Effective Tax Management for Investment Portfolios

Transcription

1 Effective Tax Management for Investment Portfolios Tax management in investment portfolios for Australia s private wealth holders. Matching Investments to their Holding Structures March 2013 Private Portfolio Managers, Level 3, 2 Martin Place, Sydney NSW 2000, Australian Financial Services Licence No

2 Executive Summary Australia s high marginal tax rates combined with the unique concessional attributes of the taxation system creates strong incentives for private wealth holders to focus on taxation issues as a very effective mechanism to increase investment returns without incurring additional risk. Tax management and related estate planning considerations are a very complex area with a variety of service providers offering a wide range of tax management components, including holistic strategy, structuring, timing advice, and investment management. This series of papers is focused solely on investment management, although to be most effective a co-ordinated and holistic approach is required across each discipline. The paper introduces the components of investment management from a tax management perspective and further outlines the tax savings of matching investments to their holding structures. Through this strategy alone, returns could be enhanced by 1.19% per annum, without altering the investment portfolio or risk profile. Future papers in the series will detail other components of tax management within investment portfolios. Our aim is to assist families and their advisors in better understanding the tax consequences of their investment management practices. We hope to build a foundation for discussion of the topic rather than provide an exhaustive analysis. Tax is a highly complex, changing, and individual area requiring specialised advice. This paper is illustrative only and cannot be taken as tax or investment advice. The paper s author is an investment manager not a qualified tax advisor and readers should consult their tax advisor on all tax related matters. 2

3 Background Taxation is a significant driver of real returns for wealthy families and individuals. This is an obvious point, but it is often overlooked by wealth advisors, research houses, and investment managers whose investment context lies in either the institutional or the retail investment universe. Recently, management expenses, sales commissions, and administrative fees have (rightly) come under increased focus as a result of FOFA reforms, modest market returns, and investor expectations. While this focus is laudable, the ability to improve returns through cost reduction is dwarfed by the opportunity to create superior returns through effective tax management. Even at the extreme, very few investors total costs exceed 3% for investment management, strategic advice, custody, and administration, yet tax can consume up to 46.5% of returns. Therefore, prospects to generate better returns through tax management are substantial and vastly outweigh cost-saving mechanisms. Sophisticated investors are increasingly looking toward after-tax rather than pre-tax investment returns; focusing attention on legal tax minimisation practices which provide a risk-free higher real return. Although the context of this paper is effective tax management rather than investment analysis, it s worth noting that investment decisions should always be based on investment fundamentals rather than tax advantages. Tax outcomes are an important but secondary consideration. The Paper s Author This paper was prepared by Private Portfolio Managers (PPM). Although we believe the commentary provided is soundly constructed and does not carry undue bias, readers are advised of the nature of our business: PPM is an independent manager of Australian and international shares. Serving high net worth individuals, wealthy families, and charitable organisations, our business is singularly a funds management service. We work with other organisations including financial advisers, accountants, lawyers, private banks, and family offices in fulfilling an investment management component of a family s overall wealth management needs. PPM employ the practices outlined in this paper, which are facilitated through an Individually Managed Account (IMA) structure, as many tax management strategies cannot be delivered through managed funds 1. 1 Consult Investment Structures Matter for additional information 3

4 Australian Tax Environment The higher the tax in a particular environment, the more crucial effective tax management becomes. In tax havens and low tax environments such as Cayman Islands, Hong Kong and Singapore, the impact of taxation on investment returns is less critical than in higher personal tax jurisdictions such as Australia. Selected Countries Sources: KPMG, PwC, Deloitte, PPM 4

5 When considering the impact of taxation on investors, the highest marginal tax rate is an indicative barometer. With Australia's highest marginal tax rate of 46.5% (including the Medicare levy), Australia is one of the highest personal tax jurisdictions in the world. Within the developed world only Japan, Netherlands, Sweden and Denmark have a higher personal tax structure. Reinforcing the importance of adopting an after-tax approach toward investment management are idiosyncrasies in the Australian tax environment, which investors can legally utilise to significantly reduce their tax liabilities. 5

6 Tax Effective Investment Management As discussed in the Executive Summary, holistic tax management is a complex and multi-faceted environment requiring structural and strategic considerations in additional to tax effective investment management. A discussion of other elements of tax strategy is beyond the scope of this document (and expertise of the Author); however, two features of the Australian taxation environment having significant intersections with tax effective investment management are: The superannuation environment where superannuation funds attract preferential tax treatment that can lead to significant improvements in after-tax returns where income is taxed at 15% or lower. Australia s imputation credit system, particularly for low tax paying entities such as charities and superannuation funds, where imputation credits can provide an attractive boost to both income and returns. These features of the local environment have significant influence on a number of tax considerations for investment management. The remainder of this section provides a cursory description for each of a variety of investment management tax strategies that can be adopted in an Australian context 2. Matching Investments to Holding Structure This strategy is sometimes referred to as asset location as it places investment assets in their most tax-effective holding location. The tax status and tax treatment of a holding structure is an important factor in considering where to locate investments. An investor in a high tax bracket can benefit from strategies to minimise taxable income, for example by investing in equities or property where the main component of return is in the form of capital gains. At the same time, higher yielding fixed interest investments may not produce optimal after-tax results where the full rate of interest is subject to tax. Where the investor has tax-free status as is the case, for example, with a superannuation fund in pension mode or a tax-free non-profit entity, 2 While beyond the scope of this document, it should be noted that many tax concessions are not available to any party deemed a 'share trader' by the ATO. 6

7 income in the form of interest does not attract a tax disadvantage and dividend income comes with the added benefit of a tax refund where imputation credits are passed on by the company. Capital Gains Deferral Delaying the crystallisation of capital gains tax events has the benefits of allowing investment funds to be deployed longer and continue to compound, while delaying a tax liability can be desirable for a variety of reasons, including the time value of money and the ability to effectively plan and manage for a potential tax liability. For superannuation funds in accumulation phase capital gains deferral has an additional and significant benefit: If the capital gain can be deferred until pension phase then no tax is payable. Investment management strategies with a long-term approach have an inherent advantage in delivering capital gains deferral, as gains are not realised as frequently and realised returns tend to be in the form of longterm capital gains. Utilising Long-term Capital Gains Tax Concessions Not all capital gains are alike. Long term (greater than one year) gains are given a 50% concessional rate. Where possible, holding investments for longer than a year is an effective mechanism to halving the capital gains tax liability. Short term (less than one year) capital gains are taxed at the normal applicable rate. Matching Capital Gains with Losses As the name would suggest, this strategy involves realising capital losses in the same period that capital gains are incurred. The strategy provides full tax relief from capital gains tax, where capital gains can be fully offset. Partial offsets are also possible where gains and losses are not fully matched. Transaction Timing The timing of a particular transaction can have a significant impact on taxation outcomes. Delaying or bringing forward the tax year in which a transaction occurs can affect its tax treatment by creating an opportunity to offset capital gains or losses, or may simply delay a tax liability by up to 12 months. 7

8 Other timing considerations include minimum holding periods to legally claim franking credits, or where tax rates differ in two years, matching the tax event to the most advantageous tax year. ex-portfolio Transactions An investment portfolio can be utilised as an effective tax strategy to help offset transactions that have occurred outside the portfolio. By taking losses or gains within the investment portfolio, losses or gains incurred outside the portfolio can be offset. Other Structural Considerations There are a range of other legal and structural considerations for taxation management within an investment portfolio. Placing assets in a tax advantaged structure can be a very effective mechanism to increase real returns. Expert strategic tax advice is suggested to ensure the tax efficiency of any wealth holders financial affairs. See the Additional Sources of Information section in this document. 8

9 Matching Investments to Holding Structure Investment structures are always crucial considerations in targeting aftertax returns. Holding structures include fully taxable entities and various forms of tax shelters such as charitable trusts, companies, private ancillary funds, and superannuation funds; which have different tax concessions depending on whether the fund is in accumulation or pension phase. Matching investments to these different structures can produce significant after-tax benefits. For example: High income generating investments would be more appropriately placed in a tax-free structure, where regular tax liabilities from income generating investments do not occur The question of whether or not to realise capital gains in a tax-free structure is not influenced by tax considerations, merely by the return prospects of the investment All other factors being equal, high capital growth investments are best placed in a high tax environment as they produce few tax events until sold, and then often attract tax concessional rates Companies that are likely to buy back their shares are best held in tax-free or low tax environments where the tax benefit of the buyback can be utilised. Australia s superannuation system provides a powerful tax shield for investments. Placing income generating investments in these structures aids in enhancing after-tax returns 3. The situation is similar with capital gains realisation. Through this investment matching with holding structure strategy significant tax savings can be achieved legally. An oversimplified but typical scenario illustrates a 1.19% per annum increase in returns through the tax savings achieved with effective matching of investments to an appropriate holding structure. As an illustrative example, assume an investor has a portfolio of 20 stocks with the following characteristics: Yield 4.5% Turnover 20% per annum Capital gains 8% per annum Realised capital gains (0.2*8%) 1.6% per annum 3 Investment returns are enhanced through the tax advantaged superannuation structure; however certain types of returns may receive greater tax advantages than others. 9

10 A further assumption is these stocks are allocated equally across both a fully taxable account at the highest marginal tax rate and a superannuation fund in accumulation phase. Both the taxable account and the superannuation fund hold exactly the same 20 stock share portfolio. Based on these assumptions the investor s after-tax returns are 11.25% per annum 4. These returns can be further enhanced by allocating stocks according to the structure where they will produce the best after-tax return. Using the exact same 20 stock portfolio, rather than holding the same stocks in the personal portfolio and the superannuation portfolio, high growth, low yield stocks are allocated to the personal portfolio while lower growth, high yield stocks are held in the superannuation portfolio. The result of this reallocation of underlying share positions according to the structure where they will generate the greatest after-tax returns provides an annual return of 12.44% 5. The difference between the matching strategy and the identical portfolios is 1.19%, which represents a risk-free return improvement without changing any underlying investment exposures 6. A variety of other scenarios can produce similar benefits, but all tax matters are highly specific to the individual. Appendix 1 contains the complete workings of this illustrative scenario. Appendix 2 shows the scenario calculations in tabular form. 4 See Appendix 1 5 See Appendix 1 10

11 Implications Given the increasing sophistication in tax awareness and significant opportunities to enhance returns through careful management of tax considerations within an investment portfolio, we foresee: An increasing call for investment managers to disclose their tax management practices Utilisation of tax management as a differentiator between investment managers Private wealth holders placing additional weight on tax efficiency when allocating funds to investment managers Better disclosure of the tax efficiency of managed funds (as already exists in overseas markets 7 ) Increased communication and co-ordination between investment managers, wealth holders, and their other service providers to implement holistic tax management strategies Better reporting and benchmarking on after-tax investment outcomes A heightened focus on tax management at both investment management and strategic advice levels. 7 See The Mutual Fund Tax Awareness Act of 2000 (US) 11

12 Appendix 1 Matching Investments to Holding Structure Worked Example Detailed below are the workings of a typical investment matching scenario. The investor has a portfolio of 20 stocks with the following characteristics: Yield 4.5% Turnover 20% per annum Capital gains 8% per annum Realised capital gains (0.2*8%) 1.6% per annum Divided equally and holding the same shares in an individual and superannuation portfolio. The individual component of the portfolio is taxed at the highest rate (46.5%), and after-tax returns amount to 10.04% - calculated as [4.5%*(1-.465)+6.4%+1.6%*( )] Franked dividends would enhance returns by 0.31% to give a total return of 10.35%. For the superannuation portfolio, after-tax returns are 11.67% - calculated as [4.5%*(1-.15)+6.4%+1.6%(1-.1)] Adding franking credits improves this return by 0.49% to give a total return of 12.16% for the superannuation portfolio. Combining the portfolios provides a total return of 11.25% - calculated as [(10.35%+12.16%)/2] These after-tax returns can be further enhanced by using the same 20 stock portfolio, but holding, high growth, low yield stocks in the personal portfolio and lower growth, high yield stocks in the superannuation portfolio. The characteristics and returns of the tax structure matched portfolios are 8 : Personal Portfolio: Yield 2.68% Turnover 10% per annum Capital gains 10% per annum Realised capital gains (0.1*10%) 1.0% per annum Returns for this portfolio, including the impact from franking credits are 11.39% - calculated as 2.68%*(1-.465)+9%+1%*( )+.18% Superannuation Portfolio: Yield 8.0% Turnover 30% per annum Capital gains 6% per annum Realised capital gains (0.3*6%) 1.8% per annum Returns for this portfolio, including the impact of franking credits are 13.49% - calculated as (8.0%*(1-.15)+(.7*6%)+1.8%*(1-.1)+.87% The total return of the two portfolios amounts to 12.44% - calculated as [(11.39%+13.49%)/2] When compared to the unmatched portfolio s return of 11.25%, total returns have increased by 1.19% without altering the underlying investment exposures. 8 Perpetual operation of both personal and superannuation portfolios is assumed. 12

13 Appendix 2 Matching Investments to Holding Structure Tabular Workings PORTFOLIO WITHOUT TAX MATCHING PORTFOLIO WITH TAX MATCHING Individual SMSF Combined Individual SMSF Combined Yield 4.50% 4.50% 2.68% 8.00% Stocks Turnover 20.00% 20.00% 20.00% 10.00% 30.00% 20.00% Capital Gains 8.00% 8.00% 10.00% 6.00% Realised 1.60% 1.60% 1.00% 1.80% Tax Rate 46.50% 15.00% 46.50% 15.00% Discount CGT rate 23.25% 10.00% 23.25% 10.00% Return Calculation Yield 4.50% 4.50% 2.68% 8.00% 1-tax rate 53.50% 85.00% 53.50% 85.00% 2.41% 3.83% 1.43% 6.80% Unrealised gains 6.40% 6.40% 9.00% 4.20% Realised gains Gains 1.60% 1.60% 1.00% 1.80% 1 - tax rate 53.50% 85.00% 53.50% 85.00% 1 - discount CGT rate 76.75% 90.00% 76.75% 90.00% 1.23% 1.44% 0.77% 1.62% Without franking credits 10.04% 11.67% 10.85% 11.20% 12.62% 11.91% Franking credits 0.58% 0.58% 0.34% 1.03% 1-tax rate 53.50% 85.00% 53.50% 85.00% 0.31% 0.49% 0.18% 0.87% Final Post Tax Returns 10.35% 12.16% 11.25% 11.39% 13.49% 12.44% 13

14 Additional Sources of Information Investment Management for Private Taxable Investors, Wilcox, Horvitz, dibartolomeo, CFA Institute Looking for the Value-Add Private Advice Needs of High Net Worth Australians Is Your Alpha Big Enough to Cover its Taxes? Revisited Mutual Fund Tax Awareness Act of Family Wealth Keeping it in the Family, James Hughes, Bloomberg Managing Investment Related Taxes Capgemini World Wealth Report Reporting Investment Performance After Tax %20Reporting%20Investment%20Performance%20After%20Tax.pdf Asset Management for High Net Worth Investors from the Investment Firm Perspective Investment Management for Family Wealth Investment Structures Matter 14

15 Peter Reed This document may be downloaded at Private Portfolio Managers Pty. Limited ACN , AFSL This document does not take into account your individual objectives, financial situation or needs. You should assess whether the information is appropriate for you and consider talking to a financial adviser before making any investment decision. Read the Financial Services Guide, available at or by ringing prior to any decision. Past performance is not necessarily indicative of future returns. The financial service detailed in this document does not represent a deposit or a liability and is subject to investment risk including possible loss of income and capital. The information is taken from sources which are believed to be accurate but Private Portfolio Managers Pty. Limited accepts no liability of any kind to any person who relies on the information contained in this document Private Portfolio Managers Pty Limited. Private Portfolio Managers, Level 3, 2 Martin Place, Sydney NSW 2000 Australian Financial Services Licence No ACN