A premium blend

The 2007 financial year is shaping as a unique investment and tax planning opportunity for both planners and investors.

There is a significant amount of commentary on superannuation this year as the preferred investment vehicle.

However, it is the tax effectiveness of the various asset classes that attracts far less attention.

My objective is firstly to compare the investment returns of a range of different assets classes on an after-tax basis.

After comparing these returns it is worthwhile exploring some of the other characteristics of each asset class to determine the most tax-effective investment strategies available.

Finally, some practical suggestions are offered about which asset classes should be considered to maximise after-tax returns.

The challenge is to provide a reasonable basis for comparing the taxation efficiency of direct shares, managed funds, listed property trusts (LPT), and tax-effective agribusiness investments (TEI).

Each type of asset class has different income and growth profiles and there are many other features and benefits as well as limitations attached to each investment option, such as risk, liquidity and volatility.

The taxation efficiency of each asset class understandably is only one aspect of the investment returns to consider among the most appropriate investments for a client’s particular portfolio. Some of the other factors are considered later in this discussion.

For now, to focus on the taxation treatment of returns, a standard set of returns assumptions has been applied to compare after-tax internal rates of return (IRR). This measure not only considers the quantum but the timing of receipt of returns.

When comparing the tax effectiveness of the asset classes, the assumptions made are:

~ investment returns are compounded over the term;

~ investment returns include an income component (5 per cent) and capital growth (6 per cent), which is an important distinction because each return has a different taxation treatment;

~ income component of 10 per cent for TEIs;

~ franking credits assumption for direct shares (50 per cent);

~ tax deferred component for LPTs of 15 per cent has been applied; and

~ the investment term is 10 years.

Advisers not familiar with agribusiness may challenge the above assumptions for this asset class. However, leading independent research houses estimate the after-tax annualised returns for non-forestry to be 10 to 16 per cent a year.

Lonsec considers forestry projects such as pulpwood to return 6 to 8 per cent and for tropical varieties the returns are estimated to be between 10 and 15 per cent.

The after-tax outcome for each asset class is listed in Scenario 1 and Scenario 2 (please see Money Management magazine March 1, 2007 page 28).

In Scenario 1, the results assume a consistent marginal tax rate over the life of the investment period of 45 per cent.

However, Scenario 2 shows investment returns at a 15 per cent marginal tax rate. Not an unusual scenario for an investor who is commencing retirement.

The observations from the returns from both scenarios are firstly, the returns are not materially different when no other factors except taxation is considered and secondly, the after-tax returns increase significantly when the marginal tax rate is reduced to 15 per cent the year after the investment is made for the life of the comparison period.

Achieving higher after-tax returns for all asset classes in a 15 per cent tax rate environment such as superannuation clearly indicates these investments are best held within the superannuation environment. Superannuation investments attract a 15 per cent tax rate on income and 10 per cent on growth returns.

Of course, there are limitations to using superannuation, including the $50,000 cap on the level of annual undeducted contributions (under the proposed new rules) and the inability to access funds until an individual reaches preservation age.

Notwithstanding this, from a tax perspective superannuation is the best environment in which to invest to accelerate after-tax returns.

Given that all asset classes provide a higher after-tax return within superannuation, it is worthwhile further exploring the features and benefits of each asset class when seeking to maximise after-tax returns.

Direct shares held within a superannuation fund usually provide franking credits. Franking credits either reduce or eliminate the maximum 15 per cent tax payable or alternatively are refunded should they exceed the tax payable by the fund. Additionally, capital gains are concessionally-taxed should they be held in excess of 12 months.

LPTs can provide deferred taxation components to the annual returns. Some LPTs provide higher capital gain components of overall returns, which, as mentioned, are concessionally-taxed outside and within super.

But it is TEIs that provide the most significant taxation benefits.

A TEI that is 100 per cent tax deductible in the investment year, supported by a product ruling, provides either a tax refund or tax saving for the investor. Made outside of superannuation, for those on the top marginal tax rate (46.50 per cent) investing $10,000 into one of these products accrues an immediate $4,650 saving.

This is important for two reasons. One, the at risk capital from the investment is reduced from $10,000 down to $5,350 and two, the savings are released to invest in another asset class, or provide cash to contribute to superannuation.

It would be remiss not add that the Federal Government has provided certainty for forestry investments that has not been seen before in the industry.

Further, the non-forestry investments will at worst not be available from July 1, 2007, though a transitional period to phase these out seems likely.

In drawing conclusions from this analysis, it is worthwhile outlining some specific client scenarios to consider.

Consider two types of investors, younger clients (growth investors) and those in their last year before retirement (retirement investor).

For those seeking to maximise their wealth creation pre-retirement and maintain some liquidity in their portfolio, the opportunity (from a tax-efficiency perspective) is to combine investment options.

Common practice with TEI investors is to use the refund or tax saving to invest in another asset class such as LPTs, managed funds or direct shares. Gearing also provides this type of investor with additional options.

The retirement-focused investor has similar options available. Making use of TEI provides income outside the superannuation fund while using the taxation refund or savings to accelerate contributions to the fund.

In a year that everyone is seeking ways to make superannuation fund contributions, TEIs provide a compelling alternative.

This year may provide the last year non-forestry TEIs are available, as these products typically provide income streams for up to 20 years, which complement the superannuation fund’s objectives.

Although tax is only one aspect to consider in making investment decisions it does play a major role in contributing to or detracting from investment returns.

The asset classes compared above provide a similar outcome when simply comparing tax efficiency.

However, comparing the additional features and benefits of each asset class and taking advantage of changing tax rates, either within superannuation or upon retirement, is most useful.

The conclusion from this analysis is a combination of each asset class as part of a diversified investment portfolio to maximise after-tax returns and reduce risk.

Brian Collins is general manager of Great Southern Securities and will address Tribeca’s 7th Annual Tax Planning Strategies Conference in Melbourne on March 27.