Major changes to the legal and tax framework for investment funds are occupying minds and threatening changes to business models. Will US regulators relax their stance on derivatives? Could new rules for the clearing of derivatives affect the economics of swap-based index replication in Europe? Are costs of compliance certain to rise? In order to put current regulatory developments into perspective, Journal of Indexes Europe spoke to experts from both sides of the Atlantic.
The European View
JoI Europe: What are the key tax issues facing European index investors over the coming year?
Tombs: From a tax perspective, I expect to see focus on developing tax-transparent fund vehicles like the Irish Common Contractual Fund (CCF). Many European pension fund investors suffer much higher rates of withholding tax “drag” on dividends when investing via an ETF set up as a corporate fund—for example, a 15% deduction on dividends from US equities, while the index being tracked may imply an even higher rate of withholding tax deduction, say 30%. If a CCF was used, the rate would be 0%, which would be the same as if the pension fund were investing directly in the underlying US stocks.
It’s become much harder to use alternative structures like equity swaps to get around such tax inefficiencies. And while securities lending can help to optimise post-tax dividend income rates, it’s more useful within Europe than when investing in the US equity market—the CCF is looking to be the best solution for US equities.
Clearly, getting round the withholding tax issue would reduce tracking error in index-tracking funds. But, more importantly, unless this is resolved it will be very hard to convince pension funds, which are used to receiving US dividends gross of tax, to use index-tracking vehicles such as exchange-traded funds.
Increasingly double tax treaties are being written to allow pension funds to receive equity dividends with a zero tax rate, so if pooled funds don’t allow them to access this rate then they contain a built-in disadvantage for the pension investor.
JoI Europe: And what’s important for Europe’s indexing industry from a regulatory perspective?
Tombs: One regulatory initiative which may have a big impact is Solvency II, the current review of the capital adequacy regime for Europe’s insurance companies.
Under the new regime life insurance companies face stricter capital requirements. Having to pay the cost of putting up extra capital may mean that it will become much more expensive for insurance companies to invest in life insurance wrapped products offered by fund managers.
In response, insurers may choose to outsource their index-tracking portfolios to pooled funds instead. In fact, this could be a large business opportunity for the index fund industry, including ETFs. However, the rules in this area are still being hammered out, so we’ll have to wait and see exactly how they are applied.
JoI Europe: There’s been some uncertainty about the tax status of exchange-traded commodities in some countries, notably the UK. How is this being resolved?
Tombs: The UK’s tax authorities have now confirmed that certain exchange-traded certificates (ETCs) giving delta one exposure to commodities can qualify for so-called reporting fund status and hence for capital gains tax treatment, rather than assessment at income tax rates, which are typically higher. Both physically invested and synthetic commodity ETCs can benefit from this.
There are some criteria to stop the principles being used for avoidance, so each case needs looking at individually, but we aren’t seeing these criteria being an issue in practice. This very positive development should facilitate the distribution of ETCs into the UK taxpaying investor market.