A fund manager fee conundrum

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Research consistently shows a fund’s total fee burden impacts on long term returns for investors.  As a general rule lower fund costs mean more left over for investors.  This is certainly true of deep liquid markets (like large cap US equities) where information and skill is widely disseminated – it’s hard for one manager to repeatedly outperform over for 3-5 year periods.  The bi-annual S&P Dow Jones SPIVA report on active manager (under) performance is compelling reading.

Monday, April 11th 2016, 6:00AM 2 Comments

by John Berry

While this article is on manager fees, the focus is narrow - GST charged on manager fees.  Believe it or not is very important for investors, advisers and fund managers.

What is the issue?
Inland Revenue is considering how much GST should apply to fund manager fees.  Essentially part of a fund manager’s activity is a financial service and therefore potentially GST exempt.  The question is how much.  Manager’s seem to do many things that aren’t financial services (here’s a light hearted example – why don’t fund managers ever look out the window in the morning? Because if they did they’d have nothing new to do all afternoon…..!).  Here’s the issue – should GST apply on fund manager fees?

No GST – a good thing?
If there’s no GST on manager fees then investors appear to save 15%.  Yet the fund manager still pays GST on its business inputs.  So in simple terms if the investor pays no GST the fund manager still has to pay it – the fund manager is effectively subsidising the investor.

So how does a rational fund manager react?  They set their fee higher to account for the fact they pay GST but cannot recover it.  It looks like the investor has made a 15% saving, but the reality is the investor is paying a higher management fee than they otherwise would.

Some fund managers currently charge GST on only 10% of the manager fee.  Acting rationally their base fee should currently be higher than it would have otherwise been (because of their inability to reclaim GST on inputs).  There is no free money.

Zero GST on manager fees – smart or stupid?
In the ground breaking House of Lords case of IRC v Duke of Westminster, Lord Tomlin made it clear that interpreting and implementing tax law is not about fairness or morality – it is about following the rules.  So the rules are all important.

Here’s our top three reasons why making fund manager fees GST exempt is the wrong thing to do:

1. There is no saving for investors.  Wiping GST on manager fees brings a cost for fund managers which will be recovered through higher pre-GST fees.
2. As an alternative to raising fees, fund managers are likely to attempt structuring their business with “GST efficiency” (simple example - staff on consulting contracts with GST move to a salary with no GST – but there will be more complex tax arbitrage opportunities).  Accountants will love it but frankly the structuring is another wasted compliance burden that business can do without - money spent on tax advice for no productivity gain.
3. GST will not apply to services performed by the manager but will apply if the manager outsources the same services.  This is encouraging managers to perform services in-house (such as registry and fund accounting) so GST will not apply.  That is crazy – to protect investor interests fund managers should be encouraged to outsource (not in-source) these functions.  If a fund manager uses MMC for independent fund pricing then GST applies (irrecoverable cost to the manager) while if the same function is performed in-house on a spreadsheet no GST applies – the outsourcing is better for investor protection but is discouraged by tax consequences.

Let’s also think about this from a New Zealand Inc perspective.  There will be less GST collected by the government if none is collected on fund manager fees.  The revenue would be agreeing to an erosion of the tax base.  And for NZ Inc here’s the big one - we can’t take GST off food in but we can take GST off fund manager fees.  No GST on fund manager performance fees….  seriously? 

John Berry, Director
Pathfinder Asset Management Limited

Disclosure of interest:  John is a founder of Pathfinder and invests in all Pathfinder’s funds.

Tags: funds management Pathfinder Asset Management

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