The Ashmolean Museum in Oxford owns an antique violin called the Messiah. It was made by Stradivarius in 1716 and remained in his family workshop until 1775 when it was sold by his son, Paolo, to an Italian dealer. From there, it passed to a collector, Luigi Tarsio, who used to boast of his Stradivarius to his friends in Paris but never showed it to them. Once when Tarisio was speaking about it the violinist Delphine Alard said: “Your violin is like the Messiah: we wait for it constantly but it never appears.”
Pooling can feel a bit like that – endlessly awaited, but it has yet to make a substantial appearance in the mainstream. But things have changed. This time, it is not merely journalists and accountants who are heralding the arrival of pooling, but also the European Commission (EC).
In May 2004, the EC published the findings of an ‘expert group’ investigation into the single market for asset management. Among other things, the expert group recommended that: “It would be beneficial to recognise asset pooling techniques and structures. As a mid-term perspective new legislative measures should therefore be adopted for pooling techniques and structures. This should be flanked by EU-wide cooperation of national regulators to address legitimate concerns about span of control and operational risks. The industry will support this follow-up process to the UCITS Directive by providing necessary information.”
This recommendation was repeated by the EC in its recent ‘green paper’ on asset management, which proposed to establish a specialist forum group in winter 2005 to advise on the technical measures that would need to be adopted in order to achieve pooling.
So, is pooling about to join the mainstream, or, like the Messiah, will it keep us waiting some more?
In July 2005, the Investment Management Association (IMA) - the trade association that represents the UK-based investment management industry - published a report on pooling. The primary objective of the report was to provide the EC with an analysis of the tax and regulatory issues that would need to be resolved in order to make pooling a reality. The report looked at pension fund pooling and also investment fund pooling through master-feeder structures.
While there are a number of tax and regulatory barriers to pooling, the most significant barrier to pension fund pooling is withholding tax.
Payments of interest and dividends are typically made net of withholding tax. The rate of withholding tax depends on the double tax agreement (DTA) between the country of residence of the company making the payment and the country of residence of the investor receiving the payment. Typically, the rate of withholding tax prescribed by a DTA depends upon the nature of the payment (eg, dividends, interest, royalties, rent and so on) and the nature of the investor (typically requiring that the investor be a resident person who is beneficially entitled to the payment).
For example, under the US-Dutch DTA, Dutch pension funds are entitled to receive gross dividend from US companies, whereas under the US-German DTA, German pension funds are entitled to receive US dividends net of 15% withholding tax.
Pooling should be withholding tax neutral – that is, it should neither increase nor decrease the rate of withholding tax on payments from the underlying portfolio. In order to achieve tax neutrality, the pooling structure needs to be ‘fiscally transparent’, that is, the pooled pension funds should be considered, for withholding tax purposes, to retain beneficial ownership of the underlying securities.
Every country uses different criteria to determine whether or not an entity is transparent. Consequently, the challenge is to identify a pooling structure that is considered transparent by all member states of the EU and by all target countries of investment (which could potentially include the whole world, but at a minimum should include members of the OECD). This has proven to be a tall order, despite the best efforts of governments and the asset management industry.
How can this question of fiscal transparency be resolved?
IMA’s pooling report identifies a number of options. One is to develop a common approach to transparency through the auspices of the OECD. The OECD has a specific mandate to facilitate co-operation in the area of international taxation (in particular, through the evolving Commentary to its Model Tax Convention).
By happy coincidence, OECD Working Party No 1 on Tax Conventions and Related Questions is currently examining the application of the OECD Model Tax Convention to trusts, investment funds and certain other entities. It might be possible, in the context of that work, to develop a common approach to fiscal transparency for pooling purposes.
In principle, one would expect members of the OECD to be willing to develop a common approach to fiscal transparency. After all, fiscal transparency is unobjectionable to the extent that it accelerates the recognition of income and gains for taxation purposes .
However, certain other aspects of fiscal transparency are more problematic – namely, its use to create ‘hybrid’ structures that are transparent under the laws of one country, but opaque under the laws of another. Hybrid structures arbitrage on transparency/opacity to obtain a tax advantage.
The IMA report therefore proposes a solution which obtains the legitimate benefits of pooling, but avoids possible tax planning using hybrid and other structures.
One other change would be required to make fiscally transparent entity pooling a reality – namely, the operator of the pooling arrangement should be able to make consolidated claims under DTAs acting as agent on behalf of the participating funds. For example, if Dutch and German pension funds participate in a fiscally transparent pool to invest in US equities, then the operator of the pooling arrangement should be able to reclaim any US withholding tax in excess of their 0% and 15% entitlement, respectively, acting as their agent. Failing this, the Dutch and German pension funds would have to make the reclaim themselves, which would greatly add to the costs of the pooling arrangement.
A number of DTAs already include provisions to this effect. As long as the operator of the pool can provide substantive proof of their identity of the participating pension funds and their ownership of the underlying securities, no major objections need arise.
So, can we now sit back in sure and certain hope that pooling is just around the corner? No. Just as the faithful actively pray for the coming of the Messiah, so pension fund promoters and asset managers need to actively engage in the ongoing regulatory and fiscal debate if pooling is to become a reality. In particular, it is essential that readers respond to the EC’s consultative green paper on asset management ( open to respondents until 15 November), emphasising the importance of pension asset pooling to ensure regulators and tax authorities understand the urgency of removing the barriers that remain. Only then will their prayers be answered.
‘Financial services action plan: progress and prospects’, Asset Management Expert Group, May 2004 http://europa.eu.int/comm/internal_market/finances/docs/actionplan/stocktaking/report-assetmgnt_en.pdf
“On the enhancement of the EU framework for investment funds”, European Commission, July 2005 http://europa.eu.int/comm/internal_market/securities/docs/ucits/greenpaper_en.pdf
‘Pooling: how can fund managers respond efficiently to different investor needs?’, Investment Management Association, July 2005 http://www.investmentuk.org/press/2005/20050725-01.pdf
Travis Barker is European policy analyst, Investment Management Association, based in London