Taxing Investments

6 November 2009

There has been quite a lot of background noise over taxation in recent months.  We all know that the government is struggling to find ways to increase its revenues without committing the mortal political sin of increasing tax rates.  We have also seen the massive sums of money which a number of companies, especially the major trading banks, have attempted to reduce their tax liabilities by.  The recent successes by Inland Revenue will effectively provide the government with another two billion dollars which they would otherwise have had to borrow, further adding to the mountain of debt that the country faces.

It is well known that when it comes to taxation on investments, there is no such thing as a level playing ground.  Investment property has been taxation advantaged for years, so it is no wonder that property has often been the favoured form of investment.  But as the Prime Minister has been quick to point out, property prices have risen dramatically in countries where there is a capital gains tax on property.  With property prices in some of those countries having plunged over the past couple of years it could be some time before “the gains” become taxable again.  There does not seem to be a tax credit in those countries where there is a capital gains tax on property, when there are capital losses.  Governments have a need for reliable and predictable tax takes, which is a real limitation of capital gains taxes on property.

For most investors in diversified investment portfolios, there have now been two tax returns completed under the new investment taxation regime.  There is no definitive generic answer if investors are better off under the PIE regime or the FDR regime.  It varies on a number of factors.

Small investors who have taxable income of over $14,000 will generally be well served using PIE investments.  Those on lower income levels can pay more tax under the PIE regime and are unable to claim the tax credits when their marginal tax rate is less than their prescribed investor tax rate (PIR).  Under a falling market situation, foreign shares held in a PIE arrangement will pay more tax than comparable investments that are foreign investment funds that can use either the FDR or CV taxation methods.  They will also probably be paying higher fund management fees using a PIE fund, rather than for example investing in an Australian Unit trust, and will also have a very restricted choice of funds that they can invest in.  PIE versions of some Australian Unit Trusts are now available; however the management fees are higher.

Smaller investors can also be disadvantaged.  For example a couple who had invested $95,000 in the disastrous ING DYF could not claim tax losses (assuming the total foreign investment fund holding was less than $100,000) whereas a couple who had invested $105,000 in the same fund would have total tax losses of almost $82,000 which could be used to reduce any other assessable income.

Structuring individual portfolios for taxation efficiency is not straight forward, and should be done on a case by case basis.  From client comments, it is obvious that a number of tax agents do not understand investment taxation, and find that it is easier to tell the clients that they should only invest using PIE’s.  This makes the tax agent’s job more straightforward, but may not be in the best interests of the client.  Certainly if the client cannot provide a well prepared tax report to the tax agent, there may be a significant cost for the tax agent to prepare the necessary information. 

Investors who have a contractual relationship with a financial planner would expect to be provided with a tax report at no additional cost by their financial adviser.  Our experience is that it should only take a matter of a few minutes to use this information to complete an investor’s tax return.  Masterfund investors have little flexibility in how their investments will be taxed, other than by selecting their PIR rate.  These people will invariably have paid a lot more tax over the past couple of years, than those who had a well structured portfolio tailored for the clients’ needs.

Disclosure: As required under the Securities Markets Act 1988 and the Securities Markets (Investment Advisers and Brokers) Regulations 2007, a Pascoe Barton disclosure statement is available on request free of charge, by contacting Pascoe Barton Limited on (07) 306 0080 or from www.pascoebarton.co.nz.

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I don't live near your office. How do you deal with clients in this situation?

Thats a great question. The majority of our clients live several hundred kilometers away from our office. We always meet with prospective clients and continue to meet with existing clients at least once per year. Our clients make use of our 0800 telephone number, email etc, which is what they would do if they lived a kilometer away. Distance is not an issue. We have even had clients living in Tibet! The important points to consider are the quality of service and how promptly things can get done. We also have a number of clients who holiday in the wonderful Bay of Plenty, and they arrange to meet us when they are here.

I'm already invested with another advisory firm. Can I transfer my business to Pascoe Barton?

While we would love to have your business, we need to check things out on a case by case basis. In general, if your existing investments are held on a wrap platform and held under a custodial arrangement it is a relatively easy process to change. Similarily, if you own the investments directly yourself, it is an easy. Unfortunately some investors with other firms are in a bind as their investments are frozen and non transferable.

What if I just want advice?

Advice only can be offered on an hourly rate basis.  This would generally be for a specific situation, for example, preliminary estate planning. One of the problems is that unless we know a client’s full situation, it is a dangerous practice to simply offer advice.  It is all too easy for advice to be taken out of context and for an individual to go ahead and purchase inappropriate investments or combinations of investments.  You also need to appreciate that our investment recommendations generally use wholesale investments, which have lower management fees and often different investment mandates than retail investments.

Who are the fund managers and what managed funds do you use?

This is a continually evolving list. We chose our managers on a forwards looking basis and what is most appropriate for the expected market conditions. Just because a fund is on our recommended list, it does not mean that it will remain on the list indefinitely.

As we are not tied to any fund managers, we have a real freedom of choice as to which mamangers and funds we use. All managed funds need to have New Zealand or Trans Tasman registrations. As there are literally thousands of products on offer, we establish a recommended and approved product list. This is based on a combination of research and experience. We use research house fund manager reports, and invariably product providers must supply us with at least two research reports on products that we are considering for use within our managed portfolios.

While we are a boutique advisory business, we have over the years introduced several new investments to the New Zealand market. We make use of several boutique fund managers, as well as a number of well known large fund managers. 

How are your fees calculated?

Fees are calculated on the daily portfolio values.  They are deducted automatically from the clients custodial cash account at the end of each month.  There are really two components of the fee.  Firstly the Custodial Fee which is a flat fee, and the Pascoe Barton Fee, which has a progressive reducing scale fee.  Once client portfolios are over $250,000 the marginal fee percentage decreases.   Our InvestorPro fee schedule has a maximum fee of 1% (gst excl.)

I’m doing a fee comparison between advisers. Can I readily compare your fees with others?

The short answer is you need to make sure you are comparing apples with apples.  You are extremely unlikely to be able to do this accurately as everyone’s service, standards, recommendations, experience, qualifications etc are different. 

When using managed funds, our portfolios make use of wholesale funds, which have significantly lower fee levels than retail funds.  They also do not pay trail fees.  Brokerage is also rebated to clients, so our clients pay us a fee, but benefit from lower fund management fees.  Plus of course, our fees are generally fully tax deductible.  Fees are also only one component of the service.  They encompass quality advice, all our research, our continuing education commitments, quality service and unlimited (within reason), time with fully qualified certified financial planners.  We always work to do things in the most cost effective manner for our clients.

 What are some of the advantages of not being part of a large network?

• The main advantage is that we are not handicapped by having to support a large head office overhead caused by non productive staff.
• We do not have the conflicts associated with the need to support "in-house" investment products. History shows how disasterous these have been for investors. Examples include ANZ Bank investors in the ING Diversified Yield Fund and Regular Income Fund. Money Managers and First Steps.
• We do not have a “hidden head office agenda” to support any supplier because of the size of marketing subsidies received. We can also be more reactive and responsive to clients needs.
• Our advisers have to have a greater depth of investment understanding and knowledge than those advisers who are essentially sales and liaison staff who must maintain a corporate line.
• Our advisers prepare their clients investment plans and reviews. In most large organisiations para planners who are often unqualified and lack experience, do this work which in many ways is the most important aspect for successful financial planning.

How do you determine your asset allocations?

Deriving a strategic asset allocation has traditionally been based on historical returns for each asset class.  It is not forward looking, which is the basis for Tactical Asset allocations.  We have chosen to adopt a different approach basing our recommendations provided by Farrelly’s, a specialist asset allocation provider.  The methodology was described by John Bogle in 1991 as the Occam’s Razor approach to forecasting which breaks down forecasting market returns into three elements.  These are income, growth in income, and the effect of changing valuation ratios.

For accuracy, we can use these to derive ten year investment forecasts for each asset class.  The main reasons for this are that earnings per share growth are steadier over ten year intervals than it is for one year periods, and the effect of a change in Price Earning is much smaller over ten years, than one year. 

The asset allocations are quite different to those derived from the historical returns model, however the overall allocation to growth investments and income investments for each client risk profile are similar to the more traditional approach. Regardless of what asset allocation method is used, the amount of investment risk must be appropriate for the risk profile of the client.

What needs to be remembered is that long term strategic asset allocations are like a roadmap.  There are alternative routes to get you there, or you may find road works or unexpected delays along the way.  We expect that both asset allocation methods will achieve similar long term investment returns.  Along the way there will be periods when there are significant differences in performance.

How do you assess the Research that you receive?

Research is a very important tool, but it must be interpreted in a manner so that it can be practically applied to client portfolios.  We question the researchers as to how they make their recommendations.  There needs to be logical reasoning behind any recommendations.  For direct share investments, we usually use a consensus viewpoint, as the research is invariably provided by the research departments of various share broking firms.  Unfortunately, history shows they can have somewhat biased opinions depending on their relationship with the company they are researching.  Fortunately, relationships are now generally disclosed if there is a conflict or perceived conflict of interest.  In our selection of managed funds, we normally require supporting research from a minimum of two research houses.

What sort of investments do you offer for fixed interest?

In our client portfolios we use a combination of fixed interest investments. This includes direct (traded fixed interest) fixed interest either brought on initial offering, or on the secondary market. Depending on the client this will either be investment grade, or unrated. Our preference is to use rated investments; however there are some excellent investments that have not been rated for various reasons. Fixed interest is usually purchased on a ‘hold to maturity’ basis. This is important, as at times on a mark to market valuation, bond capital values can fall. Similarly there can also be capital gains. Low cost PIE Bond Funds are used to provide cost effective diversification and duration management. Proxy fixed income funds could also be used.

Do you offer Masterfund Investments?

Yes we can offer them, but generally we would recommend using tailored portfolios held on a Wrap account platform instead.  In our opinion, they are most suited to portfolios under $200,000 where obtaining sufficient diversification can be compromised because of minimum investment parcel sizes particularly for fixed interest. Traditionally fee levels within the Masterfunds have been too high, in comparison to what we can offer using a Wrap platform and predominantly wholesale funds. 

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