Brent Sheather: Alternative tax a capital idea

I don't know about you but the highlight of last weekend for me was reading in the Weekend Herald that there was a chance that the capital gains tax on overseas shares wasn't going to happen.

This was confirmed by the Government yesterday, with Finance Minister Michael Cullen and Revenue Minister Peter Dunne suggesting a comprimise instead, which they've dubbed the "fair dividend rate".

Hooray! The alternative in question is the deemed rate of return also suggested in this column on May 27 whereby tax is levied on the higher of actual dividends received or 5 per cent of the average market value of the overseas shares.

This alternative has three major advantages over the proposed capital gains tax. It is relatively easy to calculate. It is reasonably fair. Whether it is a capital gains tax or not is up to the individual investor: if you invest in high-cost growth-oriented share funds producing no income it will be a capital gains tax. If you invest in a low-cost international high yield fund paying 5 per cent in dividends the new rule will have no impact as you are already paying the tax on your dividends.

Cullen will like it because it deals to his mythical technology stock investor who has allegedly amassed huge capital gains and at the same time paid no tax.

More importantly it will appeal to the vast majority of rational investors who put their savings to work to generate a mix of both income and capital growth because it is far less intrusive than a capital gains tax.

So if the common sense deemed rate of return alternative is adopted what will it mean for mum and dad saving for retirement?

I have done the numbers for the roughly $100 million in international shares which my clients own and as this component of their portfolio already generates $3.3 million in taxable dividend income the 5 per cent deemed return will not mean any increase in tax and, more importantly, neither will it unduly influence their investment strategies. What the proposed tax will do, however, is focus investors' minds on the income that their portfolios produce which, of course, also means keeping an eye on how much of that income is disappearing in annual fund management and adviser trailing fees.

With world stock markets yielding barely 2.5 per cent before annual fees of 2 per cent or so the typical international equity-oriented unit trust produces little or no income for mum and dad. This hasn't been too much of a problem in the past as stock markets rose at rates well above trend and, because fees paid equalled dividends received, no income tax was payable.

Over the past 10 years world stock markets have returned an average of around 9 per cent a year - deducting 2 per cent for fees and with no tax to pay still left mum and dad with 7 per cent a year. In the new deemed rate of return tax environment, with world stock markets likely to return 7 per cent to 8 per cent a year in the future, Cullen getting 2 per cent (39 per cent of 5 per cent) and fund managers taking 2 per cent, mum and dad will be left with less than 4 per cent.

Before too long they are likely to be asking their financial planner why they should be taking the risk of equities for the return of a bank savings account.

Besides a renewed focus on costs, perhaps another unintended consequence of adopting a 5 per cent deemed rate of return for taxation will be that investors will increasingly look at the dividends produced by their international share portfolios.

Mum and Dad Battler, recently retired, will probably not want to put their hands in their pockets to pay the deemed rate of return tax on their international unit trust which itself produces no free cashflow. Yet in a bear market where capital gains are hard to come by and there is no cash income left after fees this scenario is inevitable sooner or later.

Historically, locally based international equity-oriented unit trusts have produced little or no operating cashflow for dividends, but there are markets (UK and Australia) where dividend yields of almost 4 per cent are quite achievable if combined with low fund-operating costs. Some of the NZ listed UK investment trusts provide this sort of alternative.

The tax changes may well encourage mum and dad to become true value investors looking for high dividends and low operating costs - exactly the sort of strategy which has produced good returns from sharemarkets in the past.

Furthermore, research in the US and internationally suggests that high-dividend-paying stocks actually produce higher capital growth in the future rather than less. If it happens, the deemed rate of return looks to be a reasonable result for everyone except perhaps high-cost capital growth funds.

It is probably also worth reflecting on how much the proposed capital gains tax has cost the country so far. Thousands of people have spent hours writing submissions, accountants and consultants have been employed at huge cost to provide expert opinion; the vast majority of which have stated the obvious - a tax which biases equity investment to the home market is a nonsense.

In the last six months how many mums and dads at the coalface making investing-for-retirement decisions have opted for inappropriately diversified portfolios to avoid the proposed capital gains tax? What costs will they incur in correcting their portfolios? Who is going to foot the bill for all this unnecessary and unproductive waste of resource?

Assuming the deemed rate of return option gets the okay, Cullen and Dunne must bear some responsibility for their ill-fated attempt at misallocating the nation's savings.

The capital gains tax on just one asset class is a fantasy that should never have got past Dr Cullen's advisers and certainly never have been made public.