IRD's Christmas gift to investors

Passive funds have been saved from the axe, but the rules have got tigher. Philip Macalister explains what is happening.

Monday, December 18th 2000, 6:53AM

Investors in index or passive funds could be forgiven for thinking that the Inland Revenue Department gave them a welcome Christmas present last week.

Much to their, and that of fund managers, the department gave its long-awaited pronouncement on the future of the popular, tax-effective index funds.

The good news was that the department wasn't going to kill off the $2.5 billion passive fund market, but it signalled it would take a tougher approach from now on.

PricewaterhouseCoopers tax expert Paul Mersi says there was a reasonable degree of expectation that IRD may have stuck the killer punch with this statement.

"This was the best opportunity they had to kill them off."

He says it is likely passive funds will be around for a while longer because there are few chances in the near future to close them down.

Throughout their short life passive funds have had a tumultuous time, and if the past is anything to go by, it will continue that way.

The Stock Exchange started it off when it launched its TeNZ index fund, which tracks the 10 biggest stocks listed on the exchange.

What it did was something that the experts in the field - fund managers - had never quite worked out how to do. That is create a fund that got around the law which requires managed funds to pay tax on any capital gains.

The exchange went to the IRD and successfully sought a binding ruling which in effect said if it built a fund that replicates and tracks the companies in the NZSE10 then it wouldn't have to pay tax on any capital gains.

This ruling provoked passionate debate amongst managers, not least of all from promoters of actively managed funds as it put them at a significant disadvantage.

According to AMP Henderson Global Investors an actively managed fund has to generate an extra 3% return each year just to keep up with passive funds.

Since 1996 index funds have carved out a significant place in the savings world. There are more than 20 retail funds on offer (although the IRD has issued 45 binding rulings), ranging from AMP Henderson Global Investors' $1 billion-plus WiNZ international index fund, through to tiny funds such as Dorchester's 1st Fifteen fund which has $558,000, according to IPAC Securities.

While investors and fund managers may have breathed a sigh of relief when they read the IRD's statement last week they shouldn't think the last hurdle is over.

What the IRD did was, for the first time, to publicly clarify its thinking on how it decided whether or not it should grant a binding ruling. However, the devil is in the detail as it has tightened up the criteria for creating new funds, plus it has put a question mark over some of the existing funds.

The key points of the statement are that a fund has to track its index within defined parameters. If the difference between the two moves outside these boundaries, then the binding ruling will become null and void.

It is unknown whether any of the existing funds fail to meet this hurdle. If they do they will have to modify the way they run their fund when it comes time to reapply for the binding ruling.

The other key point relates to what benchmarks a manager can use.

The department says the benchmark must be "a generally recognised index that has identifiable rules and requirements that can be examined (eg: the NZSE40 or the MSCI World Index).

"If the index is one that has been created for the purposes of the fund, then the Commissioner will want to review its basis, and may either rule conditionally or decline to rule favourably. "

Also, index funds have to relate geographically to generally recognised stock exchanges of New Zealand, Australia, the entire world (ie: a global index) or of all countries included in the grey list.

They generally can't be based on industries or sectors.

This latter point is at odds with the latest trend in the funds management industry, namely sector funds like technology, biotechnology and Japan.

It also raises questions over a number of existing funds such as Guardian Trust's three funds which track New Zealand and Australian property indices and some which track modified indices, such as the Dorchester First 15, and Second 15 funds.

IRD assistant manager adjudication and rulings John Mora says he couldn't make any comment on existing funds. However, he makes it clear some may not get their rulings renewed.

"It's entirely possible a fund which had a ruling in the past may not get it again," he says.

"There's absolutely no guarantee that the (present) ruling will be automatically be regiven."

IPAC Securities general manager David van Schaardenburg says a tightening of the rules limits the growth of new index funds and entrenches existing offerings.

He says the decision creates greater barriers to entry for people wanting to launch funds and potentially limits the development of new funds, such as ones which track a particular sector.

Mr Mersi says that managers had been pushing the boundary with some of their binding ruling applications in an effort to gain a distinctive advantage over their competitors.

He says the statement outlines the department's view on what is allowable.

"IRD wanted to put a hard line in the sand to stop a bit of creep around the edges," he says.

"They have probably drawn the line inside where some thought (the department) had got to."

What has been misunderstood about this statement is its impact on investors. In many circles the statement has been portrayed as anyone who invests in a passive fund with a binding ruling will get tax-free capital gains.

Not so, says Mr Mersi.

This statement only relates to the funds and it has nothing to do with individual investors.

Mr Mersi says an investor could be hit up for capital gains on two grounds.

If an investor bought a fund with the intention of seeking a profit they could be taxed on those gains.

Likewise, if an investor traded index funds, that is flipped from one to another in an effort to pick the markets he thought were going to perform well, then he could again face a tax bill.

This argument can be extended beyond index funds to the new wave of tax-efficient vehicles that have hit the market this year, namely United Kingdom authorised unit trusts and Open-Ended Investment Companies.

Like index funds these funds don't pay capital gains tax, but for a different reason.

Their tax-free status comes from the law they are established under in the United Kingdom.

The reason why investors in these funds may be at risk is because the bulk of the UK funds in the market are sector specific funds and there is a temptation that investors will switch from one fund to another in an effort to time markets, or sectors.

Investors who make gains this way are putting themselves at risk.

The final risk is that department is only prepared to issue a new ruling for a maximum of three years.

The whole issue of whether will come up again in 2002, unless the Government changes the rules.

« UK trusts stage a revival

King builds an empire »

Special Offers