Common trusts' uncommon qualities
We are all conscious of the fact that pension schemes are increasingly seeking to invest through pooled vehicles and to consolidate their use of investment managers. We are also very aware of the fact that, whereas it is relatively easy to construct a vehicle suitable for pooling pension schemes within a particular country, it is much more difficult to achieve the same result internationally. The ideal cross-border pooling vehicle will have at least four qualities (five in the context of passive management):
1. Admissibility – pension schemes domiciled in all major jurisdictions will be allowed to hold units in the fund, subject to normal prudent considerations on diversification of the underlying assets.
2. Tax Transparency – where the investment return delivered to the investor is a function of the tax domicile of the investor rather than that of the pooled vehicle.
3. Simplicity – the pooled vehicle has a simple legal structure which is readily understood in all major jurisdictions. Ideally, one would desire that the regulators in the pooled fund’s tax domicile do not impose onerous accounting or reporting obligations.
4. Coverage – where the range and type of asset classes available is wide enough to cope with local preferences.
5. Liquidity – in terms of passive management one would prefer that the pools are substantial in size to facilitate tight tracking across all asset classes.
While a lot has been written and discussed around the concept of a pan-European pooling vehicle, we believe that such a vehicle does not currently exist. Although there is a general trend towards regulatory and fiscal liberalisation in the European pension fund market, we suspect it will be some time before such a vehicle is created. It follows therefore that the creation of a global or even pan-European pooled vehicle solution inevitably will currently involve some compromise between the first three factors above and may involve the use of more than one family of pooling vehicles/structures.
The purpose of this article is to present an outline of how our US-based collective trust fund structure operates and how it has been applied to provide asset management solutions across a variety of European countries.
As a result of owning a trust bank in the US, we are in a position to operate two types of US-based collective Funds: group trusts (A-Funds) and common trust funds (B-Funds). These collective funds are established under a trust structure and hence any assets invested therein are not commingled with our own assets. We are the trustee of each of the collective funds trusts and hold legal title to the trusts’ assets for the exclusive benefit of the trusts’ beneficial owners who own an undivided interest in the trust’s assets.
In a common trust fund (B-Fund) structure, the client establishes a trust with us as the trustee. We, as trustee, then contribute assets to the common trust funds that reflect the client’s investment strategies. The B-Funds are considered look-through vehicles for US income tax purposes where the trust’s income and capital gains/losses are directly attributable to the participating client. These are the funds that are increasingly being used by companies in Europe to commingle their pension plan assets across a number of countries.
So how do our B-Funds stack up against our five criteria?
The position in Europe on the use and admissibility of pooled vehicles is less rigid than in the US, where pension plans are generally not pooled with other types of tax-exempt investors. However, while being less rigid, Europe is inevitably more complex given the number of different tax and regulatory jurisdictions. In the UK and Ireland, regulation permits pension schemes to invest in a wide range of pooled vehicles, subject only to solvency and diversification constraints. At the other end of the scale, Germany places significant restrictions on the ability of schemes to invest in pooled vehicles other than in certain domestic funds. Currently, in terms of European pension plans, the B-Funds are considered admissible and contain assets from pension plans in the UK, Ireland, Sweden, Finland, the Netherlands, Switzerland and Norway. World-wide, the B-Funds contain pension assets from a wide variety other locations.
2. Tax Transparency
In general, pooled vehicles available in Europe are not tax transparent. The net-of-tax investment return received by the investor will generally depend on the domicile and nature of the vehicle itself, which will not necessarily be the same as the tax treatment the investing pension schemes would have received via a segregated arrangement
While, as is the case with admissibility, no perfect solution exists to the problem of tax transparency, our B-Funds offer high levels of transparency. This is no mean achievement given the differences in international tax and legal systems and hence the complexity in constructing a fund that is tax transparent in its own domicile (the US in this case) and in countries in which it is expected to invest.
The complexity here relates primarily to the treatment of withholding tax which creates a significant problem for ‘tax transparent’ equity funds. This is due to the fact that the rates of withholding tax (WHT) on equity dividends are based on bilateral tax treaties which are determined by the tax domicile of the fund (for non-transparent funds) or the actual participant (for transparent funds) and the double taxation treaty existing between that domicile and the relevant tax authorities in the country where the equity held is registered.
For the B-Funds (domiciled in the US) the tax treatment varies by country of investment. In most countries, the B-Fund is treated as a transparent entity. As mentioned earlier, this means that the beneficial owner(s) of the income for withholding tax purposes are the underlying participants. In these transparent markets, tax is withheld according to provisions of domestic law, and a reclaim filing must be made in the name of the participants to receive any applicable treaty benefits. We developed a proprietary system that calculates and accounts for all tax reclaims based on the source of the dividends and the actual tax domicile of the participating pension plan.
However, in a few markets, the B-fund itself is treated as the beneficial owner of the income for withholding tax purposes. In these countries, the rate of tax is determined according to the double taxation agreement in place between the United States and the country of investment. In the majority of these countries, treaty benefits are received at source – there is no need to submit a reclaim filing.
WHT treatment on fixed income assets is simpler. In general, tax treaties provide that pension plans are entitled to receive bond income without deduction of WHT. A transparent fund, such as the B-Fund will generally preserve this treatment.
It is almost inevitable that pooled vehicles designed to be tax transparent will score poorly on legal and operational simplicity. By definition, a tax transparent vehicle which pays different returns to different clients, depending on their individual tax status, leads to complexity in the preparation of tax reclaims. While, in respect of the B-Funds, we undertake most of these activities on behalf of the participant, to do so involves relatively detailed documentation. This enables us to take responsibility for tax-treaty monitoring and tax reclaim.
Given the variety of clients investing in the B-Funds worldwide, it is imperative that a pooled fund structure of this type, offers investors sufficient flexibility, regarding asset class building blocks, to implement their specific investment strategy. To achieve this, the B-fund range of pooled funds includes over 90 equity funds (active & passive, regional and country-specific) and over 35 bond funds (regional, country specific, corporates etc).
In the case of passive management, size is good. Given the size of assets currently invested through the B-Funds, in excess of $40bns, investors can expect competitive tracking against a wide range of indices.
In summary, investors will continue to seek economies of scale by using a limited number of investment managers. The challenge for the asset manager is to ensure they provide the investor with an efficient means of accessing their services. While B-Funds, in our view achieve this objective, we need to ensure that, where more appropriate, alternative pooled structures are made available, for example, life funds in the UK.
In addition, with the rules in Europe constantly changing, we need to be ever vigilant that new possible pooled fund structures are continuously evaluated. For example, going forward and bearing in mind recent developments in UK regulations governing the operation of pooled vehicles, is there a role for OLAB (Overseas Life Assurance Business) funds in Europe?
Micheal O’Brien is director of product strategy for European institutional business at Barclays Global Investors