Money: IRD's Christmas gift keeps punters happy

Passive funds have won a reprieve, PHILIP MACALISTER* reports, but the rules are going to tighten.

Investors in index or passive funds could be forgiven for thinking the Inland Revenue Department gave them a welcome Christmas present last week.

Much to their relief, and to that of fund managers, the department gave its long-awaited pronouncement on the future of the popular, tax-effective index funds.

The good news was that the department was not going to kill the $2.5 billion passive fund market, but it indicated it would take a tougher approach from now on.

PricewaterhouseCoopers tax expert Paul Mersi says there was a reasonable degree of expectation that the IRD may have delivered the killer punch.

"This was the best opportunity they had to kill them."

It is likely passive funds will be around for a while longer, because there are few chances for now to close them .

Throughout their short life passive funds have had a tumultuous time, and if the past is anything to go by, this will continue, Mr Mersi says.

The Stock Exchange started it when it launched its TeNZ index fund, which tracks the 10 biggest stocks listed on the exchange.

What it did was something the experts in the field - fund managers - had never quite worked out how to do.

It created a fund that got around the law which requires managed funds to pay tax on any capital gains.

The exchange went to the IRD and successfully sought a binding ruling, which in effect said that if it built a fund that replicated and tracked the companies in the NZSE-10, then it would not have to pay tax on any capital gains.

This ruling provoked passionate debate among managers, not least from promoters of actively managed funds, as it put them at a significant disadvantage.

According to AMP Henderson Global Investors, an actively managed fund has to generate an extra 3 per cent return each year just to keep up with passive funds.

Since 1996, index funds have carved out a significant place in the savings world. More than 20 retail funds are on offer (although the IRD has issued 45 binding rulings), ranging from AMP Henderson Global Investors' $1 billion-plus WiNZ international index fund through to tiny funds such as Dorchester's First Fifteen fund of $558,000, according to IPAC Securities.

While investors and fund managers may have breathed a sigh of relief when they read the IRD's statement last week, they should not think the last hurdle is over.

What the IRD did was to publicly clarify, for the first time, its thinking on how it decided whether it should grant a binding ruling.

However, the devil is in the detail, as it has tightened the criteria for creating new funds and put a question mark over some of the existing funds.

The key points of the statement are that a fund has to track its index within defined parameters. If the difference between the two moves outside these boundaries, then the binding ruling will become null and void.

It is unknown whether any of the existing funds fail to meet this hurdle. If they do, they will have to modify the way they run their fund when it comes time to reapply for the binding ruling.

The other key point relates to what benchmarks a manager can use.

The department says the benchmark must be "a generally recognised index that has identifiable rules and requirements that can be examined (for example, the NZSE-40 or the MSCI World Index).

"If the index is one that has been created for the purposes of the fund, then the commissioner will want to review its basis, and may either rule conditionally or decline to rule favourably."

Also, index funds have to relate geographically to generally recognised stock exchanges of New Zealand, Australia, the entire world (ie, a global index) or of all countries included in the grey list.

They generally cannot be based on industries or sectors.

This last point is at odds with the latest trend in the funds management industry - sector funds such as technology, biotechnology and Japan.

It also raises questions over several existing funds, such as Guardian Trust's three funds which track New Zealand and Australian property indices, and some which track modified indices, such as the Dorchester First Fifteen, and Second Fifteen funds.

IRD assistant manager, adjudication and rulings, John Mora says he could not comment on existing funds. But he makes it clear some may not get their rulings renewed.

"It's entirely possible a fund which had a ruling in the past may not get it again. There's absolutely no guarantee the [present] ruling will be automatically regiven."

IPAC Securities general manager David van Schaardenburg says a tightening of the rules limits the growth of new index funds and entrenches existing offerings.

The decision creates greater barriers to entry for people wanting to launch funds, he says, and potentially limits the development of new funds, such as ones which track a particular sector.

Mr Mersi says managers had been pushing the boundary with some of their binding ruling applications in an effort to gain a distinct advantage over their competitors.

The statement outlines the department's view on what is allowable, he says.

"IRD wanted to put a hard line in the sand to stop a bit of creep around the edges. They have probably drawn the line inside where some thought [the department] had got to."

What has been misunderstood about this statement is its impact on investors.

In many circles the statement has been portrayed as saying anyone who invests in a passive fund with a binding ruling will get tax-free capital gains.

Not so, says Mr Mersi. This statement relates only to the funds, and has nothing to do with individual investors.

Investors could be hit for capital gains on two grounds.

If they bought a fund with the intention of seeking a profit, they could be taxed on those gains.

And if they traded index funds - that is, flipped from one to another in an effort to pick the markets they thought were going to perform well - they could again face a tax bill.

* Philip Macalister is the editor of online money management magazine Good Returns. Good Returns is a leading provider of news on managed funds, mortgages, superannuation, insurance and financial planning.