The trouble with Ralph

Asset managers will need to switch their focus from pre-tax to post-tax returns on equity funds following the introduction of the new Ralph capital gains tax (CGT) rules.

Asset managers will need to switch their focus from pre-tax to post-tax returns on equity funds following the introduction of the new Ralph capital gains tax (CGT) rules.

The Ralph changes to CGT generally reduce an individual’s tax liability by only including 50 per cent of any gain in their assessable income provided they hold the investment for more than a year. It has widespread implications for the management of collective investment vehicles, such as unit trusts. It also has implications for superannuation funds, which will now pay an effective 10 per cent tax rate on capital gains realised on qualifying assets.

Ralph will readjust the asset management playing field, which until now could largely ignore issues like CGT.

The after tax return is obviously a prime concern for the majority of investors. While it is well and good that a fund delivers a pre-tax return of say 11 per cent, if investors are then hit with a large tax bill, they will quickly turn to a fund that’s more tax savvy. A fund that takes into account available CGT concessions to generate a better after tax return will obviously be more attractive.

Funds will need to review their investment mandates to make sure that both their before tax and after tax returns to investors are attractive. This hasn’t been an issue until now. At Zurich, for example, we are planning to introduce a managed growth tax effective fund by July 1.

From a CGT point of view, passively managed funds are likely to gain greater benefits from the Ralph changes than funds that churn over stocks rapidly.

Research houses, which currently compare fund performance in pre-tax terms, will also need to develop new measures that take into account both direct and indirect benefits flowing on from CGT concessions.

The next 18 months is likely to be a time of confusion for both asset managers and investors. Because there’s so much background noise happening as a result of other tax changes, I doubt if most asset managers have had a chance to adequately assess and address Ralph issues.

As a case in point, it took industry several years to digest and react to the real benefits of imputation tax credits after they were introduced in 1987.

The current financial year, when interim rules apply, will pose even more challenges for asset managers. For investments made before September 21, 1999, unit trusts will have to choose between the old system to calculate CGT and the new provisions. This choice is likely to impact unit holders differently depending upon whether they are individuals, superannuation funds or companies.

To make things even more complicated, a quirk in the legislation means that individuals and superannuation funds will not be able to obtain the full benefit of the CGT concessions in respect to the gains realised within a unit trust before July 1, 2001. As a trade-off, I suspect most fund managers will try, wherever possible, to minimise realising capital gains until after this date.

The Ralph changes may also have implications for the way that listed companies decide to distribute profits. Since imputation tax credits were introduced, there’s been a strong focus on franked dividends in the Australian market. But in the current low-inflation economic environment, you can get a slightly better interest yield from capital growth compared to income under the Ralph reforms. This may mean that some companies will decide to pay smaller dividends in the interest of giving investors a greater capital gain. This will take us back to the old days before imputation credits.

According to research conducted by Zurich and PricewaterhouseCoopers, investors will be better off under the new CGT rules if asset growth is twice the level of inflation.

Funds coming from other parts of the world are also likely to become substantially less attractive for retail investors, because they will incur a tax liability on 100 per cent of their net gain.

Paul Baker is at Zurich Financial Services.