In 1789 Benjamin Franklin famously wrote “in this world nothing can be said to be certain, except death and taxes.”  However tax rules are not always certain - the real world application is often unclear.  This month we look at tax issues for investors around PIE and Australian Unit Trust structures.  We recognise that for most sane advisers, fund managers and investors, tax is not an exciting topic – so we’ll keep this commentary short and succinct.

There are a number of factors to consider when comparing the efficiency of PIE and Australian Unit Trust (AUT) structures for investing in international shares.  Before we jump into the tax considerations, here is a summary of some of the key non-tax factors:

• Currency exposures:  Australian Unit Trusts are typically not built for NZ investors – any currency hedging will be for the benefit of A$ investors.  Be aware of underlying currency exposures (do you want un-hedged A$ exposure in the portfolio?).
•  Compliance costs matter:  PIEs are a clear winner over AUTs on the tax compliance front. PIE income does not need to be included in a tax return – a significantly lower compliance burden for investors.
•  Watch out for the “fund of funds” structure:  Many PIE funds investing in international shares do not hold any shares because they feed into an offshore share fund.  This will introduce another layer of costs and may also mean that some of the inefficiencies of offshore structures (that we mention below), also apply to that PIE fund. 

Below we consider 4 of the tax implications of PIE and AUT structures.  While some may appear confusing and complicated, please note there are likely to be other tax issues that we have not considered here!

1. Australian Unit Trusts (AUTs) and the hidden withholding tax drag

AUT are a popular investment vehicle for Australian fund managers distributing product into NZ.  Many investors recognise the positives of AUTs such as the ability to fall under the Foreign Investment Funds rules (see paragraph 2 below). 

However what is not widely recognised is that AUTs can be inefficient for NZ investors where the AUT holds international shares.  This is because dividend payments to Australia will likely have withholding tax deducted but a NZ investor does not get a corresponding withholding tax credit.  This means the NZ investor can effectively suffer tax twice on the international dividend income (once with the withholding into Australia and again in NZ).  International shares held through a PIE structure do not face this leakage.

Let’s try and quantify the expected tax leakage in an AUT.  The standard US withholding tax rate for NZ and Australian investors is 15%.  If a NZ investor holds US shares directly or via a PIE managed fund then US tax is withheld on dividends but the NZ investor receives a credit for the 15% tax.  This is quite different to a NZ investor investing in an AUT which in turn holds the US shares.  In this case the AUT receives the 15% tax credit but cannot pass it on to the NZ investor.  Using the current dividend yield on the popular US$12 billion iShares Dow Jones Dividend ETF (DVY) we look at the potential tax leakage of an AUT:

Investing in international shares through an Australian Unit Trust rather than a NZ PIE may have a cost - the inability of NZ investors to receive value for offshore withholding tax on dividends.  The actual cost will depend on several factors including the dividend yield, withholding rates and application of the FIF rules (see para 2 below).  But in the above example (based on a broad iShares US equity ETF) the cost to NZ investors can be 0.37% per annum. 

2. The FDR vs FIF debate – the AUT advantage

A different strand of the AUT vs PIE tax efficiency discussion relates to NZ investors in an AUT falling under the Foreign Investment Funds (FIF) tax rules.   In very simple terms the FIF rules allow an election for tax on a Fair Dividend Rate (FDR) or Comparative Value (CV) basis.  The FDR calculation is essentially a “wealth” (or asset) tax which assumes income of 5% is generated every year – whether or not the investment goes up or down and whether or not dividends are actually paid. The CV basis is a more intuitive “growth” (or gains) tax where tax is levied on the actual gain or loss each year (being capital gains plus dividends).  If a share goes up 7% in a year and a dividend of 3% is paid, then on a CV basis taxable income is 10% and on an FDR basis taxable income is fixed at 5%. 

The CV basis is preferable if the annual gain is <5% while FDR is preferable if the annual gain is >5%.  Unlike AUTs PIE funds holding international equities are taxed only on a FDR basis.  PIEs do not fall under the FIF rules and so cannot elect to be taxed on a CV basis.

The expected cost of this for PIEs will depend on the assumptions used.  We have seen work on this by one of NZ’s main brokers using the key assumption that international equities fall in one of three years and gain by 5% or more in two of three years.  Their calculation produced a 0.30% p.a.  potential tax inefficiency of the PIE against the AUT structure. 

3. Australian Unit Trusts and the non-deductible fund manager fee

But wait, there’s more!  If an AUT is taxed on an FDR basis then NZ investors are assumed to have income at 5% of the opening value of the investment.  In this case there is no tax deduction for fees of the Australian fund manager.  By contrast if the investor had held the same offshore shares through a PIE fund, then manager fees are tax deductible. 

This tax inefficiency for Australian Unit Trusts applies only when FDR is used.  Let’s try and quantify this for a $100 investment in US shares using the following key assumptions:

• The Australian fund manager (AUT) and NZ fund manager (PIE) each charge fees of 1.50% p.a.
• The offshore equity investment goes up by $10 for the year (10% on $100 invested) so FDR calculations will apply to both the AUT and the PIE

Let’s assume that in one of every 2 years markets go up by more than 5% (so an AUT investor would elect FDR treatment) and in one of every 2 years markets fall (so an AUT investor would elect CV treatment).  This means that in one of every 2 years the NZ investor in an AUT would suffer a cost of 0.67% through being unable to get a tax deduction for the Australian fund manager’s fees.   If (based on our assumptions) FDR applies in one of every 2 years, the Australian Unit Trust has an average tax leakage of 0.33% per annum because the NZ investor cannot get a tax deduction for the Australian fund manager’s fees.

4. The tax rate is capped in a PIE at 28%

This tax advantage of a PIE is well recognised – a high rate investor’s tax is capped at 28% in a PIE against potentially paying the highest marginal rate (33%) when investing in an AUT.

5. Final thoughts

What does this tell us?  Tax can be a minefield to understand and also a black hole for adviser fees.  The only certainty about tax is, one way or another, it has to be paid. Some quick thoughts:

Focus on the after tax return.  Fund managers report returns before tax.  Banks advertise deposit rates before tax.  Dividend yields on shares are published before tax.  Be aware of the tax cost or benefit (normally a cost!) as the after tax return is the real investing experience.  Note that the tax efficiencies/inefficiencies set out in paragraphs 1-4 above do not show through in pre-tax fund returns (they only impact post tax returns).

The tax differences between PIE and AUTs are complex:   PIEs and AUTs are popular legal structures that both have distinct (and complicated) subtleties around tax treatment.  PIEs are criticised for only having FDR tax on international equity investments but also benefit from a tax rate capped at 28% (vs 33% for AUTs).  What is not widely recognised is that AUTs also have tax inefficiencies such as leakage from the loss of withholding tax credits and the loss of tax deductions on manager fees.  Complex?  You bet, but before investing in international funds, study and challenge all aspects of tax treatment.

Compliance costs and currency hedging matter too:  So which structure (PIE or AUT) is preferable?   PIEs are a clear winner over AUTs on the tax compliance front - PIE income does not need to be included in a tax return – a significantly lower compliance burden for investors.  PIEs are also likely to have currency hedging suited to NZ investors (unlike AUTs which are typically built to suit Australian investors).

Do not ignore tax effects.  A comparison of the tax efficiencies (benefits) and tax inefficiencies (costs) for both AUT and PIE structures is complicated – but important. While tax efficiency should never be the principle driver of any investment decision, it remains a key consideration. 

John Berry
Executive Director
Pathfinder Asset Management Limited

Pathfinder is a fund manager and does not give financial advice. Seek professional investment and tax advice before making investment decisions.