Why pay the taxman?

When it comes to tax, not all investments are created equal


By Mark Fryer

Personal finance editor


Most of us would no doubt prefer to dream of the profits our investments might make, rather than dwell on the costs of investing.

Ironically, though, while all the dreaming in the world will make no difference to our profits, we can do something about some of the costs.

One of those costs we can do something about is tax.

For while the politicians have been preaching the gospel of the level playing field since the mid-1980s, there is nothing level about the way in which investments are taxed.

It's not just what you invest in that makes the difference. How you invest can be just as important.

For a start, there is a big difference between "direct" investments (you buy the shares, the property, or whatever, yourself) and those which are "indirect" (you give your money to a manager who buys investments on your behalf).

Most investors who buy shares from a broker, for example, get to pocket any capital gains. But if you put money into exactly the same shares, but do so through a unit trust, a third of all your gains go straight to the taxman.

Those taxes may be hidden, because they are paid by the fund manager, but they still come out of your pocket.

To add to the confusion, besides the direct/indirect distinction, there are also major differences in the way the various categories of indirect investments are treated.

While efforts have been made to sort out some of those inconsistencies, progress has not been rapid.

In the meantime, anyone who wants to put some money aside for the future has to find the method which is most "tax efficient" as the jargon goes. In other words, the one that (legitimately) pays as little tax as possible.

That is especially important if you are investing with the aim of earning long-term capital gain, rather than income, since there are big differences in the way capital gains are handled, depending on the way you invest. And over the long-term, the difference between an investment that pays tax and one which does not can really add up.

First, you have to work out exactly what sort of investment you are talking about, preferably before putting your money in. Check the investment statement (look for the heading "what sort of investment is this") or the prospectus and, if necessary, ask the person recommending the investment exactly what sort of product it is.

Bear in mind that there are essentially two things you can be taxed on: income, such as interest or dividends, and capital gains, such as the rise in the value of shares or a property.

One last thing: the following comparison of some of the more common investment options assumes that, like most of us, you are not regarded by Inland Revenue as a trader - someone who buys assets with the intention of selling them for a short-term capital gain.


DIRECT INVESTMENTS


Fixed interest


Interest payments are taxed at your own personal rate. Some fixed-interest investments which can be traded, such as Government stock, may also produce capital gains, which are taxable.

Verdict: efficient, unless you trade for capital gains.


New Zealand Shares


Depending on the company, dividends may come with tax credits, meaning investors on the 33 per cent rate have no more tax to pay. If you are on a lower rate, the credits mean any dividends are taxed at your own personal rate. Some companies include only partial tax credits or none at all; check before you invest.

Capital gains are tax-free, unless you are an active trader.

Verdict: efficient.


Property


Can raise some complex tax questions. But as a general proposition, income from rent is taxable at your own personal rate, while capital gains are tax-free, assuming you did not buy for the purpose of re-selling or fall into some other categories which would make them taxable.

Verdict: efficient.


INDIRECT INVESTMENTS


New Zealand Unit Trusts


Unless classified as a passive fund, a unit trust pays tax at 33 per cent on its income and capital gains. The dividends they pay can come with imputation credits, meaning they are effectively taxed at your own personal tax rate. Any gain in the unit price is tax-free in the hands of investors.

Verdict: inefficient, because they pay tax on gains that would be tax-free if the investment was owned directly. Especially inefficient for anyone not on the top tax rate.


Superannuation


Unless classified as a passive fund, super schemes pay tax at 33 per cent on any income and capital gains. Payouts are tax-free in the hands of investors (because the money has already been taxed).

Verdict: inefficient, because capital gains are taxed. Especially inefficient for investors on lower tax rates, since any earnings the fund makes on their behalf are taxed at the top rate.


Group Investment Funds


Unless classified as a passive fund, most are taxed in much the same way as unit trusts, paying tax at 33 per cent on income and capital gains. Some specified funds (usually those which put their money into fixed-interest investments) can deduct tax at an investor's personal rate.

Verdict: inefficient, because capital gains are taxed, although this is not an issue with income-oriented funds.


Life Insurance products


These pay tax at 33 per cent on income and capital gains. Investors do not have to pay tax on any money paid out, which sometimes leads to these being touted as providing "tax-free" income. In reality, it's not tax-free at all; the only reason the investor does not have to pay is because the fund has already done so. Payouts can include tax credits.

Verdict: inefficient, because capital gains are taxed. However, the ability to earn non-taxable income may be attractive to some investors, who are worried about jeopardising their eligibility for income-tested benefits.


Passive Funds


This group of managed funds cuts across the previous categories; some passive funds are unit trusts, some are group investment funds and so on.

The important issue is that passive funds have obtained a ruling from Inland Revenue confirming that they are not liable to pay tax on any capital gains, because they follow a "passive" investment strategy, rather than actively trying to pick the best investments. Like the other funds, they still pay tax on any income, at 33 per cent, and can provide tax credits.

Verdict: efficient; capital gains that would not be taxed if the investments were made directly are not taxed just because they have been made through a managed fund.


Australian Unit Trusts


Pay out any income and realised capital gains to investors, who are then taxed on those payments at their own personal rate. New Zealand investors cannot use Australian tax credits which these funds may provide. Any gain in the unit price is not taxable.

Verdict: inefficient, because capital gains are taxed.


Australian listed trusts


Pay Australian company tax on their income and capital gains. Any rise in the share price will not be taxable, but investors must pay tax on any dividends.

Verdict: inefficient, because capital gains are taxed.


UK Investment Trusts


Not taxed on their capital gains. Any dividends will be taxable, at the investor's personal rate, but any rise in the share price will not.

Verdict: efficient; capital gains that would not be taxed if the investments were made directly are not taxed just because they have been made through a managed fund.


AND THE WINNERS ARE ...


If it's tax efficiency you want - and few of us actually like paying more tax than we have to - the best bets are: direct investments of any type, passive funds or UK investment trusts.

Competing investments, especially those which aim to produce capital gains, are all fighting with one hand tied behind their back because they have to pay tax on those gains.

Tax is not the only thing to think of when choosing an investment. For example, buying shares directly may be more tax-efficient than doing so through a (non-passive) unit trust, but if you are a small investor you may only be able to afford shares in a few companies at most. On the other hand, a unit trust, even if it is distinctly inefficient tax-wise, allows even small investors to have a diversified portfolio.

Similarly, if you like the idea of active fund management, as opposed to the passive approach, you'll have to accept tax as the price (unless you use some of the UK investment trusts, which are actively managed but pay no tax on capital gains).

But if you are thinking of investing in something that is not tax efficient, it would be worth stopping to ask why, and whether you might be better off putting your money where the taxman won't get so much of it.