Tax review puts funds on equal footings
Money flows into managed funds are likely to be redirected if the suggestions in the McLeod tax review are implemented.
Tuesday, July 3rd 2001, 10:30AM
Think of the managed funds industry as being like a river. The money flows down between the river banks until it gets to the estuary. When it gets there lots of little streams develop to find the route of least resistance to the ocean.
With managed funds each of those little streams represent different ways of investing, whether it be through different asset classes like shares and property, or different investment vehicles such as unit trusts and superannuation funds.
Some of the newest and fastest flowing of these streams are index funds and offshore based trusts which bathe in tax advantages over their New Zealand counterparts.
If proposals from the McLeod tax review are implemented a big dam will be built across this river and money will be channeled to the sea by quite a different route - more like a series of concrete canals.
The review, which was commissioned by the Government, but is not Government policy, is proposing some quite radical shifts to the way investors and managed funds are taxed.
The shifts proposed are not bad: there are winners and losers and many investors could end up paying less tax than they currently do.
Likewise, the Government could reap less tax revenue than it does now.
The fundamental shift is to the idea of levying taxes on what is called a risk free rate of return model. This concept has attracted significant attention as the review committee suggested using it to tax the equity in a person's home.
Politicians of all hues have ruled it out in that context. However, in a broader investment concept the end result is quite different.
It works like this. Instead of having tax on capital gains and income there would be one tax and that would be levied on how much money a person had invested at the start of each year.
The rate of return would be set annually on the amount of capital invested, not the level of dividends or the capital gains.
One of the fundamental differences between what is being proposed and the current system is that one is before and the other is after. Each year you play the investment game and at the end of it you tally up the score and pay the appropriate amount of tax of the end result.
Under the McLeod way you pay your tax on the starting amount and that's it.
Think if it like a Lotto ticket. If you buy a $5 lucky dip for this weekend's draw it's worth $5 on Friday. With McLeod you pay tax on the $5.
But if you bought the ticket this week you would take your chances and pay tax on the value of the ticket after the draw (usually nothing, but possibly a while lot more).
The first point is that the timing of the tax payment is different.
The second major point is that the tax is calculated differently.
Because, under McLeod, you are paying upfront regardless of the outcome a benchmark rate is set.
In the review panel's case it is set on the equivalent of what is known as the risk-free rate of return, taking into account inflation.
This is one of those things that is calculated by academics. They say, "what would I earn on my money if I invested it in something which has no-risk of falling over?"
In most cases the ruler used in this exercise is the rate of return on long-term Government bonds.
In New Zealand a 10-year bond is issued at about 4%, hence that is the rate used.
Once the Government (probably Inland Revenue Department) has calculated the risk-free rate of return that is then applied to all investments.
For example, at the start of the year if you had an investment portfolio of $10,000 you would pay tax at your marginal rate on 4% of that sum. If your marginal tax rate was 39c you would pay $154.
If at the start of this financial year you had $10,000 invested and it grew by 10% you would then pay tax on $11,000, which at 39c equals $390.
One of the big differences in the two systems is if you make a loss. Under today's system you could get a tax credit. Under McLeod's you would have paid the tax upfront and would have to wear the loss.
Review head, Rob McLeod, says he wants people to think about the idea and how it would work. Although it has been controversial in New Zealand in the past fortnight with regards to home ownership, it is a concept which is supported by the OECD and is used in nine European countries including Switzerland, the Netherlands, and Belguim.
The beauty of it from the point of view of investors is that decisions on where to place money wouldn't be made on tax considerations.
For many people it's hard enough just deciding some of the basic questions: Shares or Property? Bonds or cash?
It gets really difficult when it comes to deciding whether to go for active or passive management, listed or unlisted property, or New Zealand funds or foreign based ones?
With New Zealand investors the answer often seems to revolve around tax considerations.
"(Investors have) a strong degree of tax minimisation in this country," BT Funds Management chief executive Craig Stobo says. "There's a desire for the best after tax income you can get."
Money Managers marketing director Al Scott agrees. He says when a person considers the return first and then the tax status.
These two factors are inextricably linked as a so-called tax efficient fund can deliver a better return than a tax neutral one.
This desire for tax efficient funds has triggered off wave after wave of new investment products.
First it was UK listed investment trusts. These are UK based investment companies which are, in many cases dual listed on the London and New Zealand Stock Exchanges.
Investment trust guru, Peter Irwin of Credit Suisse First Boston, estimates that about 18,000 investors have $430 million invested in the 18 trusts listed on the New Zealand exchange. On top of that New Zealanders also invest directly into funds which are only listed on the London Exchange.
Next off the block was index funds, such as TeNZ and WiNZ. Again it is difficult to get a hard number on how much money is invested into these funds as wholesale offerings aren't covered by research houses.
Research house FundSource says there's about $775 million in retail equity index funds. However, when wholesale is included the total is likely to be in excess of $2 billion.
The latest version of tax-efficient funds are UK-based unlisted unit trust, including Open-Ended Investment Companies or OEICs, and Australian-domiciled funds.
ANZ and Money Managers, who are the two players with Australian funds, have a combined total of about $700 million under management, while there is another $100 million in UK OEICs.
AMP Henderson is the biggest player in the OEIC market with about $60 million and Royal & SunAlliance is considered to be second with $20 million. Other players in this market include Armstrong Jones, Challenger, and the Public Trust.
Under the McLeod ideas these funds would lose their tax-free status and be taxed on the risk-free rate of return basis.
Likewise, the concept could be extended to passive funds so they are treated identically to other funds.
KPMG tax partner Chris Abbiss says the proposals in the tax review remove many of the differences between savings vehicles.
If the Government chose to implement the changes it would make the investment decision making far easier than present because people would be selecting funds on their merit, not on their tax status.
However, the McLeod report is only a discussion paper and there is no way of knowing what the government may pick out of it.
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