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We cannot stress enough the importance of choosing ‘value creators’ – optimal drivers of compounding returns that should help increase the purchasing power of your investment portfolio.
However, long term real growth has two natural detractors. The first is inflation, the second is one of life’s two certainties: taxes[1]. This article focuses on the latter.
This summary looks to highlight some areas where investors can avoid inefficiencies that can negatively impact investment returns. Given the breadth of the subject matter and its nuances, our aim is to approach the topic in broad strokes.
Investing inefficiently can be costly
Investors often use funds[2] for their convenience, efficiency, and breadth of investment range. However, the taxation of funds can differ markedly depending on the nature of the underlying holdings, the vehicle type, and jurisdiction.
For example, a US taxpayer investing in a non-US collective investment fund may be subject to the Passive Foreign Investment Company (“PFIC”) rule. Given the tax treatment of PFICs, particularly with respect to gains and dividends, holding the non-US investment fund can erode a portfolio’s purchasing power. The negative impact can also rise disproportionately over time.
Similarly, UK investors face a similar issue. A UK taxpayer buying an offshore fund should seek clarification from HMRC that the fund itself is an offshore reporting fund, as the tax treatment of gains on offshore reporting funds differs from those that have reporting fund status.
In some instances, holding instruments directly versus in a fund vehicle can be more advantageous for investors. For example, a UK taxpayer may use a fund for exposure to Sterling-denominated fixed income instruments. However, if a UK taxpayer were to, for example, invest in a portfolio Qualifying Corporate Bonds, the investor can benefit from more favourable tax treatment given the capital gain exemption.
For example, let’s take a Sterling-denominated bond, which is bought at 95, maturing at 100. The bond pays a 6% annual coupon, pre-tax.
Assuming you are an additional rate taxpayer, the post-tax annual income of the coupon is around 3.3%. On top of that you pay 20% capital gains tax upon maturity upon maturity. The total yield to maturity will be severely reduced on a post-tax basis. Investors need to consider the type of instrument, and the pre- and post-tax income of the type of security they intend to purchase.
What holds true in both cases, is that the real return required by an inefficient investment would need to be considerably higher than had the investor chosen a more efficient vehicle in the first place, due to the difference in tax treatment.
The impact of withholding tax
Continuing with the theme of fixed income instruments, one key element which is sometimes not considered is withholding tax. Whilst double-tax treaties do exist between nations, being cognisant of exactly how countries implement withholding tax at source is an important consideration given the impact it can have on an instrument’s yield and overall return.
For example, if a bond pays an annual coupon of 3%, and a 26% withholding tax[3] applies, the net coupon received is ca. 2.2%. This is pre-tax that you then pay on the coupon, thereby severely reducing the income element. Some banks do offer tax reclaim services, but this can be costly and time consuming. It may seem like a negligible point, but when Eurobonds typically trade in minimum denominations of 100-200,000 nominal, the overall impact to returns can add up over time.
Understanding the impact of other countries’ rules, depending on the type of investments held in the portfolio, means that investors can look to re-allocate capital to instruments where this is non sequitur.
When jurisdiction matters
We have seen a couple of examples where the tax treatment ascribed by country’s respective agencies can disproportionately impact returns. On the flipside, an investor’s domicile can be a factor for different tax treatment by a security’s issuing country.
If investments are undertaken through an investment vehicle which appears on a list such as the European Union’s list of non-cooperative jurisdictions for tax purposesor that of an individual country’s ‘blacklist’, then specific restrictions may apply which can detrimentally impact returns. For example, France places a 75% level on gains made if the domicile of the holder appears on the country’s blacklist[4]. This includes individuals or companies domiciled in countries such as the BVI.
In Portugal, Cayman Islands is one of the countries where income derived from this location does not benefit from the favourable income tax treatment of the non-habitual resident scheme. Therefore, any issuer domiciled in the Cayman Islands would be inefficient for those looking to optimise their portfolios under this regime. As a point of comparison, France does not include the Cayman Islands on their list.
Being aware of the domicile and the impact it can have on returns can lead to a smarter allocation of capital by investors.
All in all, there are myriad of factors to consider in terms of efficient allocation. The compounding effect can see inefficiencies detract a significant portion from a portfolio’s performance over time. The effects can be mitigated provided are aware of how their individual circumstances should be taken into consideration or seek professional advice where possible.
Disclaimer:
As a caveat, this article is not intended to give advice on any specific issues nor is it exhaustive or should be construed as giving advice. Please seek professional advice before action is either taken or refrained from because of information contained in this article.
Appendix:
1) A reference to an extract from a letter written by Benjamin Franklin to Jean-Baptiste Le Roy, November 13th, 1789: “…in this world nothing can be said to be certain, except death and taxes.” Sparks, Jared, 1856
2) This is a generic reference to Exchange Traded Funds, UCITS vehicles, OEICs, Mutual Funds etc. Each vehicle and their suitability should be considered individually. Investors should refer to the relevant regulatory documentation or speak with a qualified financial advisor before purchasing.
3) As is applicable to Italy, https://taxsummaries.pwc.com/italy/corporate/withholding-taxes#:~:text=A%2026%25%20base%20standard%20withholding,and%20non%2DItalian%20resident%20investors
4) https://www.bdo.gg/en-gb/insights/french-tax-insights/french-blacklist-and-tax-impact
