The tax paid by a super fund can be one of its biggest expenses so you would expect that it would be managed as efficiently as possible.
In small superannuation funds, such as SMSFs, that is relatively easy as the fund is usually directly invested and, in most cases, the investments are attributed to a member’s account. But is that the case for large super funds? Do they manage the tax on their investments and, if so, how do they do it? These were the questions that we set out to answer.
Our research was triggered by the personal experience of one of the authors when working as a tax manager in a large superannuation business. The Deputy Managing Director asked an actuary (as actuaries are better at numbers than tax people!) to review the returns on one of the funds of the company. It was found that the returns could have been increased by 2% per annum had the investment managers taken tax into account when they made their investment decisions.
That was a long time ago, so the question now was whether that was still the case: do investment managers of large super funds still ignore tax when investing, to the detriment of the fund members’ returns?
Our starting point was the thinking that the performance bonuses of the Investment Managers of large super funds are based on whether their returns beat certain investment indices, such as the All Ordinaries index. Those indices do not account for tax so, arguably, Investment Managers can ignore tax because they are not rewarded for recognising it.
There are other reasons why Investment Managers might ignore tax, such as the fund structures, tax complexity, costly administration and so on.
In preparation for our research we identified from the academic literature 21 ways that a super fund could efficiently manage its tax. These ranged from ‘good housekeeping‘ tax practices, such as holding investments for at least 12 months to receive the 33.3% Capital Gains Tax (CGT) discount and effectively managing imputation credits, to the other end of the spectrum, such as quite exotic and expensive tax management practices.
What we wanted to know was the attitude of the Chief Investment Officers to managing the fund for tax. But instead of asking them about the 21 tax management methods, we focussed on their attitude to eight of those: were they positive or negative towards taking tax into account by reference to each of those eight?
The second thing that we were interested in was whether they actually did manage the tax of the fund and, if they did, how exactly it was done.
Finally, after the Cooper Review, the regulation of superannuation funds changed from 1 July 2013 so that Investment Managers are now legally obliged to take tax into account when investing. We wanted to know if Chief Investment Officers had changed the way they did their job.
What we found
Again, our starting point was the generally accepted view that because investment managers do not get paid to be tax efficient, they ignore it. We spoke to about 30% of the large fund market, and we found that the Investment Managers are now pretty ‘tax savvy’. In fact, they invested the funds by considering the tax effect even though the members of their fund are not directly told about the tax savings. Of course, the members’ returns are after-tax, but even though the hard work of managing the tax efficiently was not clearly visible to the members, the managers still considered it a worthwhile exercise.
Managing tax in a big super fund is more complicated than in a SMSF. Take investment in Australian shares. SMSF trustees can invest in Australian shares directly and manage the tax effects. In a large super fund, the investment manager usually appoints a number of sub-managers, some who actively trade Australian shares and others who just invest and hold in accordance with an index. The two sub-managers might hold shares in the same company, with one manager holding theirs for more than 12 months but the other manager holding the shares for less. The latter wants to sell the shares but the other doesn’t. The best tax result for the fund, which is a reduction of 33.3% tax on the profit, is to sell the ones that have been held for over 12 months but those are being managed by the manager who does not want to sell. The fund’s Investment Manager has to adjust the performance of each of the sub-managers accordingly. This would not be a problem in a SMSF.
Next we wanted to know what methods these large funds used to manage their tax on investments.
There were no major surprises here. Most funds reported managing the 12 month CGT discount rule and investing for imputation credits. But that was about it. As mentioned, we identified at least 21 different ways to manage tax efficiently but broadly, only two of these are widely used in practice.
Finally, we wanted to know if things changed for Investment Managers after 1 July 2013 when the law told them to take tax into account when investing. Again, there were no surprises, as the majority expected not much change.
However, there was one unexpected result. When we asked if they were concerned about tax risk, such as reputational damage from being seen as tax avoiders, the responses astounded us. Yes, indeed that was a concern of the majority of the Chief Investment Officers. It was surprising to us as we are tax people and the 21 or so tax practices and, indeed, the eight we had specifically asked about, were not ‘offensive’ in tax terms. But they saw them as a risk. We put that down to the fact that the people who we were talking to were not tax people and, perhaps were overly cautious about the complexities of tax and penalties if you get it wrong.
What was the overall message?
It is much harder to manage the tax in a large superannuation fund than in a SMSF but the Chief Investment Officers of these large funds are tax-aware when investing. They use CGT and imputation credit management methods to reduce tax but they are concerned about crossing the line between tax efficient management and tax avoidance.
One issue that did come up was a comparison between the way that these large funds look after their tax and how SMSFs do it. We hope to do a similar exercise in the SMSF market.
Professor Margaret McKerchar and Mr Gordon D Mackenzie, Australian School of Business, Tax and Business Law, UNSW. Research funded by the Institute of Chartered Accountants of Australia. The full report is called, ‘Tax-Aware Investment Management by Public Offer Superannuation Funds in Australia: Attitudes, Practices and Expectations’.