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How we Mitigate Portfolio Related Tax for Clients

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New Zealand is considered to have a simpler tax structure than jurisdictions such as the UK, Australia and the USA.  As a result, less attention is generally paid to tax as it relates to investment portfolios.  However, as advisers there are a number of things we can do to help minimise the taxes our clients pay.

In this article we outline some of the ways we can help clients enhance their wealth by thinking and acting smartly in relation to tax.

 

1. Reduce taxes for New Zealand sourced income by using PIEs

Each investor in a PIE pays tax at their prescribed investor rate (PIR).  Even though we use AUTs (Australian unit trusts) for international share investments, we use PIEs for New Zealand shares and fixed interest.  This means investors on the highest marginal tax rate (with incomes greater than $48,000) pay only 28% tax on any previously untaxed dividends and income received from New Zealand shares and fixed interest.  This compares with the 30% or 33% they pay on other income over $48,000.

There are essentially two ways you can hold New Zealand shares and fixed interest – directly, or through a PIE.  If an investor holds shares directly they pay tax at their marginal rate, which for many is 33%.  If you hold the assets through a PIE, an investor who would otherwise pay tax at 33% will instead pay tax at 28%.

Moving from 33% to 28% tax is a significant benefit.  For example, we estimate that an investor on a 33% marginal tax rate, who invested in New Zealand shares through a PIE, would pay tax of approximately 1.14% annually.  However, if the investor held the same shares directly, we estimate the annual taxes to be 1.35%.  Therefore, investing in a PIE is expected to save this investor approximately 0.21% in tax each year.

 

2. Reduce the average tax burden on foreign investments

In general, we recommend owning foreign investments via managed funds.  Without the use of managed funds, it would be entirely impractical and prohibitively expensive to purchase 8,000 different companies across 40 different countries.  But what type of funds should we use?  Should we use a fund domiciled in New Zealand and taxed as a portfolio investment entity (PIE), or should we use a foreign investment fund domiciled internationally, such as an Australian unit trust (AUT)?  The tax implications of each are different.

There are several reasons why holding foreign equities in an AUT may be more tax effective than using a PIE.

  1. A PIE is taxed on an assumed 5% return each year, regardless of its actual investment return. An AUT is only taxed if it achieves a positive investment return, and only on its return up to 5% (returns above 5%, like a PIE, are not taxed).  However, if an AUT makes less than 5%, it is taxed on this lower amount.
  2. An AUT is taxed on the basis of what an investor owns on 1 April each year, meaning new investments made after 1 April are effectively tax free until the next 1 April rolls around. This is potentially important for regular savers.
  3. PIE tax is based on an investor’s taxable and PIE income over the previous two tax years. This can be painful during an investor’s first year in retirement, for example, when they may be taxed as if they were still fully employed.

Based on the first point above, AUTs are likely to be more tax efficient than PIEs for international share investments.  Using the years 1991 to 2015 as a proxy for potential future investment outcomes, we calculate that investors in an AUT on the highest marginal tax rate will, on average, pay about 0.10% per annum less tax on Australian share investments and 0.21% per annum less on other international share investments.  While we express this as a per annum average, in reality, the savings are lumpy.  An AUT might pay slightly more tax in a good year, but typically pays a lot less tax in down years.  Nevertheless, the average expected saving is meaningful, especially when you consider that the average management fee of the international funds we recommend is around 0.40%.  This means the average tax saving may be equal to as much as half the total management fee of those funds.

 

3. Potentially reduce the tax burden on foreign investments in the first year of investment

As mentioned earlier, tax on AUTs is based on the amount invested on 1 April each year.  This introduces the idea that delaying new purchases of foreign assets until after 1 April may be beneficial.  Imagine you had a new portfolio to invest and 1 April was just around the corner.  If you waited until 2 April to invest any new funds into AUTs holding foreign equities, these investments would go an entire year tax free.  For regular savers it means that, for at least a portion of the year, their new investments are not being taxed.  Who wouldn’t want a tax holiday for up to one year?

This represents a substantial benefit.  As a result, as 1 April approaches each year, we may recommend delaying new investment into foreign investment funds such as AUTs.  We calculate the cut-off date to be where the expected after tax/after fee return of holding these investments for the remainder of the existing tax year is lower than the expected tax benefit from delaying new investment until 2 April.  This date typically falls between February and March each year.

So what is the potential benefit of delaying investment?  We estimate that, by waiting until 2 April, investors on a marginal tax rate of 33% may save up to 1.13% in tax.

 

4. Annually review an investor’s PIR to avoid excess tax

An investor’s PIR is the rate of tax they pay on PIE income.  It is entered into the custody platform by the adviser.  The PIR is selected based on the amount of taxable income and the amount of PIE income an investor earned over the previous two tax years.

Why does the PIR need to be regularly reviewed?  Firstly, a couple often have different PIRs.  For example, if one spouse isn’t working, their PIR is probably lower.  Secondly, when clients go through life transitions, such as retirement or divorce, PIRs can change.  Each year we review each of our clients’ PIR and ask them to reconfirm the current rate is still appropriate.  If the wrong PIR is selected and an investor pays too much tax, that money cannot be recovered.

The fact that a husband and wife may have different PIRs often creates opportunities for advisers to help mitigate tax.  For example, if a non-working spouse with a lower PIR received an inheritance and wanted to invest the proceeds, should the couple set up a joint portfolio?  Probably not.  In this scenario, a joint portfolio will generally expose the assets to a higher PIE tax burden than if the portfolio was established only in the name of the non-working spouse.

Of course, tax is not the only consideration here, but it is among the areas an adviser will review with clients when making a decision on the ownership structure of an investment portfolio.

 

5. Discuss effective distribution strategies from a family trust

We generally recommend investors do not set up trusts for tax reasons, because the cost and expense of administering a trust can outweigh the benefits.  However, for clients that do need a trust, we work with them and their accountant to maximise the tax efficiency of any trust distributions.  Whilst accountants will usually take the lead with these discussions, we support and work closely with all professional advisers to the trust to ensure all the decisions make sense and distributions are made to the appropriate beneficiary.

For example, imagine that a husband and wife had a trust and wanted to support their 18 year old son in his first year at university.  They could give their son money from their bank account but, from a tax perspective, it might be smarter to distribute income directly from their trust.  Why?  Because their son is probably in the lowest tax bracket (10.5%), while they might be in the highest tax bracket (33%).  If the parents distributed $14,000 from the trust and their son had a marginal tax rate of 10.5%, he would pay $1,470 in tax.  If they took that income themselves and they were in the highest tax bracket, they would pay $4,620 in tax.  In either case, their son gets the money they want him to have, but making a considered decision to distribute directly from the family trust could potentially save $3,150 in tax.

 

6. Minimise taxes by bringing forward charitable giving

Many investors support charitable causes, however, because the future is unknown, it can be difficult to determine how much they can afford to give.  Often the default ’solution’ is to leave money in their will.  Unfortunately, this has two big drawbacks.  While they are still alive, the donors:

  1. Don’t get to enjoy seeing the good work that their money can do.
  2. Deprive themselves of the available tax benefits.

What are those tax benefits?  Prior to 1 April 2008 the maximum refund available for charitable giving was $630, meaning that only the first $1,890 of an individual’s giving received tax relief.  This has now changed, and individuals can claim the lesser of:

  • 33.3% of total donations made, or
  • 33.3% of their taxable income.

Income that qualifies includes portfolio income such as dividends and interest, New Zealand superannuation income and traditional forms of income.

We work with investors to help them determine the money they can afford to give away each year, including funds earmarked for charitable giving.  This means that any charitable giving is planned and intentional, and therefore much more likely to be claimed back as a deduction at tax time.  This is noteworthy, because a charities.org.nz survey found that only 26% of donors claimed a refund on donations made[1].  Perhaps this is a result of many New Zealanders giving to organisations that approach them for money, rather than having their own planned strategy for charitable giving.

 

7. Portfolio recommendations are based on after tax returns

When deciding what portfolio allocation to make to New Zealand shares, international shares, emerging markets shares and fixed interest, we consider the expected returns after all taxes and fees.  A consideration of expected investment outcomes on an after tax basis can meaningfully alter asset allocation decisions.

For example, our analysis shows that, due to their risk exposures, Australian shares may have higher long term expected returns than New Zealand shares.  While that is positive, New Zealand investors can’t claim credits for any corporate tax paid by Australian firms in the way that they can for tax paid by New Zealand firms.  By considering after tax – rather than pre-tax – expected returns, our asset allocation decisions take this difference into account.

By basing asset allocation decisions on after tax returns, we recognise the nuances in the various tax structures of investments.  This means that, all things being equal, we will recommend a greater percentage of assets with lower tax burdens than we would if we only considered investments on a pre-tax basis.

 

Tax is only one consideration

Although we’ve provided several reasons why we pay special attention to tax, we need to emphasise that tax is only one consideration when making investment and transaction decisions.  There may be many reasons to hold assets in one structure or another, or in one name or another.  Making decisions solely for tax reasons can lead to bad advice.  We don’t actively seek to avoid tax.  Rather, we seek to pay no more than the required amount of tax based on overall sound financial planning.

 

Summary

Good investment advice should always consider an investor’s tax situation as part of any strategic plan designed to help them achieve their investment goals.

When it comes to investment portfolios, tax planning is about enhancing investors’ after tax returns without incurring any additional risk.

There are seven key ways we seek to add value in relation to tax:

  1. Reducing the tax burden on New Zealand sourced income
  2. Reducing the tax burden on foreign investments by using foreign investment funds
  3. Reducing the tax burden on foreign investments in an investor’s first year of investment
  4. Reviewing an investor’s PIR to prevent overpayment of taxes
  5. Supporting trust distribution strategies to lower marginal rate taxpayers
  6. Helping to minimise taxes by bringing forward charitable giving
  7. Making investment recommendations based on after tax returns

We recognise that none of the above tax planning items are exceptional, however, in our view, great advice is not found in doing the exceptional, but in doing the obvious exceptionally well.

This is the result we seek to provide our clients in every aspect of our service.

 

DISCLAIMER

This document has been provided for general information purposes only.  The information is given in good faith and has been prepared from published information and other sources believed to be reliable, accurate and complete at the time of preparation, but its accuracy and completeness is not guaranteed.

Any information, analysis or views contained herein reflect our opinion at the date of publication and are subject to change without notice.  To the extent that any such information, analysis, views or opinions may be construed as advice, they do not take into account any person’s particular financial situation or goals and, accordingly, do not constitute personalised advice under the Financial Advisers Act 2008, nor do they constitute advice of a legal, tax, accounting or other nature to any persons.  Past performance is not indicative of future results, and no representation or warranty, express or implied, is made regarding future performance.  To the maximum extent permitted by law, no liability or responsibility is accepted for any loss or damage, direct or consequential, arising from or in connection with this document or its contents.

Reference to taxation or the impact of taxation does not constitute tax advice.  The rules on and bases of taxation can change.  The value of any tax reliefs will depend on your personal circumstances.  You should consult your tax adviser in order to understand the impact of investment decisions on your tax position.

[1] https://www.charities.govt.nz/charities-in-new-zealand/public-trust-and-confidence-in-charities/