Life after tax returns

With a wave of reform about to hit the industry, financial advisers will soon have to change some of the considerations they take into account when recommending certain investments. Damian Graham argues there will be more focus on after-tax returns, and lists relevant factors in generating an after-tax focused investment management outcome.

 When making investment recommendations on behalf of a client, an adviser has to factor in a myriad of considerations. With the upcoming regulatory reforms that are soon to be put in place – which include requirements like the best interest duty and opt-in – there are now even more considerations to take into account.

One of the key considerations that can be overlooked is the likely after-tax outcome of an investment decision, and the benefits that can be brought to a portfolio by managing investment decisions through analysis of this outcome.

While tax should never be the sole driver of an investment decision, it is certainly an important underlying consideration. Tax impacts can soon overpower the other costs of investing and leave an investor and their adviser in a less than desirable position.

Though most would agree that it is beneficial, it is clear that after-tax management is not widely understood or readily available in a great deal of investment structures.

Further, there is a significant amount of work required to individually manage even a relatively modest number of portfolios on an after-tax basis, and to reach the best outcome for each individual client. 

After-tax portfolio management, in its simplest form, seeks to have as its main focus the after-tax return each investor receives, in addition to the investor’s pre-tax returns. The rationale for focusing on this is pretty simple: it is the after-tax returns that investors are able to use to meet their investment objectives, not their pre-tax returns. 

As a principle, I believe there are five primary factors that are most relevant in generating an after-tax focused investment management outcome. The fundamental basis of these factors is the ability to truly customise portfolio management activity to the individual client circumstances and then to monitor the real impact.

1. Firstly, the ownership structure of the assets is important, as direct ownership enables the portfolio manager to tailor the taxation ramifications of investment decisions on a client by client basis. This typically separates structures like managed accounts from structures like unit trusts, where the investment manager will be unaware of the tax situation of the underlying client.
2. Secondly, I believe the style of portfolio construction used should be different for different tax scenarios to drive after-tax efficiency and better after-tax returns.
3. Thirdly, it is important to ensure the tax impact of any portfolio management activity can be reviewed before undertaking that activity.
4. Fourthly, once a transaction is undertaken, there should be the ability to determine the taxable parcel of the security that creates the optimum after-tax outcome.
5. Lastly, the ability to measure the efficiency of a specific objective of after-tax returns should be available to the investor to help them verify whether the approach is actually tax efficient.

We can use the term 'tax alpha' to define the benefit to after-tax returns from tax efficient portfolio management activity. Tax alpha is more predictable than typical investment alpha, as the impact of a transaction from a tax perspective is known before the transaction is affected, whereas the impact of a transaction from an investment perspective is not.

To take a workable example, the efficiency an after-tax focus can deliver can be seen in recent off-market buy-backs undertaken by the likes of BHP Billiton and JB Hi-Fi.

These opportunities are generally only suitable for those investors with a low marginal tax rate who have the ability to utilise imputation credits on franked dividends. For investors with a high marginal tax rate or for investors that cannot utilise imputation credits, these opportunities will not deliver an after-tax return above the pre-tax return.

Accordingly, it is important to be able to participate in a buy-back only for those investors that will get a better after-tax return in doing so.

The issues of after-tax management introduce a number of core considerations for an investor, including those of portfolio construction, customisation and scale. 

When managing clients, a portfolio manager is faced with an investment that has all the components of franked and unfranked income, capital gains discounting, holding periods for imputation credits or tax-deferred income (such as is the case with company buy-backs, property trust distributions and so forth) – the after-tax outcome will depend on the individual investor for whom the portfolio manager is making decisions.

Therefore, to reach the optimal outcome, a highly customised and individual approach for a client is required. 

When thinking about portfolio construction, not only would a portfolio manager need to take into account all of the usual principles of diversification, the risk/return of each stock, the income or yield and so on, they also need to consider the tax implications of each holding too. 

This brings us onto scalability and the real ability for an adviser to drill down into this level of detail for every client if they are holding direct shares. Owning securities directly in the portfolio has its advantages, as investors can tilt their portfolio based on their personal circumstances and objectives as well as ensuring portfolio management activity is undertaken to maximise after-tax returns.

One of the most powerful reasons to own investments directly is the ability this grants investors to manage the timing and management of activity within the portfolio.

However, as everyone knows, managing multiple direct share portfolios for multiple clients is a challenge in itself, and has the potential to become even more so with upcoming regulatory reform.

What today’s environment is telling us is that opportunities to make the process of creating returns for clients more efficient are growing in demand. We have seen an increased uptake of managed accounts, with advisers adopting them within their broader advice offering to deliver customised and tax-managed outcomes in a scalable fashion.

This is a trend that is likely to continue as advisers and clients alike demand greater flexibility and transparency.

Damian Graham is the head of Macquarie Private Portfolio Management.

Disclaimer: MPPM is part of the Macquarie Group of Companies. No members of the Macquarie Group give, nor does any member purport to give, any taxation advice. The taxation information in this document is based on laws current at the time of writing. The application of taxation laws to each investor depends on that investor’s individual circumstances. Accordingly, investors should seek independent professional advice on taxation implications before making any investment decisions.

MPPM is not an authorised deposit-taking institution for the purposes of the Banking Act (Cth) 1959 and MPPM’s obligations do not represent deposits or other liabilities of Macquarie Bank Limited ABN 46 008 583 542 (MBL). MBL does not guarantee or otherwise provide assurance in respect of the obligations of MPPM.