Australia: Pre-tax versus post-tax returns - the Telstra dilemma

Investors are typically focused on after-tax returns. However, fund managers in Australia are usually measured against each other by asset consultants and research houses and reported in the media on a pre-tax basis.

According to Navigator research manager Stuart Fechner this can sometimes create a dilemma for managers since some investment decisions can be attractive on an after-tax basis but unattractive on a pre-tax basis.

"The Telstra buyback is an example of this dilemma for some fund managers. This is because of the large amount of franking credits involved in the buyback, which can make it unattractive on a pre-tax basis but attractive on an after-tax basis," said Stuart. He added "of course, tax issues are just one consideration in deciding whether or not to participate in the buyback"

"Investors would probably expect fund managers to participate in the buyback or not, depending on whether the fund manager invests for after-tax or pre-tax returns. However, some fund managers may choose to participate in the buyback, even if it hurts their pre-tax performance, because of the tax benefits. These managers seek to strike a delicate balance between tax effective returns for unit holders and a lower pre-tax return," Stuart said.

The following table shows some investors with low tax rates may benefit more from tendering into the buyback than selling shares on market. However, this is unlikely to be the case for investors taxed at the top marginal rate. Herein lies another dilemma for fund managers, which is that a decision to participate in the buyback may boost after-tax returns for some investors in their funds but not for other investors. This is because the investors themselves have different tax rates.

	Example 1	Example 2	Example 3
Tax rate	0%	15%	48.5%
Effective CGT tax rate	0%	10%	24.25%
Pre-tax value of capital and dividend*	$4.05	$4.05	$4.05
After-tax value of capital and dividend	$5.14	$4.60	$3.37
After-tax value of capital loss**	$0.00	$0.51	$1.24
Tota Total after-tax value	$5.14	$5.11	$4.61
*assumes a buyback price of $4.05, which includes a capital component ($1.50) and a fully franked dividend ($2.55) **assumes that shares were purchased as part of the T2 offer

"Investors within a fund nevertheless pay tax on distributions from a fund at different rates. Therefore, participation in the buyback may be in the best interests of some unit holders but not necessarily in the best interests of others. "

Stuart says that the decision by fund managers to participate or not is further complicated by uncertainty surrounding the final tax implications. This is because the final buyback price is unlikely to be the price the ATO uses to calculate the capital loss (or gain). The capital component will be adjusted by the Tax Office on the basis of moves in the S&P/ASX 200 during the tender period.

"Fund managers are often reluctant to commit to managing exclusively on a pre-tax or post-tax basis. Often they balance the underlying investment decision with minimising turnover and preferring stocks that offer some level of franking.

Vanguard has recently elected to publish fund returns on both a pre-tax and after-tax basis. However while making these calculations is useful for investors, it is not without some difficulty since investors have different tax circumstances.

"In order to understand fund managers’ approaches we asked: Do you manage for pre-tax or post-tax returns and will you participate in the Telstra Buyback?" said Stuart.

A summary of their responses is shown below.

Fund Manager	Do you manage for pre-tax or post-tax returns?	Will you participate in the Telstra Buyback?	Why/why not?
Colonial First State	Investment decision is paramount and tax considerations, unless material, are secondary	Believe it is not in the interests of their investors to make a comment on this	N/A
ING	Focus on after-tax return opportunities as they present themselves	Has historically been a significant participant in buybacks Will continue to seek tax effective opportunities for clients	Do not comment on specific future stock selection
Investors Mutual	Valuation is the paramount consideration but are cognisant of the after-tax implications Preference for stocks that offer some level of franking to form the core of their portfolios	Will depend on the price range offered for the buyback and IML’s valuation of the stock Where IML’s medium term valuation is above the high end of the buyback price range we are less likely to participate in a buyback	N/A
IOOF/Perennial	Manage for post-tax returns Process focuses on gross as opposed to net dividend yields and targets a low level of turnover	Will probably participate in the buyback for some of their institutional mandates, but in general do not for the pooled trust	Buyback would not suit all participants within their pool Where participating for an individual mandate, post-tax return to the client is deemed the key
Vanguard	Turnover of fund assets is less than replication of already low index turnover Fund captures the market level of dividends and franking	Cannot comment on any particular buyback, particularly one that is yet to occur	N/A

This shows fund managers have various approaches toward managing their funds and deciding whether or not to participate in the Telstra buyback. However, Mr Fechner cautioned "the buyback is complex and there may be other reasons why investors may choose to participate in the buyback or not."

Please refer to the Telstra Buy-Back Tender booklet for full details of the terms of the offer, which is available from the Telstra website.

Stuart Fechner is available for interview.

-ends-

For further information please contact:
Bernadette Collins
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Notes to editors:

• Aviva Australia is a group of two specialist financial services companies: Navigator and Norwich Union Life Australia Ltd. Portfolio Partners, the Australian funds management arm of Aviva plc, is a sister company. Through these companies we provide products and services in the areas of wealth creation, wealth management and wealth protection for more than 300,000 customers throughout Australia.
• Globally, Aviva Australia is part of Aviva plc, the world’s fifth largest insurance group, the largest insurer in the UK and one of the top five life companies in Europe. Aviva was formed in May 2000 through the global merger of CGU plc and Norwich Union plc.
• Aviva is a leading provider of life and pensions products to Europe and has substantial businesses elsewhere around the world. Its main activities are long-term savings, fund management and general insurance. It has premium income and investment sales from continuing operations of A$78 billion, and more than A$624 billion of assets under management (as at 1 July 2004). The group has more than 56,000 employees and 30 million customers worldwide.
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