Brent Sheather: New tax - dumb and dumber

As with so much of the rhetoric of politicians, what they would have us believe about the new investment tax laws looks likely to be quite different from the reality.

Michael Cullen and Peter Dunne may even genuinely believe they are doing the right thing by investors and the country as a whole. They are not.

For the retail investor, the upside, if you can call it that, of the proposals is that ridiculously expensive local managed funds investing in New Zealand and Australian shares are no longer subject to capital gains tax.

Big deal, you still wouldn't want to own most of them.

In fact, the real significance of the new tax laws is not whether people will pay more tax, it is that different assets will pay different rates of tax.

This difference is so substantial that it will distort investment decisions in that investors will tilt existing and new investment away from international shares and managed funds with lower fees than local instruments and away from a prudently diversified portfolio.

What's left of mum and dad's international share investments outside Australia by the April 1, 2007, implementation date will likely never be repatriated until the shareholder dies and it can be done without incurring capital gains tax.

Indeed, with the relative investment metrics of overseas sharemarkets already stretched, what rational investor will wish to continue exposure and risk one-third of returns going in capital gains tax?

Throw in huge compliance costs and reduced flexibility to move funds back home and international investing for New Zealanders is starting to look like a dead duck.

By comparison, the NZ Super Fund had 86 per cent of its share portfolio invested outside NZ and Australia as at December 31. Globally, professional fund managers invest about 80 per cent of their equity portfolios in US/UK/Europe/Asia. Cullen and Dunne are, through taxation, urging local investors to adopt a different, more risky strategy.

Some investment advisers are on record that they will continue to recommend a high overseas, ex-Australia, weighting. This is brave talk and probably just reflects their own inertia and infrastructure costs but my guess is that they haven't discussed it with their clients yet.

A moderately well-off couple who have saved all their life and put together a $500,000 portfolio at age 65 will, as per the average pension fund, have about $300,000 in shares and property, some $200,000 of which is typically invested in international markets outside Australia. This couple may well need to progressively draw down on their portfolio as they get older, which means incurring the capital gains tax on $200,000 of their present portfolio. Not likely.

At the coal face, the impact of the proposed legislation is already being felt; faced with an uncertain tax environment mum and dad are voting with their feet when they need cash for a new car, hospital bill and so on - they are favouring the sale of their international shares and paying less attention to relative value or the need for diversity. The fall-out from the proposed laws is already costing the country. When, and if, the tax becomes certain, the real selling will begin.

Cullen has clearly indicated that the new tax laws are designed to get the fat cats who don't pay their share. The reality is that wealthy investors with a $2 million portfolio can afford to forget their international shares.

As they probably will never need to draw on their entire savings in their twilight years, they alone can enjoy the luxury of a properly diversified portfolio. Even these very well-off investors may wish to preserve their flexibility to keep reinvestment options open (son/daughter need a loan to buy a house) and may thus incur unnecessary costs in shifting some of their assets from US/Europe/Asian markets to Australia.

This tax really is a stupid idea unless, of course, you are an intermediary, whose profits will benefit in the short term from the additional turnover. Long term, the tax is a major negative for the financial planning industry.

The huge cost of complying with the new tax laws will inevitably see many investors decide that international shares are not worth the trouble. As it has been proposed thus far, the proposal looks to have more holes in it than an Iraqi police station.

Apparently, Australian-listed stocks will avoid the capital gains tax; thus we will have the ridiculous situation of stocks like Brambles - listed in Australia, operations all over the world and relatively few New Zealand shareholders - which will probably be outside the new tax.

The latest version of the tax proposal lets GPG shareholders off the hook but, from an investment perspective, is even more bizarre and less reasoned than the first.

The Government through taxation is now telling investors don't invest outside New Zealand and Australia but, if you must, use a small, high-risk, leveraged, listed fund managed by a small group of near retirees who eschew diversification and, instead, run highly concentrated portfolios.

In other words, forget the investment theory.

Investors overseas cannot believe these proposals. They raise the obvious questions as to why these people are in charge of the country and what is next?

What hasn't been discussed are the substantial brokerage, spread and market impact costs that will be incurred by individuals seeking to avoid the proposed new tax.

The total cost of selling a share on the London Exchange is estimated at 1.8 per cent. Assuming the same cost to reinvest in Australia, then every $100 million of savings brought closer to home will incur transaction costs of around $3.6 million. Who is going to pay for this? Mum and dad.

The good news is that it's not law yet and still has to go through the select committee stage where further modifications may and should be made.

Cullen's big worry seems to be that some international sharemarkets have low dividend yields, thus permitting New Zealand investors to avoid paying their fair share of tax. This is fair enough but its remediation need not punish as punitively the relative attractiveness of this asset class.

A possible solution might be to stick with the proposed tax on overseas sharemarkets outside Australia using the higher of dividend income or 5 per cent and scrap the capital gains tax idea.

This would mean that, given the dividend yield on Australian and NZ equities averages about 5 per cent, the level playing field between asset classes is preserved and it deals to the mysterious high-net-worth, tax-avoiding, local Dell shareholders who apparently haunt Cullen's nights.

At the same time, it gives mum and dad an incentive to go for higher-yielding overseas sharemarkets which history suggests is not a bad thing in the long run. The only other obvious upside from the proposed legislation is that it makes dying marginally more attractive.

* Brent Sheather is a Whakatane-based investment adviser.