Setting and disclosing tax assets
Bank of New Zealand Investment Management provides a fund manager's perspective on the vexed issue of how to handle tax losses.
Tuesday, March 9th 2004, 4:55PM
During periods of sustained negative investment returns from equity markets, fund managers are faced with determining the level to which tax assets are able to build up and be reflected in unit prices within a fund. In setting a policy around tax assets, both those assets that are to be reflected within the unit price and those that will remain within the fund but not factored into the unit price are key considerations.
An overriding principle is that a fund manager must balance the intergenerational equity of investors, with the risk of allowing an asset to grow to an unsustainable level. The objective in striking the right balance between these issues is to protect the interests of past, current and to some extent future investors. In other words, to treat investors who are leaving, staying, or joining in as equitable manner as possible.
The Investment Savings & Insurance Association of NZ Inc (ISI) guideline on this issue is described in the following recommended disclosure to be included in promotional material.
“In accordance with the Industry Guidelines for Tax Asset Recognition in Unit Pricing published by the Investment Savings and Insurance Association of NZ Inc. the unit price of the fund takes into account the value of tax assets that arise from investment losses which the manager has calculated may reasonably and prudently be utilised over time by offsetting them against tax payable on future earnings of the fund. Should the fund be wound up before the tax assets have been utilised by the fund, the value of the unused tax assets would not be reflected in the returns to investors.”
Not allowing any tax assets within the unit price of a fund removes all risk of non-sustainability, but has no degree of intergenerational equity. However having an unrestricted level of tax assets within a fund may provide full intergenerational equity but could increase the risk of non-sustainability.
On the basis that future investors have no explicit right to benefit from any known existing tax assets outside of the unit price of a fund, then ISI’s generic disclosure is fundamental in protecting equality between past, current and future investors. To disclose any levels of tax asset (whether inside or outside of a unit price) creates an opportunity for arbitrage by future investors, which would be to the detriment of current and past investors. It may also unduly influence the behavior of current investors.
There is a view that if a manager wishes to disclose a fund’s tax assets – then they can mitigate the arbitrage opportunity by communicating to all investors and the market in general, at the same time. Such communication should not be limited to simply advising investors and the market the size of any tax assets but ensuring that they understand the implications of those tax assets. Clearly this issue is likely to be very complicated for many retail investors to understand. Even if a manager believed they could communicate to all investors and guarantee such investors understood the issue, the arbitrage opportunity for future investors is still not removed. It simply provides current and better informed investors the opportunity to arbitrage the situation…to the detriment of their fellow investors.
The considerations in setting a tax policy
A key consideration is what level of tax asset within the unit price of a fund is sustainable. If, during periods of sustained negative returns the tax asset is allowed to grow too large (as a percentage of the fund’s assets), then there is a risk that the investors in that fund face a future write down in the value of their investment. This risk is increased greatly if there are significant outflows - which can be a common occurrence for equity funds during periods of negative returns. In such a situation the ‘last man’ standing may be left with an investment that does not have any tangible assets behind it. The question of sustainability can only be answered through detailed modeling of potential investor flows, long run return expectations and variability, short-term return expectations, nature of the returns, make up of the investor base and the size of the fund.
A tax policy can address the sustainability consideration by setting a ‘cap’ on the level of tax asset that a fund can carry – which should be reviewed periodically. Setting a cap acts as follows:
· - a tax asset cap of 0% means that there are no future tax benefits recognized within a fund’s unit price;
- a cap of 5% means that future tax benefits are recognized in unit pricing until the tax asset reaches 5% of the value of the fund, and then any extra tax assets are not recognized within unit pricing;
· - no cap means that all tax assets are recognized in unit pricing.
But here is the key – whether the tax asset (or the future tax benefit) is recognized within unit pricing or not – it still exists and will still have some future tax benefit.
This gives rise to another major consideration – intergenerational issues. These can be demonstrated using an example of three identical funds using either a 0% cap, 5% cap, or no cap option.
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Net
returns generated by
different tax policies
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Year 1
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Year 2
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Equity
markets fall by 20% (gross)
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Equity
markets recover 30% of their value (gross)
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Total
return over both years 4.0% (gross)
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Fund A: operates
a 0% cap on tax assets
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-20.0%
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28.4%
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2.7%
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|
Fund B: operates
a 5% cap on tax assets
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-16.0%
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22.2%
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2.7%
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Fund C: does not
cap tax assets
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-13.4%
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18.6%
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2.7%
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For Fund A (0% cap): Investors take the full hit of the –20% return in year 1. At the end of year 1 a $1,000 investment would fall to $800, and a tax asset of $66 would be generated within the fund, but not be factored into the investor’s balance. In year 2 when the market recovers 30% the investment will grow to $1,027 (which is a net of tax return of 28.4% for year two). This is because the tax asset of $66 from year 1 can offset most of the year 2 tax bill of $79.20.
For Fund B (5% cap): Investors take a partial hit when the market falls 20% in year 1. At the end of year 1 a $1,000 investment would be partially cushioned and only fall to $840 as there would be a tax asset factored into the value of the investment of $40 (or 5% of the value of the investment), but there would still be a tax asset of $26 within the fund that was not factored into the investor’s balance. In year 2 when the market recovers 30% the investor’s balance will grow to $1,027 (which is a net of tax return of 22.2% for year two). This is because the combined tax asset (within the unit price and outside the unit price) from year 1 is used to offset most of the tax bill from the growth in year 2. The net return in year 2 is lower than Fund A as some of the future benefit of the tax asset had already been factored into the value of the investment.
For Fund C (no cap): Investors receive full tax loss cushioning on the 20% market drop in year 1. At the end of year 1 a $1,000 investment would only fall to $866 as the full tax asset of $66 is factored into the value of the investment. In this situation all tax assets within the fund have been factored into the investors balance. In year 2 when the market recovers 30% the investor’s balance will grow to $1,027 (which is a net of tax return of 18.6% for year two). While the tax asset from year 1 is still used to offset some of the tax bill from the growth in year 2, the net return in year 2 is lower than Funds A and B as the full future benefit of the tax asset had already been factored into the value of the investment.
Fund A and Fund B are open to arbitrage opportunities as new investors can join and reap the benefits of the tax assets generated by current and past investors who have suffered the impact of the declining markets. In the Fund C example investors in the fund during the period of decline receive full tax loss cushioning, and investors in the fund while it increases get returns less tax to pay. Which provides perfect equity between past, current and future investors, but increases the risk to the “last man standing”.
The risks and implications of a poorly set tax policy are such that fund managers should apply as much rigor and expertise to the setting of the tax policy as they do in selecting investment opportunities.
BNZ Investment Management Limited’s tax policy is in line with the overriding principle to balance intergenerational equity between investors, while protecting investors from non-sustainability of a tax asset (if any). As such, for our retail funds we do not disclose our level of tax assets within a unit price, outside of a unit price, or any level of cap in the operation for our retail funds – our disclosure is limited to that recommended by ISI. We believe this policy is the fairest way of balancing inter-generational equity with non-sustainability risks.
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