Achieving consistent distributions for investors in hedged international managed funds Macquarie Investment Management Dated: OCTOBER 2013 A
Contents Contents Overview 1 Background 2 Distribution with no TOFA hedging election 4 Distribution with TOFA hedging election 6 TOFA hedging election in Macquarie funds 8 Conclusion 8 B
Overview Australian managed funds that invest in global markets are naturally exposed to the sometimes violent swings in the value of the Australian dollar. Fluctuations in currency can lead to unexpected performance implications for investors. As such, hedging of currency exposures has become an important consideration with a number of funds choosing to hedge their foreign currency exposures. However, while hedging mitigates the volatility in the fund s performance caused by currency exposures, it actually increases the volatility of the income distributions from the fund. The dilemma occurs due to the taxation regime governing funds in Australia. The effect of the law is firstly that the fund must distribute all its realised income in the financial year otherwise the trustee will be liable to pay tax on any undistributed income at the current rate of 46.5 per cent. Secondly, gains/losses from currency (FX) hedges and fixed interest securities (such as bonds, floating rate notes, bank bills) and equities (such as listed infrastructure stocks) are taxable on a realisation basis. Changes in the value of the underlying fixed interest securities or equities are not distributable until the asset is realised, which may be a number of years after the asset is purchased. However, the FX hedges used to hedge currency risk on foreign currency denominated assets are typically rolling three month FX forward contracts, which are realised on a much more frequent basis than the underlying asset. This causes a timing mismatch between the gains/losses resulting from the hedges and the gains/losses from the underlying asset. The effect is that a fund will frequently be forced to distribute gains resulting from FX hedges as those contracts are rolled every three months, even though the respective underlying asset may not have yet been realised. If a loss is made on an FX hedge, this loss reduces income that would otherwise be distributable by the fund. This unintended consequence of hedging foreign currency exposures increases the volatility of distributions to investors. This is particularly an issue for retirees looking for consistent income from their investments to fund their regular living expenses. To overcome this shortcoming, Macquarie has worked with its adviser to make an election under the Taxation of Financial Arrangements (TOFA) reforms in relation to the foreign currency hedges for a number of its funds, namely the Macquarie Income Opportunities Fund, the Macquarie Diversified Fixed Interest Fund and the Macquarie International Infrastructure Securities Fund. This tax election allows a fund to better match the gains/losses from FX hedges to the gains/losses of the underlying assets. The key benefit to investors is that the funds will have more consistent distributions that reflect the economic performance of the fund and the way it is managed. This paper discusses the background behind the election and the benefits to investors in these funds. 1
Background Taxation of trusts For Australian tax purposes, trusts are generally treated as transparent vehicles that do not pay tax in their own right. That is, trust beneficiaries generally pay tax on amounts of income allocated to them by the trustee with that income retaining its character in their hands despite the income legally passing through the trustee. However, there are circumstances where this flow-through treatment does not apply. Most relevantly, where a trustee accumulates (ie does not distribute) income arising in a particular year, the trustee will be taxable on any such income at the current rate of 46.5 per cent. This policy discourages trustees from retaining items of income to defer tax obligations or alter the amount of tax ultimately incurred by the beneficiaries. These principles apply equally to small discretionary family trusts and large managed funds. Clearly for managed funds, it is very important to ensure that all income is distributed to investors for a particular year to retain the tax transparent treatment described above. However, additional considerations apply where a trustee distributes an amount in excess of the income derived by a fund for a particular year. In the circumstances of a unit trust, any distributions made by the trustee in excess of the fund s net income is treated as a return of capital. While such a distribution is not immediately taxable, it reduces an investor s cost base in their units in the fund, which may create a larger future tax liability for that investor on redemption. The unitholder s holdings are in effect involuntarily reduced in the meantime. Taxation of Financial Arrangements (TOFA) TOFA reforms were introduced into tax law with effect from the 2011 income year. These provisions were introduced to provide a comprehensive and overarching framework to address the taxation of the economic substance of financial arrangements. These rules cover a very broad assortment of financial instruments, arrangements and situations and apply to managed funds as well as other taxpayers. In general terms, these rules set out various methods that apply to determine the tax implications of holding qualifying securities. For example, TOFA provides a framework for recognising taxable income from holding fixed interest securities. Taxpayers may also qualify to make particular elections under TOFA and one such election, which is of particular interest for a manager of international investments, relates to currency hedging instruments. Broadly, if a taxpayer is eligible to make this election, the timing and character of the tax implications from realising the currency hedging instrument will be matched to the underlying asset being hedged. 2 Clearly for managed funds, it is very important to ensure that all income is distributed to investors for a particular year to retain the tax transparent treatment described above.
Background Impact on distributions Applying this information to a managed fund established as a unit trust, it is in the best interests of the trustee and the unitholders to distribute no more and no less than all of its net income for a particular year. For a fund with a relatively simple investment universe, it may be quite straight forward for the trustee to exactly distribute its net income. For example, consider the situation of a fund with a single holding in an Australian equity. The income from dividends would be recognised as net income for a particular income year when the cash is received by the fund and the gain/loss on the equity would only be recognised when the holding is sold, which may be in a subsequent income year. This reflects the underlying performance of the fund and investors in this situation would receive a distribution as intended by the investment manager. The primary example of this is the use of foreign currency hedges to remove the fund s exposure to foreign exchange risk and therefore reducing the fluctuations in investment returns. Due to the ease of liquidity, customisability and relative simplicity, FX forward contracts are typically the instrument of choice in hedging FX exposures with 1 or 3 month contracts providing a balance between cost and flexibility in rebalancing. With the recent volatility of the Australian dollar (see Chart 1) many managed funds that hedge their currency exposure have seen large variability in their distributions. This is because the realised gains/losses on the foreign currency hedging contracts affected the distribution for the fund. The problem arises when the fund s investible universe increases to include assets where the taxation treatment does not match the underlying economic performance of the fund. This leads to mismatches between the performance of the fund and its taxable distributions each year. Chart 1: Volatility of AUD AUD/JPY (RHS) AUD/USD (LHS) AUD/EUR (LHS) AUD/GBP (LHS) FOREIGN CURRENCY (USD/EUR/GBP) PER AUD 1.2 1.0 0.8 0.6 0.4 0.2 Apr 97 Aug 97 Jan 98 Jun 98 Nov 98 Apr 99 Sep 99 Feb 00 Jun 00 Nov 00 Apr 01 Sep 01 Feb 02 Jul 02 Dec 02 May 03 Oct 03 Feb 04 Jul 04 Dec 04 May 05 Oct 05 Mar 06 Aug 06 Jan 07 May 07 Oct 07 Mar 08 Aug 08 Jan 09 Jun 09 Nov 09 Apr 10 Aug 10 Jan 11 Jun 11 Nov 11 Apr 12 Sep 12 Feb 13 120 100 80 60 40 20 JPY PER AUD Source: Bloomberg, May 2013 3
Distribution with no TOFA hedging election To demonstrate why this is so, consider the following example: A fund holds a USD denominated corporate bond maturing in 10 years worth USD $100m and a series of 3 month FX AUD/USD forward contracts with a face value of USD $100m at the current rate of 1 AUD/USD. The bond pays an annual coupon of USD10m under each exchange rate scenario. The intention is to hold the bond for the long term and the FX forward contracts are to remove the USD exposure with those FX forward contracts rolled every 3 months across the income year. What happens if the AUD/USD rate increase/decreases in the income year in addition to the bond coupon and how does this affect distributions (assuming all else constant)? The impact of these scenarios is shown in table 1. Table 1: Value of fund (AUD) Rate at the end of the tax period Bond value 200m 100m 50m Bond coupon (inclusive of FX impact) 20m 10m 5m Gain/loss on FX forward (100m) 50m Total portfolio value 120m 110m 105m Net taxable income (80m) 10m 55m Chart 2: Breakdown of portfolio gains/losses Coupon value (AUD m) Bond value (AUD m) FX Forward (AUD m) 150 20 AUD GAIN/LOSS (m) 100 50 0 100 10 50 5-50 -50-100 -100 Source: Macquarie Investment Management, September 2013 4
Distribution with no TOFA hedging election Chart 3: Comparison of net portfolio gains vs distributable income 80 60 40 Net portfolio gains Distributable income AUD (m) 20 0-20 -40-60 -80 Source: Macquarie Investment Management, September 2013 By hedging the USD exposure it can be seen that the overall value of the fund changes only by the value of the coupon (and its related FX movement) and hence the performance of the fund will be more closely linked to the movement in value of the underlying security. The gain/loss from the bond value due to FX movements is offset entirely by the loss/gain from the FX forward contracts. In contrast, the net taxable income available for distribution fluctuates between a gain of 55m AUD and a loss of 80m AUD. There are large swings in the taxable income in this example depending on the movement in the AUD/USD exchange rate. The logic for each scenario is described on the right. 1. The AUD depreciates: The increase in the bond s AUD value due to FX has not yet been realised and the gain from this instrument is not included in the taxable/ distributable income for the fund. The FX forward position however, is included in taxable income as the losses have been realised when the FX forward contracts are rolled every three months. The fund now cannot distribute the underlying fund income of +20m AUD unless the trustee decides to do so via a return of capital. 2. The AUD appreciates: Since the decrease in bond value due to FX has not yet been realised, the loss from this instrument is not included in the taxable income for the fund. The FX forward position, however, is included in taxable income as the gains have been realised when the FX forward contracts are rolled every three months. The fund must now distribute a gain of 55m that is not reflective of the portfolio s income (+5m AUD). From the above example, we can see that the difference in the timing of recognising the gains/losses for tax purposes between the hedging instrument and the underlying asset leads to mismatches between the fund s distributions and the net gains of the portfolio. difference in the timing of recognising of gains/losses for tax purposes between the hedging instrument and the underlying asset leads to mismatches between the fund s distributions and the NET GAINS OF THE PORTFOLIO. 5
Distribution with TOFA hedging election The TOFA hedging election recognises that mismatches in tax treatment can occur between the underlying hedged asset and the hedging instrument. It allows taxpayers to elect to use an alternative method to calculate their taxable income subject to certain criteria. Broadly, if a taxpayer is eligible to make this election, the effect is that the timing and character of the tax implications from realising the hedging instrument will be matched to the underlying asset being hedged. This election can apply to foreign currency hedges. If we assume this election is made, based on our previous example the impact will be as shown in Table 2. Table 2: Value of fund (AUD) Rate at the end of the tax period Bond value 200m 100m 50m Bond Coupon (inclusive of FX impact) 20m 10m 5m Gain/loss on FX forward (100m) 50m Total Portfolio Value 120m 110m 105m Net taxable income 20m 10m 5m Chart 4: Breakdown of portfolio gains/losses Coupon value (AUD m) Bond value (AUD m) FX Forward (AUD m) 150 AUD GAIN/LOSS (m) 100 50 0 20 100 10 50 5-50 -50-100 -100 Source: Macquarie Investment Management, September 2013 6
Distribution with TOFA hedging election Chart 5: Comparison of net portfolio gains vs distributable income 80 70 60 Net portfolio gains Distributable income AUD (m) 50 40 30 20 10 Source: Macquarie Investment Management, September 2013 Under each scenario, neither the unrealised gain/loss on the bond value nor the realised loss/gain on the FX forward is recognised as taxable income. This is because the FX forwards have been designated as qualifying hedging instruments pursuant to the TOFA hedging election and as such, the timing of recognising the gain/loss on the hedges is matched to the underlying asset. That is, the gain or loss on the FX forwards used to hedge the bond will be carried forward and only recognised at the time the bond is sold. Hence, by making the TOFA election the fund is now able to distribute the economic income of the fund and avoid sudden changes in its distributable income caused by movements in exchange rates. As the below chart summarises, by making a TOFA election, the volatility in distributable income due to changes in the value of FX hedges is avoided. Chart 6: Summary of impact of TOFA election Net portfolio gains Distributable income Distributable income (no TOFA) 80 60 40 AUD (m) 20 0-20 -40-60 -80 Source: Macquarie Investment Management, September 2013 7
TOFA hedging election in Macquarie funds Macquarie Investment Management Limited (MIML) has made TOFA hedging elections in respect of the foreign currency hedging arrangements for the Macquarie Income Opportunities Fund, the Macquarie Diversified Fixed Interest Fund and the Macquarie International Infrastructure Securities Fund (the Funds). Making the TOFA election was a detailed and lengthy process. MIML s internal tax team led an extensive project to make the elections for the Funds. Part of the process was to undertake significant fundamental analysis to examine the benefits a TOFA hedging election could provide for our clients. We believe our investment in making the TOFA hedging election provides several fundamental benefits for our investors. As we have seen above, making the TOFA hedging election removes FX volatility from distributions and in so doing ensures that investors receive distributions corresponding to, and those investors being taxed on, the economic income earned by the fund. This also promotes intergenerational equity between unitholders as distortions in distributions across income years arising from the differential tax treatment of certain assets have been removed. Specifically for the Macquarie International Infrastructure Securities Fund, it also means the character of the hedging instruments will also match the underlying hedged assets ie gains/losses on FX hedging contracts can be treated as capital gains (losses) that are only recognised when particular hedged shares are sold (shares being treated as capital assets for tax purposes as distinct from fixed interest securities). We believe the Funds are one of the first in their respective peer groups to make a TOFA election. There may be a variety of reasons why other managers have been unable to or have chosen not to make this election for their funds. These include the type of hedging instruments and strategies used for hedging, the fund structure employed, and the cost and time involved on the part of the manager in making such an election. We reiterate that making the TOFA election is not a simple process. The election was a significant investment in order to achieve a more desirable outcome for our clients, being the comfort that the distributions from the three MIML funds will not be impacted by FX movements. Conclusion In adopting the TOFA hedging election, we believe that the distributions for our funds going forward will be more aligned with our investment strategies and provide clients with a consistent distribution regardless of the volatility in currency markets. We continue to look for ways of better managing our funds to meet the needs our clients. 8
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Conclusion For more information speak to your financial adviser or call Macquarie Investment Management on 1800 814 523, email mim.clientservice@macquarie.com or visit the website at macquarie.com.au/mim Macquarie Investment Management Limited (ABN 66 002 867 003, AFSL 237 492) (Macquarie) is the responsible entity of, and issuer of units in the funds mentioned in this article (Funds). Investors should consider the Product Disclosure Statements (PDS) relating to the Funds in deciding whether to acquire or continue to hold units in the Funds. The PDS is available from macquarie.com.au/pds or by calling 1800 814 523. Investments in the Funds are not deposits with or other liabilities of Macquarie Bank Limited or of any other Macquarie Group entity and are subject to investment risk, including possible delays in repayment and loss of income and capital invested. Neither Macquarie Bank Limited nor any other member of the Macquarie Group guarantee any particular rate of return or the performance of the Funds, nor do they guarantee the repayment of capital from the Funds. The Macquarie Group does not give, nor does it purport to give, any taxation advice. The taxation discussion in this article is general in nature and is based on laws current at the time of writing. Those laws and the level of taxation may change. The application of tax laws to each investor depends on that investor s individual circumstances. Accordingly, investors should seek their own independent advice on taxation implications before making any investment decisions. 10 MGI146 10/13