The Evolving Challenge of Maintaining Tracking for Index Funds in an Ever-Changing Environment
In light of a variety of regulatory, tax and accounting developments, the competitiveness of index funds in Europe may face new challenges. Here, we examine some potential solutions that may allow investors and promoters to meet their obligations, while still maintaining the quality of the product and minimising tracking error.
The European Market Infrastructure Regulation (EMIR) was introduced by the European Union in 2012 to reduce systemic, counterparty and operational risk, and increase transparency in the OTC derivatives market. It was also designed as a preventative measure to mitigate against fallout during possible future financial crises.
EMIR introduces requirements that where a fund has currency hedged share classes, the fund may have to use assets of the fund to post as collateral, which would mean that overall, the fund is less invested as a percentage of the net asset value. As an alternative to accruing or posting cash assets which would deplete the level of investible assets, posting non-cash collateral instead may be an option worth exploring.
In some countries, tax authorities may look to challenge reclaims received by foreign funds, resulting in lower levels of Dividend Withholding Tax (DWT) reclaims being issued. Organisations should assess the countries from which a product regularly receives DWT rebates, reviewing the risk that these countries may change their approach or rules, monitoring where the tax is governed and the potential impact on the fund, and the effect on the performance of the fund if these rebates were not available.
Where a country applies a DWT that the fund is subject to, this will directly impact on the performance of the fund, and countries have double tax treaties in place to determine the level of DWT. Fund managers should consider the rates available through funds in different jurisdictions to identify the most favourable ones. The benefits of an Irish domicile to ETFs has been well documented in this area.
On 27 June 2017, the International Accounting Standards Board (IASB) issued IFRIC Interpretation 23 — Uncertainty over Income Tax Treatments to address how to reflect uncertainty in accounting for income taxes.
The Interpretation specifically addresses the following:
- whether an entity considers uncertain tax treatments separately;
- the assumptions an entity makes about the examination of tax treatments by taxation authorities;
- how an entity determines taxable profit (tax loss), tax bases, unused tax losses, unused tax credits and tax rates; and
- how an entity considers changes in facts and circumstances.
The Interpretation provides guidance on considering uncertain tax treatments separately or together, examination by tax authorities, the appropriate method to reflect uncertainty and accounting for changes in facts and circumstances. The Interpretation is effective for annual reporting periods beginning on or after 1 January 2019, but certain transition reliefs are available.
An index tracking fund does not have discretion as to what to invest in, so the fund manager should consider different options on how to structure exposures in order to minimise uncertain tax exposures, and should give consideration to the difference between net asset value accounting policies and IFRS accounting standards. Since this move brings IFRS more in line with US GAAP, fund managers should consider the approach taken for comparable US funds if there are any.
The increased use of synthetics or derivatives may also be a consideration in jurisdictions where the tax treatment is unclear, and a synthetic exposure may help to minimise uncertain taxes. Where funds utilise a fully replicated or partially replicated approach by physically holding assets, the use of synthetics may lead to a hybrid approach in how exposures are obtained. However, the fund manager would need to consider the impact on investors.
For ETFs, consideration also needs to be given to who is liable for the tax and to what extent a fund passes on the tax to authorised participants. However, where an authorised participant bears the tax cost, this may feed through to the bid / ask spread on the secondary market.
The Multilateral Treaty is a far-reaching initiative in international tax that should be considered for all new fund structures and in reviewing current structures. It is imperative that fund managers can demonstrate that a fund was not established in a particular jurisdiction for tax purposes. This is known as the Principal Purposes Test (PPT).
Ireland is chosen as the location for funds, and in particular for ETFs, for many reasons including the ability to avail of EU passporting rights, strong recognition of the country as an asset management centre, and significant infrastructural supports. The benefits of the tax treaty network are considered but typically this is a by-product of establishing in Ireland and not a principal purpose.
Treaty benefits could be denied to a fund where they have not met the PPT, so fund managers must ensure that set up documentation refers to all benefits of locating in Ireland, and not only the tax benefits.
Certain regulatory, tax and accounting challenges must inspire more innovative solutions. Asset managers must continue to find ways to keep their products competitive, and ensuring an index tracking fund is fully invested and minimises tracking error is vital to being competitive.
Kieran Daly, Director, EY Wealth and Asset Management, Dublin