Funds feel the heat

By PHILIP MacALISTER

The managed funds industry faces a crisis. Its latest weapon to deliver good returns for investors is being shot down by the Government.

Finance Minister Michael Cullen fired the fatal shot several weeks ago when he announced, out of the blue, that tax-effective Australian unit trusts (AUTs) are going to be destroyed.

For fund managers this is a major disaster but it is a situation they have got themselves into by being so competitive.

The first to take advantage of AUTs was Russell Investments (formerly Frank Russell) when it designed a set of "tax-effective" funds for ANZ, called the Ascent Investment Programme.

Much to Russell's surprise, this highly innovative product wasn't copied for some time. However, once copies began they spread like wildfire throughout the funds management industry. Many managers who opposed the idea felt they had to start using AUTs if only to protect their business.

Now most managers offer AUTs and nearly every new fund that has come to the market recently has used some sort of tax-effective structure.

The irony is that managers knew that this advantage couldn't last forever.

St Laurence director Kevin Podmore says that when his company was making its fund, it "considered there to be a high probability that the Government would, sometime in the future, change the tax law pertaining to AUTs".

"Our tax advisers considered there to be at least a 30-month window of opportunity. Given Dr Cullen's recent comments, we now believe the window of opportunity has probably shortened to closer to 18 months."

The crux of the problem is that, by using an AUT, people can essentially avoid tax - even though their money may be invested in New Zealand assets.

In his speech, Cullen gave an example of an investor who goes into an AUT that invests in New Zealand Government bonds. He said that by structuring things this way the investment was virtually tax-free.

"An identical investment through a New Zealand vehicle would be clearly subject to New Zealand tax.

"From the Government's perspective this is unacceptable and, if necessary, we will change the law to ensure that this option is not available," Cullen said.

The other area of concern is how a person accounts for their investments.

While technical, it is absolutely crucial to the way the taxman looks at things.

Essentially a taxpayer can hold investments on either their revenue or capital accounts.

Simplified, investments on capital account are those bought with the intention of holding for the long term, and are not subject to capital gains tax.

People who trade investments hold these on what's called their revenue account and are subject to capital gains tax.

PricewaterhouseCoopers tax partner John Shewan says people who are using AUTs to generate income probably expect their investments to be on capital account and therefore tax-free. However, any income from an AUT is generated by the fund issuing non-taxable bonus issues, and when someone wants income they have to sell units back to the manager.

"Gains that New Zealand residents derive from the eventual sale of their units may, however, be taxable, depending on whether the investment was held on capital or revenue account," Cullen said.

"I am not a tax expert but it seems to me to be a mighty effort to argue that shares or units with no realistic dividend yield were purchased otherwise than for the purpose of sale. That would make all the gains taxable."

ONE of the concerns now is that, although the Government has made its intentions clear, the picture has become hazier for fund managers, advisers and investors. All they know is that a discussion paper will be released in October and that changes will follow.

When and what they will be remains a mystery and open to speculation.

This leaves the question: What to do now? If you are in an AUT do you stay?

Should you consider putting more money in and, if you were looking at buying an AUT, should you reconsider?

To answer these questions, an investor has to go back to the start and ask why did they look at AUTs in the first place.

Tower Managed Funds general manager Richard Baker says if an investor went into a fund primarily for tax benefits, then they are asking for trouble.

He says investors should look at the manager and its track record to see whether they fit with an investor's objective.

Shewan tends to agree with the minister on the distinctions between what is on capital and revenue accounts.

If the money is in a bond fund and the investor has to sell units back to the manager, say every month, to provide cash, "Then I would have thought those people are probably dead in the water", he says.

It's different if someone sits on the units for two or three years without any income distribution.

"They maybe all right but it depends on what they have said when they went in."

Will the Government really act?

There is some scepticism that the Government is all hot air on this issue and won't take action. After all it made similar noises about another breed of tax-effective funds out of Britain four years ago and nothing has happened.

When Labour first gained power, fund managers began rolling out British-based Open Ended Investment Companies (OEICs), which like AUTs are tax-effective.

AMP was first off the mark and is still one of the biggest players in the OEIC area. Competitors lobbied Cullen asking him to close this so-called loophole.

The minister issued strong statements saying that changes would be made to the tax regime, but these comments brought the supporters of OEICs to the minister's door.

He realised that there were two camps on this issue, and nothing has happened.

However, Shewan cautions against taking a blase attitude. He says the IRD has become tougher in many areas by forming what it calls "industry partnerships". These partnerships are aimed at toughening up various sectors in which there may be tax leakage.

His view is that some in the funds management industry have been openly taunting the Government and officials.

"If you bash the bear over the nose with a stick, he will react and he has reacted," Shewan says.

Shewan expands his warning and says that the greater issue here is that the IRD could start looking more closely at individual investors' portfolios to see whether they have been avoiding tax payments. For instance, someone who actively buys and sells shares should theoretically be paying tax on the gains.

He says the biggest frustration he has as a tax adviser is "people's refusal to accept that you can be taxed if you acquire something for the purpose of resale".

"There's this stupid notion that mum and dad investors hold everything on capital account. It is untrue. It always has been untrue and it will probably always be untrue, but people will not listen."

He says the only reason this notion has currency is that more people are getting away with it rather than it being in any way "reflective of the IRD's acceptance of that position".

"I would hope most ethical people won't be relying on the IRD not happening to catch them out," he says.

While the AUT issue is a major, it may also provide an outcome the managed funds industry has been trying to achieve for more than a decade.

A GROUP of people in the industry argues that the AUT loophole is not actually a loophole.

Their argument, which has significant support from fund managers and the Investment Savings and Insurance Association, is that the issue shows that the problem is actually with New Zealand domiciled funds.

From their vantage point, New Zealand managed funds are at a huge disadvantage to other types of investments such as property and directly held shares.

Essentially, most New Zealand managed funds are treated as companies and tax is charged at the fund level (33 per cent) not at the investors' personal tax rate.

What's more, managed funds are generally liable for tax on their capital gains too.

However, if you buy a residential property or shares directly as an investment, then you pay tax at your marginal rate and it's highly unlikely you will pay capital gains tax.

Even the Government acknowledges there are major problems with the New Zealand structure, and that people on marginal tax rates of less than 33 per cent are paying too much tax.

New Zealand Funds Management principal Richard James says even if the AUT "loophole" is closed, investors will be better off in AUTs than local funds because tax will rest with each individual investor, not at the fund level.

He defends his company's use of AUTs, "As an asset manager we have a responsibility to try and achieve the best possible returns we can for investors and tax is one part of that possible return."

He says that if people are concerned about paying too much tax, they should be more concerned about New Zealand based-vehicles as they will be paying tax at a minimum of 33 per cent and maybe even more.

The key point is that the Government and officials should be using this opportunity to sort out a number of tax issues in the savings area.

It is an opportunity for the Government to show that it is serious about encouraging quality, long-term savings.

"I think it is wonderful that the Government is choosing to look at [this issue] as long as they look in the right places," he says.

"They need to start looking at the tax law at home before they start looking abroad."

* Philip Macalister is the editor of online money management magazine Good Returns (www.goodreturns.co.nz)

* Email: Philip@goodreturns.co.nz