Squeezing out the last drops
Brendan Maton assesses the favourability of tax-transparent Dublin and Luxembourg pooled funds as a way to avoid being ensnared by US withholding tax
In straitened times, institutional investors should be looking to squeeze every possible inefficiency out of their portfolios. Towers Watson has identified withholding tax on US equity dividends as one such unwelcome element.
It reckons pension funds with a sizeable exposure to US equities should be considering vehicles such as Dublin-based common contractual funds (CCF) or Luxembourg-based fonds commun de placement (FCP) instead of the more popular SICAVs and Irish OEICs.
A withholding tax of 30% is incurred by certain overseas entities on dividends from US companies. Assuming a dividend yield of 2.8% on the S&P 500, Towers Watson believes this amounts to a drag of around 85 basis points on a €100m portfolio in the latter types of vehicle.
The custodian bank Northern Trust has found a similar gap of 81 basis points for US equities and 49 basis points for global equities by using historical data going back 10 years.
This is not a matter for those investors big enough to have direct holdings. Segregated account holders receive the full dividend without much difficulty. But for a variety of reasons, the use of pooled vehicles is on the rise - some large public-sector pension schemes use them to avoid having to use the Official Journal of the European Union's laborious tendering process.
The likes of Luxembourg-based SICAVs are tax opaque, meaning the legal entity of the vehicle determines the tax impact rather than the tax status of the underlying investors, leading to a greater tax drag for certain institutional investors than had they invested directly.
CCFs, FCPs and the Dutch FGR (fonds voor gemene rekening), on the other hand, are tax transparent, so that the underlying investors, where they have tax-exempt status, get the full benefit of the dividend.
Paul Jayasingha, senior investment consultant at Towers Watson, admits the problem is not particularly new. For decades, smaller UK pension funds have relied on their asset managers setting up a life insurance arm and life fund structure to reduce the US withholding tax drag.
Where Towers Watson is making a difference is by discussing the merits of tax-transparent pooling vehicles with asset managers themselves, not just pension fund clients.
"If there is a manager whom we recommend or rate highly, we will encourage that manager to consider setting up a CCF or an FCP," says Jayasingha. "We are not tax advisers but we are looking to do the right thing by clients."
Towers Watson not only speaks to the highly-rated managers, it also encourages those new to the European pension fund market to consider the benefits of tax-transparent vehicles as they mull how to win business.
Do the commercial managers listen? Jayasingha reckons there is about a 50% conversion rate among the house already recommended, but a lower rate among new venturers.
Three major reasons for reluctance stand out. One is the ‘drag' of administration costs for establishing a tax-transparent vehicle. Few investors in our example will recover the full 85 basis points lost because fund administrators, custodians and lawyers do not work free.
Second, the very virtue of tax-transparent vehicles, that they categorise underlying investors and process tax reclaims, leads to additional costs. This is an annual process. Finally, all upheaval upsets the status quo and involves not just administrative reform but a major communication and client-relations exercise.
"We don't just have one equity portfolio per region. For popular categories such as UK equities, we offer all different flavours. We would have to totally reorganise the funds and the investors might not vote in favour of that," says Mark Bliss, product development manager for EMEA at BlackRock.
"So if you ask me why these tax-transparent vehicles haven't yet really taken off, the fund reformation has not been compelling and cost is also a factor."
Asset managers often want to offer their investment strategy in the most popular, flexible vehicle. Tax-exempt pension funds might be just one of their target groups. If the other groups do not merit the expense of categorisation, then the managers are unlikely to bother beyond a standard UCITS.
"There is a finite number of clients we can pool," says Bliss. "Moreover, those that are eligible would have to reaffirm their tax status for each fiscal authority."
This explains why BlackRock does not yet offer any of the newer tax-transparent vehicles, though Bliss says it is an ongoing topic for discussion with clients. He expects that as regulation and the market develops, these products will gain momentum and obstacles will shrink.
Currently, there is no more than $100bn (€81bn) in total in tax-transparent vehicles. Northern Trust claims to be the market leader, with approximately $60bn in assets serviced on its cross-border platform.
Aaron Overy, head of business development, asset pooling and retirement services at Northern Trust, expects a couple of catalysts for growth. "The first is the fall in securities lending," he says.
"The income shared from this used to mask the drag on withholding tax, but since the crisis, pension funds are wary of participating in securities lending. This means they have to look elsewhere for returns."
Secondly, Overy points to the imminent launch of the UK's tax transparent fund (TTF) as a boon for UK pension plans, both large and small. The TTF will rival CCFs, FCPs and FGRs. For multinationals, they can locate the master fund for their European pension pools in the UK.
Administering authorities of the UK's Local Government Pension Scheme can use TTFs as part of the nascent framework agreements. Smaller UK funds can make their US equity portfolios more efficient using a locally-based vehicle.
Jayasingha adds a third possibility. The US Foreign Tax Account Compliance Act (FATCA), now due to become law in 2014, aims to prevent US citizens hiding wealth illegally in foreign investment schemes. European pension funds that have US citizens as participants or beneficiaries risk having to comply with US legislation or forfeiting their right to reclaim the withholding tax on US equity dividends.
Although Jayasingha is confident this risk is receding, and that European pension plans will be exempt, he says it is still too early to be sure.
FCPs and CCFs remain a matter for deliberation rather than an automatic choice. But cost-conscious European investors are already demanding their creation by asset managers.
One commercial house told IPE that a mandate worth $100m was its tipping point. Expect to see more converts to this form of managing overseas equities.