June 5, 2013

CROSS BORDER INVESTING: WHY FUND STRUCTURES MATTER: Examining Excess Returns Derived From Tax Efficient Investment Structures

by andrew.clark


The investment universe in which pensions operate today is vast and complex. An increasing number of asset classes, investment strategies, and managers provide pension schemes a variety of diversification options. This diversification of portfolios can pose problems in terms of implementation and governance; the more diversification, the smaller the average mandate becomes. Properly implementing a relatively small allocation to a certain asset class or strategy through segregated mandates may not be feasible. And even when it is feasible, the average cost of a segregated mandate tends to increase as the mandate becomes smaller.

REUTERS/Yves Herman

REUTERS/Yves Herman

Rather than giving up on the goal of diversification, tax-transparent asset pooling and the rise of contractual fund vehicles represent potential solutions. Contractual fund products allow tax treaty eligible investors to jointly invest their assets across different asset classes, strategies, and managers with other investors, thereby enabling pension schemes to diversify their portfolios in a cost-efficient manner while preserving material tax benefits. This “win-win” scenario has led many schemes to actively consider and invest in transparent funds.

This paper focuses on the withholding tax benefits often available when investing via fiscally transparent contractual funds and provides indicative returns for three scenarios.


One main objective of contractual funds is to ensure that, even though the underlying assets are no longer directly legally owned by the pension scheme but are owned by the pooling entity, the return on investment is the same as that of owning the underlying assets directly. Since pension funds typically benefit from tax exemptions, investing through a transparent fund should assist in mitigating the tax burden.

In general, there are three types of taxes that can apply to pension schemes: direct taxes, indirect taxes such as VAT, and transfer taxes such as stamp duty. Direct taxes should not arise at the investor level because of the domestic tax exemptions that can be made available to pension funds. Withholding tax may be deducted from distributions of income on investments, although the use of transparent pools[1] can allow pension investors to retain the tax treaty benefits and thereby secure the same rates of withholding tax as when they invest in the underlying assets directly.

Vehicles Available to UK Pension Schemes

To highlight three vehicles, U.K. pension schemes can use the Dutch fondsen voor gemene rekening (FGR), the Luxembourg fonds commun de placement (FCP), and the Irish common contractual fund (CCF) as examples of contractual funds. One benefit of these vehicles is that they facilitate cross-border pooling, i.e., pooling by investors from different jurisdictions. Pension pooling pioneers used these vehicles to pool overseas pension schemes of the same corporate sponsor. But these vehicles can also be used to pool the assets of unrelated pension schemes from one or more countries. In fact, several asset managers are now offering contractual funds to aggregate investors across a variety of countries. Since financial markets are likely to continue down the path of internationalization, the Dutch FGR, Luxembourg FCP, and Irish CCF are likely to become increasingly common vehicles for use by institutional investors with significant tax treaties available to them.

Examples of Potential Returns

To estimate the difference in returns for those investing in a tax-transparent structure, we prepared examples and selected the Luxembourg FCP to compare to a widely used Luxembourg nontransparent structure such as the Société d’Investissement à Capital Variable (SICAV, an open-end investment vehicle), and we used three existing equity indices—the Thomson Reuters U.S. 50, the Thomson Reuters Global Developed index, and the Thomson Reuters Europe ex-Turkey index—as well as a new set of Thomson Reuters indices detailed below:

• SICAV and FCP net return indices based on each of the three Thomson Reuters indices listed above are used.

• The indices are constructed by taking the existing gross total return index and removing a portion of the dividends to account for tax. The tax table used is provided by an outside independent pension consultant and represents investment market rates applied to a SICAV, an FCP, and a U.K. pension beneficial owner, respectively.

• The formula used to determine the net dividend amount is: Gross Dividend x (100% – tax rate%) = Net Dividend, with “tax rate” being determined according to the country of origin of the index constituent that paid the dividend and also according to the tax convention or domestic exemption applied for each index (either FCP or SICAV).

Finally, a ratio is calculated by (1) taking the difference between the FCP and SICAV returns and the base index’s gross total return for calendar year 2012 and (2) dividing each of the individual differences by the base index’s gross total return. These ratios represent the combined tax exposure for each net tax variant.

Using a UK£100-million investment as the basis for the comparison, Lipper’s results show a U.K. pension fund investing in the FCP based upon the Thomson Reuters Global Developed Index has a combined tax exposure of 0.13%, while the SICAV’s is 0.65%. For a Thomson Reuters Europe ex-Turkey FCP, a U.K. pension fund would have a combined tax exposure of 0.39%, while the SICAV’s exposure is 0.73%. Finally, for the Thomson Reuters U.S. 50 FCP the tax exposure is 0%, with the SICAV’s being 0.74%.[2]

These returns are demonstrated in the accompanying charts that show the Excess Return of the FCP and Tax Transparent total return relative to the Price Only version of the respective benchmark.


TR Global




The structure of investments (including third-party manager vehicles) can have a significant impact on tax efficiency, with the tax leakage not often easily determined. Trustees should ensure they fully review any structure before committing funds. At the same time trustees need to ensure they put in place adequate processes to deal with constantly evolving compliance obligations—both in the U.K. and further afield.

The key risk areas encountered by schemes and the best practices for mitigating these risks include:

• Governance and tax-risk management—A consistent and complete set of policies and procedures that is regularly maintained

• Current investment—Regular reviews undertaken by appropriately supported internal/external teams

• Future investment—Specific reviews of investments and their surrounding management

• Compliance—Active workflow management of filing and payment obligations, along with central oversight and control

• VAT and PAYE—Making sure mitigation of costs and adequate controls are in place to minimize risk of error

Finally, as demonstrated above, the FCP can be significantly more tax efficient than the SICAV. Assuming a 2.4% dividend rate on U.S. stocks (such as those in the Thomson Reuters U.S. 50), the tax benefit amounts to 74 basis points or UK£740,000 per year on a UK£100-million investment.


[1] A tax-transparent pooled fund is one where the pension scheme that participates in the pooling vehicle remains the beneficial owner of the underlying investments and as a result is often subject to the same taxation as when the securities are owned directly.

[2] Assumes an initial investment of UK £100,000,000 on January 1, 2012 into each index; and that the investor is a UK Pension Plan that has satisfied the tax documentation requirements. Current Dividend Yields as of 31/12/2012: Thomson Reuters Global Developed 2.986%; Thomson Reuters Europe Ex-Turkey 3.597%; Thomson Reuters US top 50: 2.423%

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