Are we in the twilight zone of tax breaks on AUTs?

Australian unit trusts (AUTs) have been in the taxman’s gun sights for some time. Revenue Minister Michael Cullen has been on record saying he favoured a change to tax rules to close what he called a “loophole” that allowed AUTs to be “circular”, that is, to invest in New Zealand assets such as government stock.

In fact there is no loophole that has allowed AUTs to be circular, but simply an application of existing tax rules on the ability for AUTs to distribute returns to New Zealanders as non-taxable (ie: tax fee) bonus units.

Under the proposed Bill

The IRD’s proposed solution – contained in a Supplementary Order paper to the Taxation (Annual Rates, Venture Capital and Miscellaneous Provisions) bill - simply cut the tax-free status from AUT bonus issues. It doesn’t just deal with circular AUTs, but takes a dragnet approach. Regardless of the unit trust’s country of origin, bonus issues made to a unitholder, whereby money or property vests absolutely in the unitholder, will be taxable when received by the investor. The unit trusts concerned will not be taxed, but rather the recipient of the trusts’ distributions will be.

A non-taxable bonus issue from an AUT will effectively cease to exist and in its place there will be a taxable bonus issue. Tax on bonus unit distributions will be at the investor’s marginal tax rate and will be derived in the income year of receipt. In a typical (although not always the case) AUT situation, receipt of a bonus issue by unitholders for taxation purposes in New Zealand will occur soon after June 30 (end of the Australian tax year). It is at this date that AUTs must distribute foreign-sourced income to investors or otherwise themselves become subject to a high Australian marginal tax rate on that income.

AUTs sold locally have been straddling Australian and New Zealand tax regimes, and it is clear that the tax benefits to unitholders from these structures will be diminished under the proposed rules. Some matters remain to be resolved and the Finance and Expenditure select committee remained open for submissions on AUT taxation to June 4 so interested parties had further opportunity to persuade the committee to modify the proposals. Two possibilities for modification are the scope of the amendment and the timing of its application in law.

In respect of scope, it’s a long shot that the AUT proposal will be altered to revert focus to the aspect that troubled Cullen, namely investment circularity. In that case non-circular AUTs could escape the change, but this seems unlikely.

As far as timing is concerned, the bill to which the proposed taxation change is attached will come into effect once it has received Royal Assent, probably around October 2004. It has been argued that the tax change should not come into effect until April 1 2005, the beginning of the 2006 tax year. Such an amendment may have more chance of success than attempts to diminish the scope of the law change.

So what do the proposed tax changes mean for investors?

Two types of taxpayer come into the picture. The more numerous are the fabled “mums and dads”, that is those with modest investment levels and 31 March balance dates. This group constitutes the bulk of retail investment clients. Regardless of whether the changes apply from the date of Royal Assent or the beginning of the 2006 tax year on April 1 2005, these people will hardly be in any rush to pay tax.

For a distribution ex June 30 2005, these people will have until February 7 2007 to pay any terminal 2006 tax liability, and if they are on a tax agency list their final payment date is April 7 2007. True, these investors (depending on whether they pass certain income thresholds) may have to file tax returns for the distribution but if they have surplus imputation credits from other income, they can offset the credits against the tax on their AUT earnings. Moreover, advisers could add filing tax returns for AUT investors to their range of client support services, adding value to their service range and finding out all sources of taxable client income in the process.

For provisional taxpayers, the position is a little more complex. These clients fall into such niches as professional investors, collective investment vehicles and individuals with large amounts of money invested in AUTs. It would be advisable for such investors to consult their tax adviser in respect of the impact on provisional tax and other tax implications of the proposed changes.

What of tax efficiency?

Tax efficiency has been advanced as an argument in favour of AUT investment vehicles, and clearly the proposed changes are intended to remove that. Fee efficiency (the relative management costs of AUTs vs New Zealand-domiciled unit trusts and group investment funds) may become the primary concern for advisers and their clients, as AUT fund manager fees may be higher than those of New Zealand-domiciled equivalents. Moreover, the proposed change is an interim measure. With a complete review of investment taxation in the offing, and possible adoption of some level playing field approach such as the risk-free rate of return method (RFRM) or some variant thereof, any upcoming taxation effects on AUTs may be subject to revision again at a not-too-distant time.

For most advisers and their clients invested in AUTs, it will be business as usual until the tax legislation is passed. After that, there will be time to take stock of what may need to be done next but there does not look to be any screaming panic pending and, in many cases, status quo may remain satisfactory. Given investor considerations noted above, there may be no need to change investment strategy or vehicles. Still relevant will be considerations such as asset class, manager style and risk/return profile in respect of whether any particular AUT still has a place in client portfolios. In the meantime, it’s a case of make hay while the sun shines, it’s not the twilight of the AUT, but simply of its tax breaks.

Michael Coote is the national manager mezzanine clients for TOWER.

Disclaimer: TOWER Managed Funds offers two Australian unit trusts: Advantage Hedge Fund and Advantage Multi-Trading Fund. Neither fund is “circular”.

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