14 - Collective Investment Vehicles

1. 14 - Collective Investment Vehicles Taxation of Financial Markets

2. Collective Investment Vehicles • Common characteristics • publicly marketed • widely held • mainly investing in financial assets • Examples • mutual funds • managed funds • unit trusts • pension funds/insurance companies • known under different names in different countries

3. Recent Developments in CIIs • Increased in CIIs due to • benefits of diversification (lower risks, higher return) • increasing pressures on public pension schemes • deregulation in financial markets • development in technology • financial innovation • tax reasons (particularly for CIIs located in tax haven) • Institutional investors invest on behalf of households • in UK: hold over 50% of household financial assets in 1995 • in US, France and Germany: about 40% in 1995

4. Notable Trends in CIIs Holdings • Increase in cross-border investments • gross cross border investment flows increased substantially • Increased interests in ‘offshore’ CIIs • 1986 - 450 offshore CIIs • 1988 - about 900 funds • 1996 - more than 5800 funds • Increased in average size of new funds • 1 fund established in 1996 was seeded with $32 billion capital (source: Micropal Ltd)

5. Tax Issues • Domestic tax issues • taxation of the investment • taxation of the investor using a CII • taxation of the CII • how to reduce tax burden of investor to a level similar to direct portfolio investments • International tax issues • Triangular case: How to avoid double taxation when CIIs, investors and income source are in different countries • Tax evasion through offshore CIIs

6. Domestic Taxation Issues • Investment in CIIs is a less sophisticated way of having portfolio investments in a company • What is the tax treatment of domestic sourced dividend income in your country? • level of company tax • personal income tax considerations • distinguish between capital and income? • Subject to withholding taxes at source? • company taxes paid creditable at personal income tax level? • Withholding taxes paid at source creditable to other personal income or final?

7. Example $100 dividend paid by corporation to Person A in Aus UK US Tax system FI PI CL Imputation rate 42.85% 10% 0 Gross up dividend 142.85 110 100 Tax rate 48.5% 40% 46.6% Tax liability 69.28 44 46.6 Credits 42.85 10 n.a. Tax Due 26.43 34 46.6 (Source OECD, 1999 - updated)

8. Foreign Source Dividend • What is the tax treatment of foreign source dividend income? • Important considerations for both inward and outward investments • Withholding tax considerations • What is the level if paid to or from countries with/without treaties? • Is double taxation relief available and on what conditions? • Underlying foreign company taxes paid • Relief usually not available for portfolio investments

9. Example Person A resident in the UK receive $100 dividend paid by corporation in Aus UK US Withholding tax 0 n.a. 15 Gross up dividend 100 110 100 Cash receipt 100 100 85 Tax rate 40% 40% 40% Tax liability 40 44 40 Credits 0 10 15 Tax Due 40 34 25 Net return 60 66 60 (Source OECD, 1999 - updated)

10. Tax Policy and Administrative Responses to CIIs • Useful to have direct investments as a benchmark • CIIs achieve the same thing indirectly • Often it is more complicated because it involves savings • Policy decisions necessary to deal with • concessions for certain CIIs involved in retirement savings? • How to protect investors (a governance issue dealt with separately by OECD’s Governance section)? • Administratively • Try to achieve a tax outcome that is similar to direct investments • But, a difficult task because of rules in other countries

11. Domestic CIIs • Types of CIIs • Unit Trusts, Investment Companies, Mutual Fund • Legally can be company or trusts • 5 general approaches to taxation of CIIs • disregard CIIs for tax purposes, tax investors • recognised CIIs but exempt from tax if fulfils certain criteria • subject to tax at normal rates, but allow distributions as deductions so tax is close to nil • subject to tax at low rates • subject to tax at normal rates as companies with full integration (eg. imputation at investor level)

12. Other Taxation Considerations • At what level should investments in CIIs be taxed? • At the underlying investment level, CII level or investor level? • Influenced by the general approaches described earlier (e.g. whether CII is treated as taxable unit or transparent) • Characterisation and timing issues • are the increases in the underlying investment (e.g. increase in units) capital/dividend/other income? • When and at which level to tax these increases? • Withholding taxes • Would withholding taxes apply • to payments from the underlying investment to CIIs? • to payments made from CIIs to investors?

13. Key Messages • A range of inter-related issues involving • underlying investments by CIIs • CIIs themselves • investors • No international norm • often a number of systems exist within one country for different types of CIIs • for examples of the possible range see OECD, 1999 • Most important criteria • needs to be internally consistent to ensure taxes collected where intended and to avoid double taxation

14. Cross-Border Intermediated Investments • Three cases considered as illustrations • a domestic CII with domestic investor, earning foreign source income • domestic investor, earning foreign source income through a foreign CII (a two country case) • domestic investor, earning income source from country A through a CII in country B (a three country case) • Benchmark is foreign direct investment: consider • income tax implications • withholding tax implications • tax relief implications

15. Domestic CII, Domestic Investor, Foreign Source Income Example: investment Foreign Co Domestic CII dividend investment returns Investor

16. Tax Issues • Income tax • should any tax be levied at the CII level: depends on whether CII transparent or not? • will income returned to investor have the same characteristics for tax purposes (e.g. dividend income)? • Withholding tax considerations • at what withholding rate should payments made to CII be subject to at source country? • CII may not qualify for reduced rate under treaty if not a treaty subject • Tax credit and imputation relief availability is unclear? • foreign tax credit on taxes paid by CII available to investor? • Underlying company taxes paid by foreign company?

17. Two Country Case Example: investment Company CII dividend investment returns Investor

18. Three-Country Case Example: investment Foreign Co CII dividend returns investment Investor

19. Income Tax Considerations • CII may pay tax in country of resident that does not give rise to foreign tax credits for foreign investor • Low tax on CII and deferral of tax until repatriation • CII resident in offshore tax haven or when taxes on CII are waived in some jurisdictions (e.g. US waive tax or regulated investment company if 90% of earnings are distributed) • earnings accumulated in CII without tax if country of investor does not have FIF rules • Conversion of the characterisation of income • dividend income of CII may become capital gains of investor, or vice versa

20. Withholding Tax Considerations • Two country case • implications are complicated under tax treaties • main issue: access reduced withholding rates by converting portfolio dividend income into capital gains (also preferential income tax consequences) • can have disadvantageous characterisation consequences • Three country case • different withholding rates could apply cf direct investment • more restrictive conditions for foreign tax credit relief wrt withholding tax imposed by source country • CII country may also impose withholding tax on dividend distributed by CII (that also may not give rise to FTC)

21. Offshore Tax Havens • CII could be resident in an offshore tax haven or a jurisdiction that provides favourable tax treatment to CII • CII invests to get income with little or no withholding taxes (often there are ways to avoid these withholding taxes) • no tax at CII level • convert income into capital gains or defer tax on distributions • OECD work with Tax Haven • Harmful tax competition • Defence mechanisms: effective exchange of information, FIF rules, etc.

22. Tax Revenue Sharing - Two Country Case • Taxes for source country • underlying corporate tax • withholding tax at source for distribution? (e.g. zero if fully franked: Australia) • availability of imputation relief to CII/investor? • CII and investor resident country • tax at CII level? Withholding for distribution to investor? • foreign tax credits available for taxes paid at source • corporate taxes paid • withholding taxes paid • credits allowed to investors for taxes paid at CII?

23. Tax Revenue Sharing - Three Country Case • Taxes for source country • underlying corporate tax • withholding tax at source for distribution? (e.g. zero if fully franked: Australia) • availability of imputation relief to CII/investor? • CII country • tax at CII level? Withholding for distribution to investor? • foreign tax credits available for taxes paid at source • corporate taxes paid • withholding taxes paid • Investor country • credits passed on to investors for taxes paid at source/CII?

24. Summary • CIIs are integral to the development of financial markets • allow intermediated investments and have certain economic benefits • Taxation of CIIs can be complex • possibilities of avoiding taxes using CIIs (e.g. offshore CIIs, conversion of dividend into capital); • can overtax CIIs and hinder their development (e.g. not provide tax relief where it usually would occur in direct investment case) • tax revenue sharing issues!!