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How Tax-Deferred Income Can Help You Deliver a Better Investment Bottom Line

  • September 29, 2014

How Tax-Deferred Income Can Help You Deliver a Better Investment Bottom Line

In the search for investment yield, one of things that can easily be forgotten is the importance of the potential tax advantages that can accompany various investments. This can include tax deferred distributions from unlisted property funds and franked dividends.

This article focuses on comparing the income returns of unlisted property funds with other income producing asset classes. However, readers should make note that an individual investor’s tax rate will have a significant impact on the relative benefit of tax advantaged income*.

The impact of tax deferred distributions on net income

The potential tax benefits of unlisted property can be shown by comparing the equivalent net return that the investor would require from Bonds as well as Cash, which have no tax advantage on income.

The table depicts the lower pre-tax income required to obtain the same net income on an after tax basis depending on the tax rate and also the level of tax deferred component. It should be noted that this analysis ignores the impact of CGT.

Highlighting the impact of the difference between an individual’s tax rate and the amount of tax paid by a superannuation fund, it is clear that the benefit of tax deferred income is greater when the tax rate is higher. The equivalent returns required for a superannuation fund to generate the same post-tax returns are much closer than for an individual on a higher marginal tax rate.

In conclusion, some of the key potential benefits of tax deferred income are:

  • Tax deferred income has the potential of delaying payment of a component of an investor’s tax liability until a capital gain or loss is realised
  • Investors do not have to search for the highest yielding investment on a pre-tax basis in order to generate greater after-tax value

Income returns – unlisted property funds versus listed property (A-REITs)

This section compares the income distributions over the eight-year period ending December 2013 for unlisted retail property funds (the PCA/IPD Pooled Property Fund Index – Unlisted Retail), Australian shares (the S&P/ASX 200 Index) and listed A-REITs (the S&P/ASX 200 A-REIT Index).

The volatility that was brought on by the global financial crisis (GFC), especially in the listed property sector, is evident in the chart above which highlights the substantial price declines in the sector. As a result of the price declines, the percentage of income distributed to shareholders relative to the market value of sector spiked. Similar effect was also visible across the broader Australian share market, although the spike was less pronounced.

Another point worth noting is that the income derived from the unlisted property funds during this period was less volatile and barring the period at the height of the GFC, generally outperformed the broader Australian share market on an income distribution basis.

However, investors should note that income return or yield should not be the only criteria used for selecting investments. Other critical elements that investors should consider include the relative differences and risks of unlisted and listed investments which include the level of gearing, liquidity and quality of assets. Importantly, investors also need to take into account their own investment circumstances prior to making a decision on a particular investment.

Glossary:

  1. Tax-deferred distributions arise as a result of differences between the earnings of an unlisted property fund and its taxable income. These differences result in tax depreciation deductions being available to the fund, which it can then pass as a tax deferred component of its distribution, to investors in the fund. Income tax may not be payable on tax-deferred amounts. However, these amounts may operate to reduce an investor’s cost base in their investment. As a result, the tax liability is deferred until a capital gain (if any) is realised.
  2. Franked dividends – Dividends paid by companies to investors are ‘franked’, meaning a tax imputation accompanies them for the proportion of tax the entity has paid over a particular period. The full distribution amount must be included in calculating an investor’s amount of taxable income, which is taxed at their marginal tax rate applied. To avoid ‘double taxation’, whereby an investor pays tax on a distribution that the company already paid tax on the investor makes use of the tax imputation credit. The result is that an investor is able to reduce the tax they pay on the dividend by an amount equal to the tax already paid by the company.

*For the sake of simplicity, this analysis assumes the top marginal tax rate of 46.5% (including Medicare Levy) and 15% for superannuation funds. Please note, the information in this newsletter is general information only and is not based on the financial objectives, situations or needs of any particular investor. To determine whether a particular investment is appropriate, investors should consult a financial or taxation adviser and consider whether a particular product or strategy is appropriate for their individual circumstances.

Data for this article sourced from Australian Unity

This article was written by SQM Research