Tax

While it was pleasing last year to see the implementation of a number of legislative solutions to problems with the tax treatment of certain savings vehicles (in particular the so-called ‘negative dividend’ problem), the last few months of the year gave rise to a number of tax and tax-related issues which will require further attention this year; recognition of tax assets in unit pricing, the consequences of potential changes to GST, and the continued possibility of further changes to the tax treatment of off-shore investments.

Valuation of tax assets

A consolation for any investor whose investments are worth less than cost is the potential tax benefit that the loss will generate upon realisation of the investment. Of critical importance in the above statement is the word ‘potential’. Tax losses are only of value if the investor has or will generate taxable profits against which the tax losses can be offset, and that this offset occurs sooner rather than later.

The value of such losses is a critical issue for both financial reporting and unit pricing purposes.

For financial reporting purposes, the rules governing the valuation of the benefit of tax losses is generally well understood; the accounting practice standard SSAP 12 requires "virtual certainty"* of realising the benefit. One might question the appropriateness of such a test in the context of a pooled investment vehicle where losses from time-to-time (especially on a mark-to-market basis) are to be expected, and where there is inherent uncertainty about future performance. This is a matter that should be considered further by the accounting regulators, however at least it does provide a framework for decision-making when it comes to preparing accounts.

In the past, it seems to have been the case that whatever value was adopted for accounting purposes in relation to tax assets was also adopted when calculating unit pricing (not just for unit trusts, but for any unitised investment such as a defined contribution superannuation fund). However, the sustained bear market has put significant pressure on this simple relationship.

In contrast to the accounting rules described above, of prime concern in determining the appropriateness of tax asset valuation for unit pricing purposes is unitholder equity – both between current unitholders, and also between past, current and future unitholders.

The length and the severity of the loss of value in international equity markets, and the consequent difficulty in reflecting the full value of tax losses for financial reporting purposes has put considerable pressure on fund managers to determine whether it is appropriate for them to similarly reduce or remove the tax asset value from their unit pricing calculations.

What has become apparent is a lack of a consistent framework or reference point in relation to which the valuation of tax assets can be determined for unit pricing purposes.

This void does not seem to be restricted to New Zealand.

Fund managers have become acutely aware of this issue and I understand that it is a matter which the ISI is in the process of addressing.

There is no right or wrong way of valuing tax losses for unit pricing purposes – in hindsight any method will leave some unitholders better or worse off than they should have been. This is no different to what happens when shares are bought and sold after an investor has made a judgement about the value of assets and liabilities in a company.

I would expect that, much like the accounting standards, the industry will adopt a consistent set of parameters that should be taken into account in determining the value of taxation assets, and processes will be put in place to formalise the decisions that are made in arriving at the values. As with accounting standards, there will always be the potential for different values to be arrived at under the same parameters, but it is more critical to have consistency of approach rather than consistency of outcome.

Given the tightness of the ‘virtual-certainty’ test for accounting purposes, it seems reasonable to expect that the valuation of tax losses for unit pricing purposes would rarely be lower than the value adopted for accounting purposes. Further, during those periods when the value of unrealised tax losses may be relatively high for some funds (such as now), one might expect that losses may be valued higher for unit pricing purposes than for accounting.

There is nothing wrong with this, it is no more than one would expect when the valuations are based on a different set of criteria that are each appropriate to their own context. It is a difference, though, that should be explained and, one which needs to be understood by investors in unitised vehicles.

GST: potentially detrimental changes mooted

The Government continues to work towards the implementation of the so-called ‘reverse charge’ mechanism (which will impose largely unrelieved GST on New Zealand funds and managers in respect of any fees for non-financial services provided from outside New Zealand). The reverse charge mechanism, together with the more recently announced proposal to zero-rate business-to-business financial services, are likely to apply from late-2004 or early 2005. The Government has committed to allowing one year to elapse between enactment and application to allow systems to be adapted.

Even taken together, these changes are likely to have a detrimental impact on the costs faced by managed funds (and/or their managers, trustees, and administrators etc). While we may only be a few months away from the introduction of legislation covering these regimes, a lot of detail has yet to be worked through and the industry will need to continue to provide significant input.

The GST Discussion Document on Financial Services which was released in October last year not only publicly announced the prospect of zero-rating business-to-business financial services, but, perhaps more critically for the funds management industry, also suggested a narrowing of the definition of ‘financial services’ - therefore rendering some currently exempt (or largely exempt) services fully subject to GST.

Of significance are recommendations that brokerage and similar intermediation services become fully subject to GST. In addition, the Discussion Document invites comments on the proposal to make unit trust and group investment fund management fees subject to GST in full. This suggestion comes less than 12 months after the IRD finally determined the extent to which such services are subject to GST under current legislation. The current status of trustee fees or fees for the management of superannuation funds could also be impacted by this approach.

A cynic may see these suggestions as being one step towards making all explicit fees for financial services subject to GST. This is an approach to the taxation of financial services which has been considered by the Government, and it may be of cold comfort to note that in the Discussion Document the Government conveys its view that "it would be inappropriate, at this time, to advance this option".

Risk free return method

As my final observation, I do no more than note that the Risk Free Return Method of taxing some or all off-shore investments is still not off the Government’s agenda. It is a regime fraught with issues. When the debate on the merits or otherwise of RFRM was in full swing last year, it was difficult to discern a consensus amongst fund managers as to whether the regime would be a positive change. I note that, if applied broadly, the regime would go some way towards addressing the current preference afforded to individuals who directly invest in equities (rather than via pooled vehicles). However, RFRM is not the only way of achieving this, and the arbitrariness of the flat-percentage annual income calculation under RFRM seems a high price to pay (in particular off what might be an historically low cost base if introduced before equity markets fully recover).

Paul Mersi is a tax partner with PricewaterhouseCoopers.

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