Tax matters: Choose your investments carefully

Alex Prineas | 05 Jun 2014

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Alex Prineas is a fund research analyst with Morningstar.

 

Investment analysis often focuses on headline performance, yet sidelines the tax implications that can substantially affect cash returns. Here we explore some of the tax considerations for three common investment structures: unlisted managed funds, exchange-traded funds (ETFs) and listed investment companies (LICs).

 

Unlisted managed funds

Unlisted managed funds do not pay tax themselves. They are tax-transparent and must pass income and realised capital gains on to investors within the financial year they are earned. Income or realised gains from managed funds will be taxed at an investor's relevant marginal rate as if they owned the assets directly.

However, a fund's investment strategy can affect tax outcomes. For example, fund managers can include tax considerations in their investment strategies to:

- Minimise turnover, thereby delaying the crystallisation of capital gains;

- Avoid selling shares before they become eligible for the CGT discount, where possible. Shares held for longer than 12 months are eligible for a 50 per cent CGT discount for individual investors, while superannuation investors get a 33.3 per cent discount;

- Use the 45-day rule (an Australian Taxation Office rule that stipulates that to be eligible to claim franking credits, shares must be held for at least 45 days); and

- Consider dividend imputation in their valuation methodologies.

The pooled structure of unlisted managed funds can give rise to some other complexities, too. For example, while income and realised gains must be passed through within the financial year, unrealised gains or losses stay within the fund until they are realised.

That means new investors may be buying into an existing tax position. In the case of losses, that may be a good thing for new investors because losses can be used to offset future gains (though it was bad luck for the investors who incurred the losses and left the fund earlier, never using those tax losses to offset future gains).

In contrast, buying into a managed fund with substantial unrealised gains means that if the fund suddenly sells those assets, an investor may get a surprise tax bill.

 

Exchange-traded funds

ETFs have much in common with unlisted funds so far as tax goes. However, one important difference is that unlike unlisted funds, when an investor leaves an ETF there are provisions to ensure they take their capital gains tax liabilities with them.

This occurs through the creation and redemption mechanism used by ETF authorised participants to keep the ETF trading close to net asset value. It means that ETF investors may be less exposed to the actions of their fellow investors, or the decisions of the fund manager to buy or sell assets.

Cross-listed ETFs (Australian listings of foreign ETFs) also have their nuances. For example, the iShares Core S&P 500 ETF's (IVV) cross-listing means Australian investors can tap into the liquidity of the primary listing, contributing economies of scale and keeping a lid on bid-ask spreads. But IVV's New York cross-listing means Australian investors may incur some US estate tax on deceased estates.

Many ETFs employ passive investment strategies that can contribute to low portfolio turnover and add to their tax effectiveness. This reiterates the point that tax can be affected by the structure of an investment and also the fund manager's investment strategy.

Listed investment companies

LICs pay company tax of 30 per cent and can retain earnings and pay dividends at the discretion of company management. The LIC structure can have a variety of tax consequences.

The ability to retain earnings can facilitate tax strategies for investors on a high marginal tax rate. For an investor on the top tax rate of 45 per cent, retained LIC earnings will be taxed only at 30 per cent (or 28.5 per cent from July 2015, if the Treasurer's federal budget measures pass through the Senate) until such time as they are paid out as distributions, which could help to delay or reduce tax.

The closed-end nature of LICs can also have tax implications. LIC capital is captive -- investors buy and sell LIC shares from each other on the exchange -- so there are no unplanned subscriptions or redemptions.

That means LICs are less likely than ETFs or managed funds to be forced sellers of an asset. That allows management to take a longer-term approach to investing, which can mean low turnover and long holding periods.

Other things being equal, low turnover and long holding periods typically are tax-effective because that delays the crystallisation of capital gains and increases the likelihood that capital gains will qualify for the CGT discount (50 per cent for individual investors and 33.3 per cent for superannuation funds).

It can be a double-edged sword, though. As with unlisted funds, unrealised gains or losses can accumulate in a LIC so incoming and outgoing investors should consider this.

 

Conclusion

I've touched on a few of the key tax issues around funds, LICs and ETFs. But by no means has this article covered everything. From this brief analysis, it's possible to conclude the following:

- It is important to understand the potential tax treatment of different investment structures;

- The fund manager's strategy can affect tax outcomes. For example, whether it is active or passive, Australian or global, large-cap or small-cap, they all can have a bearing on the level of turnover, imputation credits and potential treatment of capital gains;

- The structure and investment strategy should not be considered separately but as a whole. For example, while many ETFs boast low portfolio turnover, there is no guarantee -- it depends on the investment strategy;

- Tax is one component of investing. Making choices purely on tax considerations may be ill-advised, but tax should form a part of any investment decision; and

- We have explored only a handful of the issues in this article. Do your own further reading and seek professional tax and investment advice from relevant licensed practitioners.

This report appeared on www.morningstar.com.au 2019 Morningstar Australasia Pty Limited

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