between the FDR or CV tax calculation method, but the selected method must be applied to all FIF assets in that year. In the same tax year, investors are not permitted to select FDR for one FIF investment and CV for another. 3 Australian resident companies owned by an AUT are regarded as FIF assets for New Zealand tax purposes, as the AUT itself is defined as a FIF. However, Australian resident companies that are listed on the ASX All Ordinaries Index, maintain a franking credit account, and are not stapled stocks, are otherwise exempt from being an attributing interest in a FIF. Where these shares are held on capital account, the only income to be returned is the dividend income. Additionally, ASX companies that pay fully franked dividends are exempt from any additional foreign withholding tax deductions from distributions to New Zealand domiciled investors. If New Zealanders invest in PIEs that only hold exempt Australian shares that pay fully franked dividends in Australia, then the only tax the New Zealand investor will pay on these assets is on cash distributions received. If we assume PIE investors receive the current yield on the S&P/ASX200 Index of approximately 4.62% excluding franking credits (estimated yield as at 19 July 2016), then a New Zealand PIE investor on a 28% PIR would expect to pay approximately 4.62% x 0.28% = 1.29% in tax each year. 3

5 An average expected 0.21% tax benefit in choosing AUTs over PIEs when investing internationally outside of Australia is nothing to sneeze at. If you had $500,000 invested in international FIF assets, it equates to an average tax saving of $1,050 per year. The prior example highlighted a simple straight line calculation of the two different tax treatments. In the case of AUTs, this calculation is accurate because individuals usually only have to pay tax on their FIF assets based on their opening value at 1 April. This means that between 1 April this year and 31 March next year, FIF investors utilising AUTs don t pay tax on either: 1. Contributions, or 2. Capital gains accumulated during the period. An investor who commenced an investment in FIF assets through an AUT on 2 April would essentially receive one full year tax free 4, because the opening value on 1 April was zero. However, the simple calculation is not completely accurate when it comes to calculating the tax on FIF assets held in PIEs. With PIEs, tax is calculated and accrued on the daily value of the investments. This means that capital gains and investment contributions made throughout the year are included in the tax calculation. Not surprisingly, this further skews the difference between the FIF tax an AUT investor would pay, versus the tax a PIE investor would pay. When we consider this element together with the simple calculation, we have a scenario whereby the difference in the FIF tax to be paid within the different structures can potentially be quite significant. This was well captured by an article in Asset Magazine 5, which illustrated the example of two investors, Brian and Sue. Both Brian and Sue s marginal tax rate was 33%, meaning they would both have a PIR of 28% for PIE income. Brian invested in FIF assets through an AUT and Sue invested in the same assets through a PIE. Each invested $100,000 on 2 April each year for four years, and each experienced identical underlying investment returns (10%, 10%, -5%, 10%). The following tables summarise the respective results. 4 Assuming the investment is held and not redeemed prior to the end of the tax year, in which case the quick sales rules would apply. 5 Source: Asset Magazine Issue #122, For FIF s Sake: Why NZ global tax rules need a rewrite authored by Anthony Edmonds. 4

6 Table 3: Estimated tax and return for Brian investing through an AUT Opening value 1 April Contribution 2 April Return % Return $ Tax paid Closing value Year 1 $0 $100,000 10% $10,000 $0 $110,000 Year 2 $110,000 $100,000 10% $21,000 $1,815 $229,185 Year 3 $229,185 $100,000-5% -$16,459 $0 $312,726 Year 4 $312,726 $100,000 10% $41,273 $5,160 $448,838 Total $6,975 $448,838 Table 4: Estimated tax and return for Sue investing through a PIE Opening value 1 April Contribution 2 April Return % Return $ Tax paid Closing value Year 1 $0 $100,000 10% $10,000 $1,470 $108,530 Year 2 $108,530 $100,000 10% $20,853 $3,065 $226,318 Year 3 $226,318 $100,000-5% -$16,316 $4,454 $305,547 Year 4 $305,547 $100,000 10% $40,555 $5,952 $440,141 Total $14,951 $440,141 While this could be considered an extreme example, it nevertheless illustrates that after four years Sue paid more than twice the amount of tax on her PIE investments than Brian did investing in the same assets through an AUT 6. One of the common criticisms from supporters of PIEs is that choosing other investment structures means you ll generally need to file a tax return, but is that really such a problem? It s certainly not a problem for the many investors who already have to (or wish to) file a tax return. They include trusts, investors wanting to deduct income protection insurance premiums, and those who have made charitable donations and seek to capture the available tax deductions on those. Most business owners or others with complexity in their earnings will also commonly need to file a tax return. In fact, all investors already have another very good reason to want to file a tax return - to deduct the fee they pay their financial adviser! Since an adviser s fee is tax deductible, we generally recommend that all investors consider filing a tax return regardless of whether they own FIF investments. If necessary, 6 For simplicity this example has focused on a long term buy and hold strategy that assumes annual deposits. We do not take into account the potential tax considerations that could result from different asset redemption scenarios. 5

7 your adviser can usually recommend an accountant familiar with the underlying tax return documentation, who can complete your tax return at a reasonable cost. However, it is not a requirement (and may not even be necessary) for you to use an accountant to complete your return. Consilium Platform provides a tax report and tax guide that identifies the FIF income calculations investors need to know, and also points out the precise sections in the IRD form where each of these numbers should be placed. An excerpt from the tax guide is shown below. Investors simply have to match the numbers on the tax report marked with labels such as 17A, and place them in their tax return as illustrated. Figure 1: Excerpt from FNZ Tax Guide Although we ve provided several reasons why AUTs may be a more tax effective structure in which to invest in FIF assets, we need to reiterate that we do not select recommended investments on the basis of tax alone. Recommended funds (whether AUTs or PIEs) are selected because we believe they are the best investments available, taking into account a number of factors, only one of which relates to tax. Other important considerations are cost, diversification, liquidity, transparency and mandate stability. In general, we find that a number of the AUTs we recommend, to invest in Australian and international equities and property assets, provide a more compelling mixture of benefits. Most notably, this usually includes factors which are very easy to measure, such as significantly lower costs and greater diversification. In these cases, the existence of an expected tax benefit over the long term is really just another cherry on top. As an example, we consider two Australian large cap funds on our approved products list - the recommended Dimensional Australian Large Cap fund and the approved (but not recommended) SmartOZZY ETF. 6

8 Table 5: Comparison of AUT and PIE options on the approved products list for Australian large cap DFA Australian Large Cap SmartOZZY Tax regime AUT PIE Management fee 0.175% 0.60% Transaction fees 0.10% Maximum of 0.20%/$30.50 Holdings If we agree that the AUT holds a long term expected tax advantage over the PIE, then when we consider its lower management fee, lower transaction costs and greater diversification, the AUT appears superior in each of these categories. While there are approved PIE fund options for Australian equity, there are currently no PIE funds approved for investment in international or emerging market equities that pass all of our due diligence screens. Typically, the PIEs we have to choose from in these areas fail our investment screens due to the existence of one or more of the following: High cost High investment concentration Active management (lack of mandate stability) However, new PIE funds are always being launched and we will always consider them as potential investment options when they become available. We believe that using AUTs to invest in international and emerging market equities and international property can be expected to produce lower FIF taxes, on average, relative to an equivalent PIE fund. Investors may find this alone a compelling enough reason to favour an investment in FIF assets through an AUT instead of a PIE. However, by using AUTs we can also generally access funds at significantly lower fund management fees, with lower transaction costs and with much improved diversification. From a pure investment perspective, all of these attributes are highly desirable. For as long as that combination of desirable attributes favours AUTs over PIEs, we are very likely to continue to recommend investors utilise AUTs in their portfolios in appropriate asset classes. The trade-off is convenience at tax time. Whereas AUTs that hold FIF assets appear to be more tax effective than a PIE (on average), a PIE can be considered to be more tax convenient because investors in PIEs may not be required to file a tax return. 7

9 However, with convenience comes cost. One cost of investing in PIEs is paying higher FIF taxes on average; another is forfeiting the ability to claim a deduction for any adviser fees paid. For the many investors who already file a tax return, the tax convenience argument is simply not relevant. For those who don t, if a do-it-yourself approach to your tax return is not an option, your adviser can probably recommend an accountant to help you cost effectively take advantage of the benefits of incorporating AUTs into your investment strategy. DISCLAIMER This document has been provided for general information purposes only. The information is given in good faith and has been prepared from published information and other sources believed to be reliable, accurate and complete at the time of preparation, but its accuracy and completeness is not guaranteed. Any information, analysis or views contained herein reflect our opinion at the date of publication and are subject to change without notice. To the extent that any such information, analysis, views or opinions may be construed as advice, they do not take into account any person s particular financial situation or goals and, accordingly, do not constitute personalised advice under the Financial Advisers Act 2008, nor do they constitute advice of a legal, tax, accounting or other nature to any persons. Past performance is not indicative of future results, and no representation or warranty, express or implied, is made regarding future performance. To the maximum extent permitted by law, no liability or responsibility is accepted for any loss or damage, direct or consequential, arising from or in connection with this document or its contents. Reference to taxation or the impact of taxation does not constitute tax advice. The rules on and bases of taxation can change. The value of any tax reliefs will depend on your personal circumstances. You should consult your tax adviser in order to understand the impact of investment decisions on your tax position. 8