Money: Tax: going with the flow

By PHILIP MACALISTER

Think of the managed funds industry as being like a river. The money flows down between the river banks until it gets to the estuary. When it gets there, lots of little streams develop to find the route of least resistance to the ocean.

With managed funds, each of those little streams represents a different way of investing, whether it be through different asset classes such as shares and property or different investment vehicles such as unit trusts and superannuation funds.

Some of the newest and fastest- flowing of these streams are index funds and overseas-based trusts, which bathe in tax advantages over their New Zealand counterparts.

If proposals from the McLeod tax review are implemented, a big dam will be built across this river and money will be channelled to the sea by a quite different route - more like a series of concrete canals.

The review, commissioned by the Government but not Government policy, is proposing radical shifts in the way investors and managed funds are taxed.

The shifts proposed are not bad: there are winners and losers and many investors could end up paying less tax than they do now.

Likewise, the Government could reap less tax revenue than it does now.

The fundamental shift is to the idea of levying taxes on what is called a risk-free rate of return model. This concept has attracted significant attention as the review committee suggested using it to tax the equity in a person's home.

Politicians of all hues have ruled it out in that context. But in a broader investment context, the result is quite different.

It works like this. Instead of having tax on capital gains and income, there would be one tax levied on how much money a person had invested at the start of each year.

The first point is that the timing of the tax payment is different.

The second major point is that the tax is calculated differently.

Because, under McLeod, you are paying upfront regardless of the outcome, a benchmark rate is set.

In the review panel's case, it is set on the equivalent of what is known as the risk-free rate of return, taking into account inflation.

In other words, "what would I earn on my money if I invested it in something which has no risk of falling over?"

In most cases the ruler used in this exercise is the rate of return on long-term Government bonds.

In New Zealand, the yield on a 10-year bond is currently about 6.6 per cent. Allowing for inflation, the real risk-free rate is, say, about 4 per cent. Once the Government (probably Inland Revenue) has calculated the risk-free rate of return, that is then applied to all investments.

For example, if at the start of the year you had an investment portfolio of $10,000, you would pay tax at your marginal rate on 4 per cent of that sum. If your marginal tax rate were 39c, you would pay $154, regardless of your actual return.

This contrasts with the present system: if at the start of this financial year you had $10,000 invested and it earned income of 10 per cent, you would then pay tax on $1000, which, at 39c, equals $390.

But McLeod's scheme is less helpful if you make a loss. Under today's system you could get a tax credit. Under McLeod's you would have paid the tax upfront and would have to wear the loss.

Review head Rob McLeod says he wants people to at least consider the idea. Although it has been controversial in New Zealand in the past fortnight with regards to home ownership, the concept is supported by the OECD and used in nine European countries. The beauty for an investor is that decisions on where to place money would not be made on tax considerations.

For many, it's hard enough deciding some basic questions: shares or property? Bonds or cash? It gets really difficult when it comes to deciding whether to go for active or passive management, listed or unlisted property, New Zealand or foreign funds.

With New Zealand investors, the answer often seems to revolve around tax considerations.

"[Investors have] a strong degree of tax minimisation in this country," BT Funds Management chief executive Craig Stobo says. "There's a desire for the best after-tax income you can get."

This desire for tax-efficient funds has triggered wave after wave of new investment products.

First it was UK-listed investment trusts.

These are UK-based investment companies which are in some cases dual-listed on the London and New Zealand Stock Exchanges.

Investment trust guru Peter Irwin of Credit Suisse First Boston estimates that about 18,000 investors have $430 million invested in the 18 trusts listed on the New Zealand exchange. On top of that, New Zealanders also invest directly into funds which are listed only on the London Exchange.

Next off the block was index funds, such as TeNZ and WiNZ.

Research house FundSource says there is about $775 million in retail equity index funds. But when wholesale is included, the total is likely to be more than $2 billion.

The latest version of tax-efficient funds are UK-based unlisted unit trusts, including open-ended investment companies or OEICs, and Australian-domiciled funds.

ANZ and Money Managers, who are the two players with Australian funds, have a combined total of about $700 million under management, and there is another $100 million in UK OEICs.

AMP Henderson is the biggest player in the OEIC market, with about $60 million, and Royal & SunAlliance is considered to be second with $20 million. Other players include Armstrong Jones, Challenger and the Public Trust.

Under the McLeod ideas, these funds would lose their tax-efficient status and be taxed on the risk-free rate of return.

KPMG tax partner Chris Abbiss says the proposals in the tax review remove many of the differences between savings vehicles.

If the Government chose to implement the changes, it would make investment decision-making far easier because people would be selecting funds on their merit, not their tax status.

But the McLeod report is only a discussion paper and there is no way of knowing what the Government may pick out of it.

* Philip Macalister is the editor of online money management magazine Good Returns, which provides news, data and information on managed funds, superannuation, mortgages, financial planning and insurance. E-mail him at: philip@goodreturns.co.nz