Passive Tracker Funds Rulings Applications

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The IRD lets index funds keep their tax advantage - but with strings attached.

Monday, December 11th 2000, 8:53AM

IRD’s Rulings Unit has completed its review of the tax position of the so-called "passive" investment funds that simply track an equity market capitalisation index rather than making active investment decisions. The review has been undertaken because a number of binding rulings for such funds are due to expire in the near future, and it is important that the market, and applicants for rulings, have some certainty regarding Inland Revenue’s position.

Following its review of the relevant tax laws and cases, the Rulings Unit will continue to issue binding rulings for passive investment funds that gains on the equity investments are not taxable, where the following general criteria are met:

• Trustees or Fund Managers must adhere to strict tracking of the benchmark index at rebalancing dates (subject only to any allowable tracking tolerances (e.g. 1%), which must be no more than strictly necessary depending on the Fund's circumstances, or to any necessity of dealing in acceptable stipulated minimum amounts of investment).
• The Fund must specify periodic dates, or circumstances, at which re-balancing is to commence, and specify timeframes (e.g. 5 business days) that the rebalancing must be completed by, which must be no more than strictly necessary depending on the Fund's circumstances.
• The benchmark index used by the Fund is based on a generally recognised index that has identifiable rules and requirements that can be examined (e.g. the NZSE40 or the MSCI World Index may be acceptable indices). 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.
• The composition of the index is not determined or influenced by such factors as profitability, growth or similar factors. In this regard, unmodified market capitalisation is generally regarded as an acceptable basis for an index.
• The benchmark index used by the Fund relates geographically to generally recognised stock exchanges of New Zealand, Australia, the entire world (i.e. a global index) or of all countries included in the "grey list" listed in Schedule 3, Part A, of the Income Tax Act 1994. Where other selections or combinations of countries are put forward then the Commissioner will want to consider the manner in which they were selected, and may either rule conditionally or decline to rule favourably.
• The benchmark index used by the Fund is not based on or biased towards particular industries or sectors. In such selections, the Commissioner cannot be satisfied as to the purpose of the selection, which is a question of fact, and so a favourable ruling will not be given.
• The cash pool servicing day to day redemptions and holding contributions from investors is no more than strictly necessary, and in any event not greater than 5% of the asset value of the Fund (subject to a strictly limited ability to temporarily exceed 5% in specified circumstances). The cash pool must invest only in cash and highly liquid debt assets, and not in derivatives.
• The only events that trigger realisations or acquisitions of the Fund's holdings are:

• If there is a change in the index composition so that the composition of the Fund no longer tracks the index on a rebalancing date.
• Funding redemptions to the extent that these cannot be met by the cash pool.
• Administration or management costs unable to be met from the cash pool.
• If there is a claim on the Trustee in respect of the Fund that cannot be met by the cash pool.
• If the Fund is wound up.

• There is no ability to borrow, except in strictly limited circumstances such as:

• To temporarily fund the redemption of units.
• In extreme circumstances, for the payment of unexpected expenses that exceed the cash pool amount.
• Where a security is sold and another purchased and settlement failure occurs resulting in an involuntary borrowing.

• All discretions granted to a Trustee or Fund Manager will be reviewed on application as to their purpose and acceptability to the Commissioner, and, even if a particular discretion is accepted, in each case any ruling given will be conditional on such discretion not being exercised to enhance the Fund's performance (including the deferral or acceleration of the realisation of gains or incurring of losses).
• The Fund is not an investment vehicle for a single entity or person, or a small group of entities or persons, who may effectively control the timing of realisations of the Fund through withdrawals from the Fund. Furthermore, the Commissioner is not presently satisfied that a favourable ruling can be given where the Fund is an investment vehicle for an entity or person that would be taxable on investment gains (such as a financial institution). Other situations where the Fund is not to be widely-held will be subject to review on application, and any ruling given may be conditional upon the absence of potential manipulation of the strict tracking requirements.
• Where there is an initial start-up period during which a Fund will not be fully replicating the benchmark Index, due to insufficient funds, any ruling given will be conditional upon such non-replication continuing for no longer than is strictly necessary and, in any event, for no longer than a stipulated period (e.g. 6 months) depending on the Fund's circumstances. It would be expected that an investment method such as index sampling, to minimise deviation from the target benchmark index, would be adopted during such a period.

Funds that fall outside these criteria should not generally expect to receive favourable binding rulings (although each application will be considered on its merits) because IRD is less confident about how the courts would find in such cases and, consequently, about the Commissioner's ability to be satisfied that a business is not being carried on. Those funds can, of course, still operate in the absence of a binding ruling and, if the Department contests their taxability on investment gains, utilise the legislative tax disputes procedures to determine their tax status.

These are the important matters that have emerged from the review, but it is of course possible that other issues not encountered to date might emerge during future ruling applications.

Due to the relative lack of clarity and precedent in the case law in this area, rulings will only be issued for three years and the Rulings Unit will be closely monitoring court decisions and any legislative developments in the meantime.

It will assist in processing applications for such Funds if applicants expressly take into account the Department's position as outlined above.

This is a statement from the Inland Revenue Department.

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