After the Ralph Storm – CGT reform and After-Tax Returns

It wasn’t that long ago that news of the Ralph report dominated the financial press. Contentious issues for our industry included the initial consideration of treating collective investment vehicles (such as managed funds) as companies, the tax treatment of pooled super trusts, and dramas surrounding the taxation of life companies.

And while the Government's response to the report was released with considerable fanfare, and drew mixed but predictable responses from industry bodies with a vested interest, not much has been done since on the adviser level in the form of post-Ralph debate. Maybe it's because people only like to shout from the rooftops when things go against them.

However, in this case I think it is time to shout from the rooftops for another reason. Because the revisited CGT rules have been good - very good in fact, for the Australian managed funds industry. It has resolved some long standing issues, provided an end benefit to the clients of advisers, and set a platform for further improvement, in terms of the management of after-tax returns.

Two of the major issues largely reduced by the new capital gains tax rules were long standing concerns surrounding managed funds investments. These were the fear of investing prior to a distribution, and the fear of investing in a long-established fund, because of the capital gains tax implications of investment.

These tax implications have been diminished. That's because most of the capital gains in a distribution are likely to be concessionally taxed as the new rules state that if a stock is held in a fund for longer than 12 months, then only half the distributed capital gain is taxed.

Another benefit of the CGT rules is the incentive they provide to hold growth assets over income producing assets. This is due to the fact that while interest income is fully taxed, capital gains will, for long-term investors, be concessionally taxed. The implication is that growth investing will re-emerge as a strategy of choice for investors, particularly investors on the highest marginal tax rate.

A related issue is the relative attractiveness of receiving returns in the form of capital gains as opposed to franked dividends. Whilst franked dividends are still more tax effective than receipt of capital gains for most marginal rates and superfunds, the gap has closed, and for top marginal taxpayers the reverse is true.

Also, it is increasingly clear that imputation investing, in a global environment, is becoming less viable as an all encompassing strategy. Large Australian companies are increasing offshore revenue streams, meaning they are less able to provide franked dividends and the re-engineering of capital management means more and more companies are considering share buybacks. At the same time the diminishing number of stocks offering solid franked income payments means that investors wishing to following a pure imputation path will have a less-diversified and riskier portfolio.

A challenge which all fund managers face in light of CGT changes is the management of after-tax returns. This had been overlooked, by and large, by commentators on the industry, with many managers I suspect, still grappling with the issues at hand. As I see it, two major issues come into play.

The first relates to whether or not the fund manager tracks parcels of stocks, to determine the length of time the stock has been held. The second decision relates to theselldecision - if it becomes clear a fund manager wants to sell a stock before a twelve month period then a 'absolute return versus after-tax return' trade off question needs to be asked.

The first issue can only really be resolved by the effective monitoring of parcels of stocks which are bought. In other words, the fund manager should be looking to sell those parcels of stocks which have been held for twelve months or more, not recently purchased parcels.

Advisers should be asking fund managers what systems they have in place to deal with tax reform. This is a question which particularly needs to be asked of offshore international fund managers, who co-mingle Australian investments with pools of money managed for their foreign client base. In short, there is a risk that non-concessional CGT gains for these managers could be higher if they don't monitor the 12 month rule.

The second issue can only be resolved by having apre-twelve monthsell processin place - whereby the fund manager considers the after-tax ramifications of selling a stock prior to a 12 month period.

At BT for instance, the portfolio manager needs to determine what the impact of the pre 12 month sell decision will have across all marginal tax rates, before they are allowed to execute the decision. In other words, they need to project the anticipated value of the stock as at the end of 12 months.

They then need to consider what asellat this time would mean for all investors, and then ensure that the anticipated after-tax return is generally not less than it would have been had the stock been held for the full period, based on the anticipated price at the end of 12 months.

Of course if you are discussing after tax returns, in any context, it is hard to ignore what has happened across the Pacific, that is the disclosure of after-tax returns, with the US regulators enforcing a decision which effectively means that US funds have to report after-tax returns.

Will this become an area of debate for Australia, even though ASIC has ensured the improvement of fee disclosure?

The biggest challenge here revolves around which tax rate to use, because in the US after-tax returns are only being delivered to investors on the top marginal tax rates - which is not equitable. The end cost of a more equitable system is likely to be substantial.

But, if the regulator were to consider following the US example, it shouldn't overlook the fact that the US after-tax return is calculated taking into account the unrealised gains inherent in any growth in the unit price. This lead has to be followed, so that the investor understands the full tax liability that accrues on their investment, not just the amount of tax paid on distributions.

Finally, it is important to remember that the same after-tax issues that apply to managed funds also apply to all forms of financial products - including bank deposits, annuities, debentures, and broker accounts.

Rob Coombe is the Head of Retail at BT Funds Management