A firm that optimises for after-tax returns talks to this news service about the details that investors and advisors must consider when allocating to a particular asset. Without understanding the nitty-gritty detail, much effort is wasted.

With talk of tax hikes coming in countries such as the UK, the outcome of investment strategies cannot be judged objectively without understanding the tax bite. This means that even some hot-looking ideas don’t appear to be so great on an after-tax basis, Partners Capital argues.

Investments such as private lending can offer returns of, say, 12 per cent. However, because this asset class is classed as generating income, it brings a 40 per cent tax hit in the UK, while other areas are treated as more of a capital gain, which is typically less than income tax. Without understanding this sort of fine detail, a lot of asset allocation moves don’t make sense, Euan Finlay, head of EMEA, Partners Capital, told WealthBriefing in a recent call. The firm oversees a total of about $55 billion in assets. 

“We are optimising for net of tax returns,” Finlay said. The firm looks at the gross return and then factors in a tax regime. “You need to think of these together,” he said. 

There are investment strategies that initially appeal but once the tax implications are factored in, the glow fades. 

Getting details right – such as understanding whether a fund’s share classes enjoy “reporting status” – and hence separate capital gains and income, allowing them to be taxed separately – is crucial, Finlay said. And that is the sort of expertise that investors such as family offices, foundations, financial sector professionals and others get in working with Partners Capital, he continued.

Recent events add urgency to the conversation. In the UK, the new Labour government is pushing ahead with scrapping the country’s centuries-old resident non-domicile system, and there’s speculation that it will raise capital gains tax rates in line with income tax. Inheritance tax exemptions, such as business property relief, might be squeezed, and the same goes for tax-free allowances on pension contributions. Across much of the West, governments are strapped for cash, and they’re tempted to go after savers’ capital, rather than take the more politically difficult course of cutting spending.

Income and capital
Partners Capital’s approach to tax-efficient investing considers several steps. First, it asks if an investment is to be taxed as income or capital (with capital typically carrying a lower rate, usually to reflect the level of risk); second, the most efficient ways to play in each specific asset class; third, what sort of manager structures are used, including if share classes of a fund attract “reporting” status or not, and fourthly, whether the investment portfolio is structured to allow for deferral of capital gains until ultimate realisation of the portfolio, rather than all portfolio rebalancing activities being subject to tax. 

“We typically allocate to assets that are taxed as capital,” said Finlay. 

The difference is large: If a person is a higher or additional rate taxpayer, they pay 24 per cent on their gains from residential property; 28 per cent on gains from “carried interest” if they manage an investment fund; and 20 per cent of their gains from other chargeable assets. The top rate of UK income tax is 45 per cent. Another point is that income is taxed in the year in which income arises; capital gains tax applies when an asset is sold.

“We say to clients that they should maximise their risk budget given that riskier assets are typically taxed as capital,” Finlay continued.

Holding assets efficiently is important, he continued, giving the case of UK government debt (gilts). If an investor holds short-duration bonds, paying low coupons and at a discount to the bond’s par value, they generate little in the way of income and government bonds are not subject to capital gains tax. This sort of opportunity is “episodic,” he said. (The opportunity is current given recent rises to UK interest rates.)

The use of derivatives (options, futures, warrants and contracts for difference) can also bring exemptions from tax and is worth considering, Finlay said. 

The structure of an investment is a factor that can be a deal breaker. For example, a non-UK fund can apply to the UK tax authority for “reporting fund” status which reports the proportion of gains from capital and income, allowing those gains to be taxed accordingly. When an investment is sold, a UK individual pays a capital gains tax rate on all growth in value up to 20 per cent rather than the default income tax rates of up to 45 per cent. Not all funds provide this status, and Partners Capital has worked with managers to create share classes in funds to make this status available, he said. 

“We consider high quality managers who are not focused on tax-advantaged structures in a UK setting. In these cases, we use our scale to encourage managers to launch fund share classes in an appropriate structure,” he said. 

“There is a host of hedge fund strategies in the US that we think are compelling but in the “wrong” structures. We enter lots of conversations with managers to persuade them to issue new share classes,” he said. More than 50 per cent of Partners Capital’s investments are in structures that have been created by managers because the firm negotiated them.

As a rule of thumb, if an investor isn’t clear whether a fund’s payouts are treated as income or capital, then they should assume that it is treated as income, Finlay said.

Concerning the format of holding assets, Finlay gave the example of a fund with a 50/50 mix of stocks and bonds. To rebalance the fund to keep up with market moves, this would lead to crystallised capital gains every time an asset is sold, with CGT hitting returns. Instead, portfolios should be restructured within entities so that rebalancing no longer causes a taxable event. 

This publication asked Finlay whether he liked the look of perpetual, aka “evergreen” private market funds. Because they typically pay a set amount a year, this will be taxed as income rather than a capital gain, he said. Evergreen structures generally enable the deferral of tax until units in the vehicle are sold (and taxed as capital gains), enabling returns to compound for longer than in the draw-down structure (where the capital gain is crystallised at the end of the fund’s life.)

However, this approach may be acceptable for someone holding an evergreen fund over a long period to obtain a compounded return over time, Finlay added.