Pros and Cons of paying fund distributions in cash
Break the nexus between cash distributions and taxable income
By
Justin Wood
Mon 30 Oct 2006
Investment returns are often quite different to the taxable income generated by an investment strategy. While the taxable income from a cash fund is relatively stable and is equal to the investment return, the taxable income from a hedged international equity strategy can be wildly different from the investment return.
Investment returns are often quite different to the taxable income generated by an investment strategy. While the taxable income from a cash fund is relatively stable and is equal to the investment return, the taxable income from a hedged international equity strategy can be wildly different from the investment return.
Outcomes depend on dividends, capital gains and losses on equity trading activities, currency moves and expense allocation rules. Tax rules are notoriously complex and the detail is well beyond my understanding. I have chosen to be brief rather than comprehensive and accurate. No-one should rely on any tax rule discussion contained herein.
The main observations on cash distribution practices require only an outline of some general tax concepts. Distributing funds must ensure unit holders are presently entitled to all the trust income each year. If they don't, the trustee can become subject to tax at the highest personal marginal income tax rate. Potentially, the unit holders can also become subject to tax on the same income if their units are sold before the fund income is subsequently distributed. To ensure unit holders become presently entitled to all trust income, trustees of distributing funds must advise unit holders of their share of the fund's taxable income each year. They do this via an annual tax statement. Distributing funds usually pay cash distributions equal to the trust income the unit holders must include in their income tax calculations each year. The rationale may have been driven by personal investors' need to pay tax when superannuation and pension fund unit holdings in managed funds were much lower than is the case today. Fund manager systems have been developed to implement and continue this practice. But is this necessary?
Unit holders who are in the highest personal income tax bracket will be required to pay tax of 45 per cent, plus the Medicare levy, on the taxable income received. Even if these investors have no other cash to pay this tax, the cash distribution will provide more than twice the amount required. Where the unit holder is a superannuation fund, tax of up to 15 per cent of the taxable income received will be required. The cash distribution will provide more than six times the amount required to meet this need. Unit holders that are pension funds are exempt from tax on the taxable income received. Hence none of the cash received is required to meet a tax payment.
Many investors in the top personal income tax bracket have other sources of income and cash, and most superannuation funds are receiving contributions. Typically, they are not short of cash, rather they face a different problem, how to invest the net cash inflows they are receiving. As a result, a very high percentage of unit holders reinvest 100 per cent of all cash distributions, either immediately or within a few weeks of receiving the cash. Pension fund unit holders do not need cash distributions to pay tax, but do require cash to make pension payments. The amount required for payments is generally a regular monthly amount rather than a predominantly annual and highly variable amount equal to trust income. Linking cash distributions to the fund's income can cause pension funds to invest in 'income' strategies, where assets are held because they produce a stable return with a high proportionof taxable income, that is, investment in cash and fixed income assets. But should the asset allocation be driven to this extent by the desire to get stable income and hence stable cash distributions?
In my view, it is better to break the nexus between cash distributions and the fund's taxable income and also to break the nexus between the demand for stable pension payments and the need to invest in an asset class with stable taxable income. Suppose all distributions are automatically reinvested, giving unit holders more units rather than cash distributions. This would avoid the transaction costs of all those unit holders that get cash and then subsequently reinvest all or most of the cash received. These reinvestment costs are around 0.2 per cent to 0.3 per cent for the typical balanced fund. Cash distributions allow unit holders to receive cash with no explicit redemption transaction costs.
However, transaction costs and realised taxable gains are incurred within the fund when assets are sold to make these cash payments. Hence the costs are borne by the fund in terms of fund performance. Essentially, unit holders who do not take cash distributions subsidise those that do take distributions in cash. If all cash distributions were automatically reinvested, fund performance would be higher and taxable income would be lower. Unit holders would benefit over the life of their investment in the fund and pay an explicit cost when they require cash. In a sense this is a more 'fair user-pays' model than the current practice. Changing industry convention is hard. It requires a lot of education of investors and debate as to the merits, flaws and costs of the alternative.
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