Tax-efficiency has become an important factor for fund performance in recent years – particularly for pension funds that suffer too much withholding tax (WHT) on the dividends of their pooled equity investments. This is because UK pension schemes, as tax-exempt investors, are entitled to reduced WHT on dividends from global equities under double taxation agreements.
 

Tax efficiency of pooled funds has been neglected
 

Both large and small institutional investors continue to use pooled funds to implement their portfolio strategies. But not all have considered whether these funds have been built to be withholding tax efficient. A number of trends are driving the need to pay greater attention to the impact of tax drag on performance, including the increasing use of passive funds and the growth of auto-enrolment.

Now, with a backdrop of a potentially prolonged economic downturn, many schemes collectively face the prospect of widening funding gaps, with some scheme sponsors in potential financial difficulty.

Recent research conducted for AMX and Northern Trust shows that private sector DB schemes in the UK unnecessarily suffered more than £250 million of withholding tax in 2019. Based on these tax inefficiencies, the projected cumulative ‘tax drag’ for UK DB schemes for the 10 years from 2019 could total £2.4 billion.*

Removing withholding tax improves returns
 

Different European jurisdictions have developed specific structures which can be used to provide a Tax Transparent Fund (TTF). An example of such a TTF is the Irish domiciled Common Contractual Fund (CCF). The fund has no legal personality and therefore allows a ‘look through’ to the tax status of the underlying investor for the purpose of withholding tax on dividends. The advantages of using a global equity fund which minimises withholding tax can be significant. It can boost the performance of a fund by up to 41bps** for tax exempt investors such as pension funds.

How an investor used AMX to source a cost-efficient CCF

An investor had run a selection exercise for their equity portfolio and was interested in the approach offered by a particular global equity fund manager. The manager didn’t have an existing Tax Transparent Fund so, having been introduced to AMX, the investor was faced with three options: 

Given the size of the proposed allocation it was doubtful whether a segregated mandate was feasible. This approach also involves substantial work, particularly in terms of reclaiming taxes and setting up the required trading markets, so AMX was asked to provide a comparison of the pros and cons, from a cost perspective, of using the existing pooled fund or joining the platform. The review looked at elements including manager fees, operational costs, tax savings and the impact of VAT. 

The exercise identified that even with the AMX fee, the platform offered a better solution, particularly in terms of cost and tax savings. In addition, a tax transparent CCF version of the preferred fund could be launched by AMX, mitigating the effort for the manager.

Using tax efficient funds to achieving cost and operational efficiency

Significant scope exists for UK private DB pension funds to improve the tax-efficiency of their equity investments. If they have not already done so, now is the time to begin discussions with their advisers and investment managers about where opportunities exist to enhance the tax-efficiency of their investments – and make use of withholding tax reclaims or relief at source to which they are entitled.

By using AMX  to access tax transparent CCFs, investors and fund managers no longer have to go through the substantial effort of setting up their own management company and fund. And, as well as ensuring tax reclaims are being correctly administered; the platform provides operational oversight of the tax services provided by the administrator through the use of robust technology and expertise.

* Research conducted between January and April 2020.

** Based on MSCI World Index allocation

Photo credit: Michael Robinson