Are you being double-taxed?
Monday, March 13th 2017, 11:12AM 1 Comment
by Castle Point Funds Management
As any engaged reader of the New Zealand media will have noticed there has been a recent marked increase in the number of articles and commentary debating active vs passive and the fees charged to investors. The growth in KiwiSaver and the new Financial Markets Conduct Act have, undoubtedly, had a part to play in this by increasing the focus on reporting with an emphasis on disclosure of fees.
In general, the arguments have been around whether active managers can outperform their passive equivalents and justify their higher fees. Indeed, ceteris paribus, the higher the fee charged the lower the net return for investors. But is this really all that should matter to investors?
Let’s first breakdown the components of an investor's return.
|Net Return||= Investment gross return|
|- Tax paid|
All the commentary we have read focuses on the first two items above, namely whether an active manager can generate enough gross returns to offset fees. We don’t plan to add to this debate. Rather, we would like to highlight some different points, that can be equally material, but from talking to investors and advisers are often completely overlooked.
Let’s start with what should be an indisputable fact.
The only thing that matters to investors is Net Returns – i.e. after all fees and all taxes paid.
We should also note that we are not tax experts and are not providing tax advice and all readers are encouraged to engage their own tax advice relative to their own circumstances.
Today, we are going to look at global equities which for many investors is the largest component of any diversified or KiwiSaver portfolio.
In New Zealand, we get imputation credits from most companies when they pay their dividends. These imputation credits are generated when the company pays New Zealand corporate tax. New Zealand investors can then use these credits to offset the tax they pay from receiving these dividends. The purpose is to eliminate any double taxation of the same profits.
For global shares, most countries do not use this approach, rather they charge Withholding Tax (WHT) on dividends. Rates vary from country to country from 0% to more than 30%. New Zealand has Double Taxation Agreements (DTAs) in place with most countries represented in global equity indices. This means that when you pay WHT on overseas dividends you get Foreign Tax Credits (FTCs) in return. These FTCs can then be used to offset any tax owed in New Zealand.
So far, reasonably straight forward. Your investments pay tax overseas and the DTAs mean you should be able to claim some or all of this back. However, when you invest into a New Zealand PIE fund that in turn invests indirectly in global equities via an overseas fund (one that is domiciled in a country that is not New Zealand) these FTCs cannot be transferred back to the New Zealand PIE. The tax credits are lost.
However, if the New Zealand PIE holds the global securities directly the FTCs are not lost and the New Zealand investor can use them. The diagram below lays out how the two different approaches work in practice and the how with Indirect the off-shore fund effectively blocks the flow of FTCs back to New Zealand.
So, what are these FTCs worth? To get a representative answer we took the holdings for the Vanguard Total World Stock ETF as at 31 December, 2016 (source Bloomberg) and using company dividend yields, the appropriate DTA status and WHT rates for each country we calculated 0.37%. Yes, you could be giving up 0.37% per annum depending on how your fund invests. If you are invested into higher dividend paying global funds e.g. infrastructure, the FTCs could be materially higher. This is essentially an additional fee for investing in a fund with an inefficient tax structure.
Passive funds manage to achieve low fees through scale and efficiency. This means that they are generally based overseas to attract sufficient funds. For example, the Vanguard funds that are widely used in New Zealand are domiciled in Australia. New Zealand investors in these funds crucially lose the FTCs that would be available if the fund was structured differently.
Some funds have been setup as New Zealand PIEs to directly hold the securities and hence retain the FTCs. It is possible, but it generally costs more for the manager to do this.
Now, the other important thing to note is that for New Zealand PIE funds, global equities are taxed under the FDR (Fair Dividend Rate) regime which taxes at a deemed 5% of value. This means you generate positive taxable income regardless of investment return, which is important as FTCs cannot be carried over.
Let’s compare investing via an offshore fund vs a New Zealand fund that holds the equities directly, at different fee levels.
Assumptions: All funds earn 7% gross return. Investors have a PIR of 28%. All funds generate same level of FTCs.
If you consider just the fees you might expect to earn a higher net return the lower the fee and that is true, but it’s not an investor’s ultimate return.
|Indirect Via Offshore Fund||Direct||Direct||Direct||Direct|
|Expected gross return||7.00%||7.00%||7.00%||7.00%||7.00%|
|Return (after fees, before tax)||6.80%||6.50%||6.40%||6.30%||6.20%|
However, if we then bring tax into the equation you get two differences, the FTCs for the funds holding securities directly and that fees are a tax-deductible expense.
|Indirect Via Offshore Fund||Direct||Direct||Direct||Direct|
|Net Taxable Income||4.80%||4.50%||4.40%||4.30%||4.20%|
|Tax at 28% PIR||-1.34%||-1.26%||-1.23%||-1.20%||-1.18%|
|Net return after fees and tax||5.46%||5.61%||5.54%||5.47%||5.40%|
|Headline fee difference||+0.30%||+0.40%||+0.50%||+0.60%|
|Net return difference||+0.15%||+0.08%||+0.01%||+0.06%|
As can be seen, when an investors consider their actual returns, after fees and taxes, those Foreign Tax Credits make quite a difference. All else being equal, it could be worth paying up to 0.50% more in fees to invest in a fund that holds foreign equities directly.
In our opinion, investors and advisers should not just be asking what the fees are, but looking at the total package of fees and how the funds are structured to ensure tax leakage is minimised and net returns maximised.
For the record, our 5 Oceans Fund gets its global equity exposure via a New Zealand-based active global equity fund that holds the securities directly, to ensure our investors keep their Foreign Tax Credits.
Jamie Young is a co-founder of Castle Point Funds Management and part of the investment team.
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