Companies are looking at any structure that boosts returns on pension investments as they come under re-newed downward pressure. Martin Campbell of Northern Trust bank examines how to exploit tax benefits on pooled pension products pointing out that this technique can bring huge financial benefits.

Many pension funds opt to invest via pooled funds offered by investment managers for reasons of costs, ease of access and scale. However, an analysis of the impact of using a tax-transparent pooled vehicle on a £1 billion investment in a MSCI Euro index fund highlights the importance of tax efficient investing.

A UK corporate pension investor who invested this amount in 1997 via a tax-transparent Irish Common Contractual Fund (CCF) would have earned an additional £57.5 million over 10 years when compared to the same investment via an Irish Variable Capital Company (VCC), which is "look at" rather than "look through" for tax purposes. Of course, the CCF was not introduced until 2003 so it would not have been possible to replicate this in reality but these results are still intriguing. The £57.5 million figure is based on a fund manager performing the same as the index. If they outperform, the numbers are even better. Before expanding any further on the financial model which has been used to derive this figure, an explanation of why these additional earnings are possible is required.

An important consideration when pooling equity investments is the withholding taxes paid on dividends. Double taxation treaties between countries spell out the withholding tax rates applicable to certain investor types when investing in the securities of issuers from those countries. For example, the agreements between the United Kingdom and several countries including Belgium, the Netherlands and Ireland offer zero withholding tax rates for UK pension plans. Thus, UK pension plans that invest directly pay no withholding tax when receiving dividends from securities located within this network.

Finding a way to preserve withholding tax status

However, the same plans pay 15% to 25% tax on these dividends if they invest through most pooled vehicles or commingled funds. The lack of available investment vehicles which preserve the withholding tax status of the underlying investors and the shortage of sophisticated asset servicing solutions have traditionally been roadblocks to achieving tax-transparency for funds with multiple investors.

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Several fund jurisdictions now offer sophisticated vehicle options that are established though contracts between the investors and the vehicle sponsors, which have been confirmed as tax-transparent by many of the European taxing authorities. The Irish introduced the CCF in 2003 and tax authorities in many European nations, including Germany, the Netherlands, United Kingdom and Switzerland have provided positive tax rulings for CCFs. In addition, over the past five years, custodians and fund administrators have accepted mandates to service over £50 billion in tax-transparent vehicles. It is clear that tax-transparency is an important consideration for institutional investors and that asset servicing solutions for these vehicles are available.

The model used to derive the £57.5 million figure described in the first paragraph provides a useful tool to quantify just how important tax transparency is.

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Tax rates were verified by Northern Trust's Tax Technical Team and the Dividend Yield information was provided by Northern Trust's Risk and Performance Team.

Column two shows the weighting of the investment in the different countries included in the MSCI Euro Index and column three comprises the average yield of equity investments in each country as of 31 March, 2008.

In column four, the weighted yield for each country is calculated and summed to produce a gross dividend yield for the Euro equity index. An investor in a MSCI Euro index fund can expect an annual gross dividend yield of 3.64%.

In column five the withholding tax rates applied to a dividend paid to a variable capital company vehicle are displayed.

Column seven includes the withholding tax rates applied to a UK pension investor for dividend payments from the same countries. This analysis assumes that tax transparency is achieved in each jurisdiction so the rates available via double tax treaties to the investor are achieved when investing via the CCF in each case.

Next, column six calculates the year one withholding tax amount (assuming the £1 billion initial investment) from each country for the VCC and column eight performs the same calculation for the CCF.

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Walking through an example should cement the understanding of the numbers discussed thus far. If the UK pension plan invests £1 billion in the fund, £8.5 million (column two) will be invested in Austrian securities. Assuming an average dividend yield of 2.59% (column three) on the Austrian securities produces an annual dividend amount of £219,810 (column four* £1 Billion). At the Austrian withholding tax rate for the VCC of 25% (column five), the investor would have realised almost £55,000 withholding tax expense (column six) on the Austrian annual dividend amount. The same UK pension plan would have only paid the Austrian tax authority a 15% withholding rate (column seven) or an approximate total of £33,000 (column eight) if it invested via a tax-transparent CCF.

Compare the total amount withheld in the CCF example of approximately £3 million to the total amount withheld in the VCC scenario of approximately £6 million and the UK investor paid almost double the withholding tax in year one when investing via the VCC. This equates to a 28 basis point tax drag related to the investment in the VCC. Now, if you apply that tax drag for the ten year investment horizon between 1997 and 2007 there is a dramatic effect on the earnings of the fund. Due to the reduced withholding tax paid, as well as, the positive impact of compounding, the additional gain on the CCF investment is over £57.5 million.

Depending on the types of investments and investors, eliminating tax drag can have a major impact on the performance of an investment fund. In the example used for this article a 28 basis point uptick was created by investing through a tax efficient vehicle, without any consideration for the manager's stock picking skills or investment management fees. Tax-transparent and non-tax transparent Luxembourg or Dutch fund vehicles could easily have been substituted for the Irish vehicles chosen for this example. Modeling different baskets of equities such as the MSCI World index or the S&P 500 index also make similar convincing arguments to invest in vehicles that preserve the investor's withholding rates. The result is that the possibility of ensuring that U.K. pension funds aren't leaving money on the table is now very real.

Martin Campbell, cross-border pooling product manager with Northern Trust bank http://www.northerntrust.com/pws/jsp/display2.jsp?XML=pages/nthome/12016... [2]. Where Northern Trust's UK entities undertake regulated business, they are authorised and regulated in the United Kingdom by the Financial Services Authority.