Chapter 7 – Managed funds


7.1 This chapter discusses policy options for changing the GST treatment of manager and investment manager services supplied to managed funds.

There are differing GST treatments for management services supplied to managed funds

7.2 The current GST treatment of different types of management services supplied to managed funds is complex and inconsistent.

7.3 Consider for example, a KiwiSaver scheme that invests into many underlying funds that specialise in different investments such as United States shares or New Zealand fixed interest. Each of these funds has a manager and investment managers. The KiwiSaver scheme will buy services from a KiwiSaver manager, and for each underlying fund they invest into they will be charged for services provided by managers and investment managers.

7.4 There is a specific GST exemption for the “management of a retirement scheme”, which would apply to the management services provided by the KiwiSaver manager. However, this exemption does not apply when a retirement scheme invests into a general wholesale fund as the managers and investment managers will be providing their services to the wholesale fund rather than the retirement scheme.

7.5 For services provided to wholesale funds there are a range of differing GST practices:

  • Some managers and investment managers apply 15% GST to all of their services (as in their view their services are providing “advice” or other types of services that are subject to 15% GST).
  • Others treat ten percent of their services as being subject to 15% GST and the remaining ninety percent as exempt from GST (because they consider their services are mostly “arranging” the buying and selling of investment products and so should qualify for the GST exemption for financial services).

7.6 Inland Revenue analysed the existing law and publicly consulted on two draft questions we’ve been asked outlining the Commissioner’s considered views on how the current GST Act would apply to unit trust managers and investment managers.[2] The draft views concluded that:

  • Unit trust manager fees are exempt from GST as the unit trust manager is considered to be arranging financial services.
  • Investment manager fees are subject to 15% GST in the typical case where the unit trust manager is not required to accept decisions made by an investment manager and the investment manager does not have authority to give instructions to the trustee (who holds the assets of the unit trust). In these cases, the investment manager is considered to be providing advice (which is subject to 15% GST), rather than arranging a financial service (which would qualify as an exempt financial service).
  • Other outsourced services such as administrative or registry services will typically be subject to 15% GST as they are not financial services.

7.7 Because different types of manager and investment manager services can have complex and differing GST treatments, the current GST rules can distort competition by favouring certain types of managed funds, business structures, or judgements for how the supplier may choose to interpret the GST rules (for example, where one interpretation or position may provide them more favourable outcome than an alternative position).

7.8 The current GST rules can also add costs to managed funds products. These costs include compliance costs of identifying and working out the GST treatment of different types of management services and unrecoverable GST costs to the extent to which a provider of exempt financial services is charged GST on their inputs of non-financial services.

7.9 For these reasons, officials propose developing some special rules for determining the GST treatment of manager and investment manager services. The appropriate GST treatment of these services is not obvious as it depends on the policy objectives of the reform.

Policy objectives when considering GST treatment of services supplied to managed funds

Limiting the GST exemption for financial services

7.10 GST is a broad-based tax with few exemptions. The GST exemption for financial services means these services are undertaxed compared to other services which creates biases (discussed in the next section) and requires increased taxation on other activities to generate the same amount of Government revenue. From a GST policy perspective, the financial services definition should be as limited as necessary.

7.11 The main reason for the proposed GST exemption for financial services is valuation difficulties. These valuation difficulties arise because some financial services involve a mixture of a savings product and a service. These valuation issues do not arise for managers and investment managers as they charge a separate fee for their services (rather than a fee for a bundled mix of services and investment products).

Minimising any significant biases that GST may create

7.12 It is important to ensure that GST treatment of various managed fund fees does not provide a significant competitive advantage for certain types of savings products, managed funds, business structures or larger funds which may be better able to reduce or recover some of their GST costs.

7.13 For example, because the GST rules currently provide an exemption for “management of a retirement scheme”, there could be a bias for managed funds to invest into specialist retirement funds, rather than more general funds. This may encourage inefficient arrangements. More generally, the retirement scheme exemptions were introduced in 1985 to ensure that the GST exemption for life insurance did not encourage life insurance to be the preferred long-term savings product compared to retirement schemes. Commercial developments with how life insurance products are used, and how retirement funds invest into and are close substitutes for other types of managed funds mean there is no longer a good policy rationale for having different GST rules apply depending on whether the management service is provided to a retirement scheme, compared to another type of managed fund.

7.14 GST exemptions also create a bias for exempt service providers to provide services in-house as they face unrecoverable GST costs from outsourcing. This bias is undesirable given that outsourcing may be more commercially efficient or more consistent with financial market regulations.

Providing certainty of GST treatment

7.15 To minimise compliance costs, potential errors or competitive biases it will be important to develop a clear definition of the manager and investment manager services which qualify for a particular GST treatment.

Minimising adjustment costs compared to current commercial practices

7.16 Transitional and compliance costs could be reduced by aligning with existing commercial practices. The difficulty is there are a range of current practices.

GST treatment of managed funds in other countries

7.17 Looking at the rules in other countries, there are different ways that other GST and VAT systems treat managed funds and investment management services.

Australia and Singapore

7.18 Both Australia and Singapore’s GST rules apply GST at standard rates to all services provided to managed funds. However, both these countries then allow the funds to claim back most of the GST costs of their inputs through a reduced input tax credit mechanism. In Australia reduced input tax credits are available for seventy five percent of the GST costs except for trustee fees where only fifty five percent of the GST cost can be deducted. In Singapore a GST remittance is allowed for qualifying funds – the percentage varies each year but is about ninety percent of the GST charged to the fund.

7.19 The rationale for providing a reduced input tax credit is to reduce the bias to perform the relevant services in-house (as there are GST costs from outsourcing but none from the insourcing). Conceptually, the reduced input tax credit should be set so it is equal to the percentage of the outsourced service provider’s fee that comprises their own wages and profits (as opposed to third party costs). In practice, determining the appropriate percentage is not obvious.

European Union countries

7.20 A European Union VAT directive requires European Union member states to exempt the “management of special investment funds as defined by member states”. European Union countries exempt management services provided to funds on the basis that the VAT system should not impose additional VAT costs from investing through managed funds, compared to investing in the underlying shares or bonds directly.

Policy options for how GST could apply to manager and investment manager services

7.21 Officials propose amending the GST Act definition of “financial services” to provide a more certain and consistent GST treatment for manager and investment manager services supplied to managed funds.

7.22 Three main options for changing the law are discussed below. We welcome submissions on these or other potential policy options. If the law is changed, Inland Revenue will not finalise or implement its view of the current law (which is currently in draft).

Making all management services supplied by investment managers and other fund managers taxable supplies

7.23 This option would involve excluding services provided by fund managers and investment managers from the GST Act definition of financial services.

7.24 This would be consistent with the rationale that the financial services exemption should generally be limited to cases where there are valuation issues. This is not the case for fund managers and investment managers as they usually charge a separate fee for their services (rather than a margin or a bundled combination of services and investment products).

7.25 Applying GST to all services provided by fund managers and investment managers could reduce insourcing biases and simplify GST compliance as they would be able to claim input credits for GST charged on their external costs.

7.26 However, because the services that funds provide to investors would still be exempt from GST, applying GST to the manager’s fees charged to funds would impose an unrecoverable GST cost on funds. These GST costs are likely to lead to higher fees and reduced after-tax returns for retail investors.

7.27 Also, if the existing GST exemption for managers of a retirement scheme was retained, there would be inconsistent GST treatment as managers of retirement schemes would have no GST on their fees whereas other types of fund managers would have 15% GST on their fees. This could create biases for investing through retirement funds rather than other types of managed funds and for retirement schemes to be structured so that they receive manager services directly, rather than indirectly through investing in non-retirement funds.

Exempting all management services supplied by investment managers and other fund managers

7.28 This option would broaden the GST Act definition of financial services to include fund management. This would involve expanding the existing exemption for managers of a retirement scheme, so it also applies to managers who provide management services to other types of funds.

7.29 A more general exemption for fund managers and investment managers may be justified on the basis that the financial services exemption already extends to some services which are close substitutes for another type of exempt financial service in order to reduce tax distortions on business or investment decisions. For example, because services provided by a manager of a retirement scheme are specifically exempt from GST, a managed fund may prefer to purchase those services as opposed to services provided by an investment manager, unless investment management services are also exempt.

7.30 On the other hand, a broader financial services exemption that includes all fund manager and investment manager fees would narrow the GST base and lead to greater amounts of financial services being only partially subject to GST (on their taxable inputs), compared to other services (such as financial advice) which are subject to 15% GST.

7.31 This creates a bias because an individual investor seeking financial advice would be charged GST for that advice but a managed fund purchasing investment management services (which may include investment advice) would not be charged GST. However, this bias is unlikely to be significant enough to affect decisions about whether to invest into a managed fund or invest directly into shares or bonds.

7.32 Similarly, Discretionary Investment Management Services (DIMS) services may be disadvantaged if they are required to charge GST on their services and managed funds are not.

7.33 An exemption would impose GST costs for managers and investment managers to the extent to which they purchase inputs such as renting office space, hiring contractors, or procuring data, external advice, administrative services or computer services.

7.34 Depending on how the relevant services are defined an exemption could create boundary issues in determining whether a service was a management service or another type of service. For example, there could be incentives to bundle or reclassify some other types of services as being management services to further reduce GST costs for managed funds.

7.35 Providing an exemption for management services would also lead to policy arguments that other types of services provided to managed funds should also be made exempt from GST in order to further reduce GST costs for managed funds. See paragraphs from 7.58 onward for a further discussion about the GST treatment of other types of services provided to managed funds.

7.36 It would be important to develop a robust and certain definition of the services which qualify for any fund management exemption. European Union case law has found that the “management” of an investment fund has a broad meaning for European Union VAT purposes and can include administrative services and advice. In contrast, New Zealand has made policy decisions that administrative services and advice should be subject to 15% GST and should not qualify as exempt financial services.

Legislate that managers and investment managers are deemed to have a certain percentage of taxable (subject to GST at 15%) and exempt supplies

7.37 This approach could be used to partly tax the relevant services. It could provide certainty and consistency which may reduce competitive distortions.

7.38 Depending on the percentage used, it could also potentially align with some existing industry practices (ninety percent exempt, ten percent taxable), although this would represent a major change for other managers who are currently treating their supplies as taxable supplies.

7.39 One of the issues with this approach is that it is not obvious what the appropriate percentage should be. Any legislated percentage could either overcompensate or undercompensate relative to the true nature of the manager’s services unless it was supported by evidence. We are interested in submissions on what percentage could be considered a reasonable approximation of the taxable services provided by managers and investment managers.

7.40 As with an exemption option, a partial exemption option would also mean there was less GST charged on these services compared to other types of services which are subject to GST at 15%.

7.41 This option would also be inconsistent with the fact that the GST Act does not usually apportion output tax on supplies. (The main exception to this is section 10(6) which deems sixty percent of domestic goods and services provided in a commercial dwelling to be taxable supplies if the occupant stays for more than four weeks.)

7.42 If the manager is providing multiple types of services to the fund, a better approach could be to apply the analysis for determining if there is a single or multiple supply as discussed in the Inland Revenue Interpretation Statement IS 18/04 (Goods and services tax – single supply or multiple supplies). Applying this analysis would typically conclude that a service is a single supply if it had a dominant element and the other elements were reasonably incidental. This option of deeming a certain percentage of the supply to be taxable would therefore represent a significant departure from this approach.

Zero-rating or a reduced input tax credit mechanism

7.43 Compared to an exemption, zero-rating would further reduce the GST costs associated with providing management services to funds, as the managers and investment managers would still be able to claim back the GST costs of their own inputs.

7.44 A reduced input tax credit mechanism for the managers and investment managers would allow partial recovery of the GST costs on the inputs.

7.45 Both options give rise to many of the same disadvantages of the exemption or partial exemption options discussed above – such as the need to carefully define manager and investment manager services to provide certainty as to what services qualify for the special GST treatment.

7.46 However, compared to the other policy options, zero-rating or a reduced input tax mechanism would mean the manager and investment manager services would be substantially undertaxed (compared to both other services and to GST-exempt financial services). It would also create a much more significant precedent. Furthermore, compared to current practices it would have a high fiscal cost for the Government.

7.47 While both Australia and Singapore provide reduced input tax credits for managed funds, these countries also have a narrower definition of financial services than New Zealand that excludes services of “arranging” a financial product. Accordingly, the services provided by managers and investment managers are subject to GST in these countries.

7.48 In Australia, reduced input tax credits are available to all financial service providers, not just managed funds. The policy rationale for providing reduced input tax credits is to reduce the bias that an exemption creates to provide inputs in-house rather than outsource these to other providers. It may also be hard to justify why reduced input credits should only be provided for managed funds or managers of managed funds (which for commercial and regulatory reasons often need to outsource certain services regardless of the GST cost) compared to other financial service providers (where GST may create a bigger bias against outsourcing).

7.49 Even if the GST treatment of manager and investment manager fees generates a significant problem by discouraging outsourcing, it is not obvious what percentage of GST should be recoverable under the reduced input tax credit. Conceptually, it should be the percentage of the outsourced service providers’ fees that comprises their profit and staff wages, but in practice this can differ across service providers and will be difficult to reduce into a single percentage.

7.50 For these reasons, officials consider the case for introducing reduced input tax credits would be more appropriately considered as part of a more fundamental review of the financial services definition that considered the full range of financial services, not just manager and investment manager services. Reduced input tax credits are a logical alternative option to providing an exemption for the service of “arranging” a financial product.

7.51 Providing zero-rating or reduced input tax credits would further reduce the partial GST on non-financial services that retail investors benefit from as a result of investing through managed funds. This would make receiving these services through managed funds further advantaged compared to other services, such as individual investors buying their own research or financial advice which would be subject to 15% GST.

7.52 Finally, either a new zero-rating rule or a reduced input tax credit mechanism would have a significant fiscal cost compared to the current rules where GST partially applies to managed funds. For example, zero-rating would effectively allow GST to be removed on all administrative services provided to managed funds as these would be purchased by a manager who makes zero-rated supplies and is able to claim input credits for these GST costs.

Application date

7.53 It is proposed that the potential law change could apply prospectively but with grandparenting of existing contracts for a period (for example, three years) to ease adjustment costs and to enable new contracts to be negotiated.

Defining the relevant management and investment management services

7.54 The changes would apply to both management services by a manager and investment services by an investment manager that were provided directly or indirectly to a managed investment scheme or a foreign equivalent.

7.55 The terms “manager”, “investment manager” and “managed investment scheme” could be defined by referencing the existing definitions of these terms in section 6(1) and section 9 of the Financial Markets Conduct Act 2013.

Relevant definitions from Financial Markets Conduct Act 2013

investment manager means, in relation to a managed investment scheme, a person to whom a manager of the scheme has contracted the investment of some or all of the scheme property.

manager means,—

(a) in relation to a registered scheme (other than a restricted scheme), the person designated or appointed as the manager of the scheme:

(b) in relation to a restricted scheme, the persons designated or appointed as trustees of the scheme or, if only 1 person is designated or appointed as a trustee of the scheme, that person:

(c) in relation to a managed investment scheme if there is no person to whom paragraph (a) or (b) applies or if it is not a registered scheme, a person occupying the position of, and carrying out any of the functions of, the manager set out in section 142:

142 Management and administration functions of manager

(1) The manager of a registered scheme is responsible for performing the following functions:

(a) offering the managed investment products; and

(b) issuing the managed investment products; and

(c) managing the scheme property and investments; and

(d) administering the scheme.

managed investment scheme means a scheme to which each of the following applies:

(a) the purpose or effect of the scheme is to enable persons taking part in the scheme to contribute money, or to have money contributed on their behalf, to the scheme as consideration to acquire interests in the scheme; and

(b) those interests are rights to participate in, or receive, financial benefits produced principally by the efforts of another person under the scheme (whether those rights are actual, prospective, or contingent, and whether they are enforceable or not); and

(c) the holders of those interests do not have day-to-day control over the operation of the scheme (whether or not they have the right to be consulted or to give directions).

7.56 “Foreign equivalents” would include Australian Managed Investment Trusts (AMITs) and other entities subject to the AMIT regulatory regime as well as other foreign funds that are comparable to the relevant New Zealand funds.

7.57 The proposed changes would also apply to “out of fund” fees. Out of fund fees are charged in cases where a fund invests into a second wholesale fund that is managed by another manager, but the management fee of that other manager is invoiced directly to the manager of the first fund. This practice occurs to ensure that there is no duplication of investment management fees.

Other outsourced services which are not management services

7.58 Officials do not propose changing the GST treatment of other services provided to managed funds such as accounting, administrative or registry services. These outsourced services are generally subject to GST (taxable supplies) unless they are themselves exempt financial services.

7.59 We consider it is sensible to draw a distinction between providing management services to a fund and providing other types of services.

7.60 Providing a special GST treatment such as an exemption for administrative services provided to managed funds would create a precedent and make it difficult to justify continuing to apply 15% GST to administrative services provided to other financial service providers such as banks or life insurers.

7.61 There is already an existing precedent for exempting the “management” of a retirement scheme. In addition, under the current GST rules three similar types of fund management services (management of a retirement scheme, managers of managed investment schemes and investment managers) can have three different GST treatments which creates more significant uncertainty and biases on how these services are arranged or priced.

7.62 The same uncertainties and inconsistent GST treatments should be much less likely to arise for administrative services as there is a clearer position that such services are taxable in the typical cases where they are outsourced (as opposed to being incidental services supplied as part of a much larger, single supply of an exempt financial service).

7.63 The legislative position whereby GST applies to such outsourced administrative inputs was established in 1987 through the decision in Databank Systems Ltd v CIR (1987) 9 NZTC 6,213 which found that Databank was providing computing services to banks rather than financial services. As a result of the Databank proceedings, a clarifying amendment was also made to explicitly exclude “general accounting and record-keeping” services from the definition of financial services.

Questions for submitters

  • What are the pros, cons or practical issues associated with each of the policy options? How well would they achieve the policy objectives?
  • What types of manger and investment manager services should the proposed policy or law change apply to? What is the clearest way to define the relevant services?
  • If the law was changed, what transitional issues could arise and what measures could be implemented to enable a smooth transition to the new law?
 

[2] PUB00277aa: Goods and Services Tax – GST treatment of fees payable to manager of a unit trust
PUB00277bb: Goods and Services Tax – GST treatment of outsourced services in relation to a unit trust