Whilst the majority of pension schemes (Schemes) do not expect to pay tax, in practice, many pay sizeable amounts in the form of withholding taxes (WHT), VAT, stamp duties and potentially even income taxes. However, some Schemes struggle to accurately quantify the amount of tax that they directly and indirectly pay.
Even in respect of simple investments there are a number of situations where a tax liability can occur. Furthermore, in light of the current climate of change in the way some schemes invest, such as the increased investment in property, venture capital funds, hedge funds and derivative contracts to generate higher returns and manage risk increase, there is an even greater potential for tax liabilities to arise. Consequently, tax management and tax mitigation should not be overlooked by pension fund trustees, as they could provide a very practical means of boosting scheme returns.
Pension Pooling Strategies
Over the last few years Pooling has become increasingly significant within the pensions arena and deservedly so, as pooled arrangements have helped several multinationals to provide their related pension funds with the opportunity to benefit from economies of scale and improved governance.
The concept is straightforward; by pooling pension plan assets, a multinational can potentially benefit from enhanced risk management and governance, access to greater manager diversity (in particular for the smaller plans that may not otherwise have access to the larger investment managers), and significant cost savings from economies of scale; for example, in terms of investment manager fees and transaction costs. Pooled vehicles can commonly take advantage of the sliding fee scale used by most managers, where the basis point management charge reduces as assets under management increase.
Tax, however, rather than being regarded as a financial benefit, is often only regarded as a key obstacle to the successful implementation of a pooled pension arrangement. This ignores the fact that Schemes could potentially reduce tax burdens through the simple restructuring of investments, which can be achieved as part of an overall Pooling solution.
Traditional Investment Manager Structures
Due to changes to tax rules around the world and tax agreements between countries, the traditional tax opaque investment vehicles that are often proposed by investment managers, and which have proved very popular in the past, may no longer be as tax efficient for Schemes as they once were. In investment managers’ pooled structures, it may be the case that custodians apply non-treaty rates or treaty rates appropriate to the investment vehicle (where possible) on dividends received from underlying equities. This could represent a significant tax leakage which may go unobserved by the Schemes because of a lack of visibility.
Changing established practice so that investments are made through tax transparent investment vehicles may present a viable alternative to traditional investment structures. Tax transparent investment vehicles enable investors to pool investments, whilst potentially allowing them to maintain their treaty eligibility and resultant treaty benefits. The basic principle of tax transparency is to ‘look through’ the vehicle and apply the relevant tax treaty between the investor’s jurisdiction and the jurisdiction of investment.
In many cases by using transparent vehicles, WHT may not be suffered, or would be suffered at a lower rate, due to a favourable treaty rate being available to a Scheme.
Traditional Investment Structure:
- A UK pension plan invests in US equities through a standard pan-European investment vehicle (e.g.) Luxembourg SICAV or Irish VCC)
- No treaty rate is available. 30% Withholding tax paid on dividends received from investment in US equities
- Tax leakage = 30%
- Assuming a dividend yield of 2% and a US equity mandate = 60bps
Transparent Pooling Vehicle:
- A UK pension plan invests in US equities through a transparent FCP or CCF structure
- Under the UK/US tax treaty: Withholding tax = 0
- No tax leakage
- Assuming a dividend yield of 2% and a US equity mandate this would result in a 60 bps benefit from investing through a tax transparent pooling vehicle
VAT and Stamp Duty efficiencies
Most European Schemes are unable to fully recover VAT paid on management fees and as these costs are one of the more significant expenses incurred by Schemes, this irrecoverable VAT could represent a significant tax burden. For example, in the UK, typically only 30% of VAT can be recovered by Schemes, which can result in an absolute VAT cost of 12.25% (i.e. 70% of 17.5%). As a general rule, plans that invest primarily in European assets and which invest on a segregated basis suffer the most direct VAT.
Pooling could also offer stamp duty savings for European countries such as Switzerland and the UK. UK stamp duty may be mitigated provided appropriate steps are taken prior to the transfer of the assets into pooling vehicles. In Switzerland, an investment vehicle is typically exempt from stamp duty which limits the amount of stamp duty on contribution but also on an ongoing basis as all transactions carried out within the fund should remain exempt from stamp duty.
Consolidated platform initiatives
Achieving economies of scale can clearly allow investment managers to provide better rates of return for investors. To benefit from scale, managers should ideally offer a single range of platforms, accessible to pension scheme investors across jurisdictions. However, in the EU at least, very few managers have a product range which is consistent with this ideal. Rather, a legacy of historical barriers to the rationalisation of product ranges – including in particular tax barriers – has resulted in a market characterised by multiple platforms and duplication across ranges.
The scope for the European fund industry to benefit from greater economies of scale can be seen by considering the US market. The European market is estimated to be half the size of the US market, but has a three times the number of funds. An IMA report published in 2003 estimated that if the European funds industry could achieve the same economies of scale as its counterpart in the US, it could achieve cost savings of up to €5bn p.a.
So how can European platforms be consolidated to pass on the sort of cost savings enjoyed by investors in US funds, and what are the obstacles to doing so?
One answer lies in employing the sort of pooling techniques described above. This would involve interposing a pooling entity between participating platforms and their underlying assets, thus creating a single enlarged pool of assets, capable of enjoying greater economies of scale. As for Pooling, a key challenge from a tax perspective is selecting a pooling vehicle which optimises post-tax returns. In addition, there can be regulatory barriers to entity pooling of this kind.
An alternative to entity pooling is ‘virtual pooling’, under which appropriate contractual arrangements are put in place which allow the assets of different platforms to be managed as if they were a single pool. Virtual pooling does not involve the interposition of a new entity, meaning that participating platforms retain beneficial ownership of the underlying assets and some of the tax complications associated with entity pooling fall away; although, they could be replaced by others.
Despite the challenges, there is a growing desire to address the inefficiencies which are inherent in Europe’s un-rationalised funds industry, so this is very much an area to watch.
Real Estate Investment Strategies
Property has, perhaps more than at any other time in recent history, established itself as the third largest asset class amongst pension fund investors, offering diversity to complement both equities and bonds. Until more recently, property has historically been perceived as being able to offer both bond and equity-like characteristics without the volatility in performance returns. The last few years have seen significant changes to real estate as an asset class. Most notably, the market has seen an increase in the number of unlisted property vehicles and who could forget the arrival of the Listed Real Estate Investment Trusts (‘REITS’)? Investors in real estate can now establish a level of diversification not previously possible through direct property investment.
However, the extent to which schemes will benefit from the types of returns offered by investment in property vehicles (listed and unlisted) will, in part, depend upon the management of the taxes arising on income and gains. Despite the recent introduction of the tax efficient REIT type vehicles by a number of countries, most Governments would still appear to be reluctant to fully relieve taxes on such a tangible and easily identifiable source of income as property.
Although there are exceptions, Schemes do not generally pay corporate income taxes. Therefore, if they invest into investment vehicles that themselves suffer tax, or pay out income net of WHT which cannot be suitably relieved by the application of a tax treaty, this can affect expected returns. Moreover, whilst a number of real estate vehicles will have been developed with institutional pension scheme investors in mind, after consideration of tax, it is simply not the case that all vehicles will be suitable investments.
One jurisdiction that has recently introduced particularly onerous tax regime for UK Schemes is Australia. In accordance with tax law enacted on 1st January 2007, income and realised gains earned by UK Schemes in Australian Unit trusts holding real estate investments will effectively be subject to 45% Australian tax. However, this tax will not generally be factored into quoted IRRs, since 30% of this tax will be collected in the form of WHT and UK Schemes are required to pay the remaining 15% tax themselves by submitting local corporation tax returns. Therefore, a pension scheme investing into such a fund expecting to receive an IRR return of 20% would only in practice receive a net after tax IRR of 11% and would additionally be burdened with an additional Australian tax compliance burden.
Derivative Investment Strategies
A number of exemptions from tax exist for UK Schemes. However, tax issues can arise as income from ‘trading’ activities does not fall within any of those exemptions. Income from ‘trading’ activities will be subjected to 40% tax, which could have a significant impact on a Scheme’s returns. Therefore, when making investments, there is often a strong incentive for UK Schemes to avoid the making of any investments that might be treated as some sort of ‘trade’ for tax purposes.
The question of whether an activity is trading in nature is becoming more common in the context of derivatives which are being used more than ever by Schemes to protect investments and generate returns as investment assets in their own rights.
Some help is available in this area in the form of recently issued UK tax authority guidance, the main points of which include:
1) There is no difference between a ‘real’ and a ‘synthetic’ transaction (i.e. a derivative should be treated in the same way as the instrument from which it derives value).
2) Short positions are conceptually the same as long positions.
3) Derivative contracts that give exposure to part of an asset are conceptually the same as derivatives that give exposure to the whole asset.
4) Multi-derivative strategies should not be unbundled for tax purposes, as long as there is evidence that the transactions were undertaken in relation to a clear strategy.
The tax treatment of derivatives has always represented a relatively ‘grey area’ of taxation and the motive (usually determined by an examination of the ‘facts and circumstances’ of a particular case) behind any transaction is the key to determining the tax treatment.
VAT Considerations
As we have seen above, irrecoverable VAT can represent a significant cost to Schemes. Therefore, readers may be interested in the fact that the VAT landscape is currently in a state of flux as a result of a number of recent legal Cases and more general upcoming EU Review of the VAT landscape. Therefore, with a view to maximizing returns, now would appear to be an opportune time to consider whether more beneficial rates of VAT recovery might be achieved.
Conclusion
When it comes to tax it is never easy to make generalisations, however, to assume that a Scheme is tax exempt and therefore suffers no tax is often far more from the truth. With the increasing pressure on Schemes to generate higher returns, now could be an ideal time to take a long-hard look at the Scheme’s tax position and suitable tax management techniques.
Biography of Hazell Hallam, Senior Manager at Deloitte
Telephone: +44 (0)20 7303 4208 Email: hhallam@deloitte.co.uk
Hazell Hallam has almost a decade of experience in investment management and all aspects of the taxation of collective investment vehicles including pension, private equity, property, infrastructure and hedge funds. She sits in Deloitte’s Financial Services Tax practice and has a particular interest in the development of tax efficient investment vehicles for European Investors. Seconded from Deloitte, she was formerly tax advisor to the Investment Management Association (IMA), the UK trade body for the UK’s £2,000 billion asset management industry.
Other contact details to be contacted for more information:
Eliza Dungworth- Head of investment management tax
edungworth@deloitte.co.uk
Tel +44 (0)20 7303 4320
Gavin Bullock- Head of pension funds tax
gbullock@deloitte.co.uk
Tel +44 (0)20 7007 0663
Matt Tombs- Head of development
mtombs@deloitte.co.uk
Tel +44 (0)20 7303 4044