A slice of PIE

Following changes to the Trust tax rate, which saw the tax rate lifted from 33% to 39% for Trusts generating income over $10,000 a year, interest in Portfolio Investment Entities (PIE) has increased.

What is a PIE?

First introduced in 2007, PIEs are not a new concept when it comes to the investing landscape and have always played a role in our portfolio construction process.

Although many investors may be unfamiliar with the ‘PIE’ acronym, over 3.3 million New Zealanders already invest in PIE funds through their KiwiSaver scheme.

A PIE is a pooled investment vehicle, like a managed fund, that meets certain criteria set out by the Inland Revenue Department.

PIE funds typically provide a diversified exposure to a particular asset class such as cash, fixed income or shares. Some hold a mix of these assets.

Diversification is a key reason to invest in PIE funds. Benefits related to portfolio implementation and rebalancing are also compelling reasons to use them.

Another important feature of PIE funds is that tax applied to investment income is capped at 28%. This compares with a top personal tax rate of 39% for individuals who earn over $180,000 per annum.

From 1 April 2024, a trust that earns above $10,000 per year, and holds this income, is also taxed at a rate of 39%. This compares with a 33% tax rate previously.

Income distributed from a trust to its beneficiaries can still be taxed at their tax rates.

How different tax rates affect returns

On the surface, it seems that tax savings from using PIE funds would significantly improve investment returns. However, this isn’t necessarily the case.

By way of example, let’s consider investments in New Zealand equities.

It’s important to remember that when investing in New Zealand shares, tax only applies to the income component of your total return. This is usually the dividends received.

Over the past decade, total returns from the New Zealand sharemarket have averaged almost 9%per annum.

Capital gains have accounted for around 5.5% of the annual return, implying a dividend yield of 3.5%.

For someone in the 39% tax bracket, investing in a PIE that replicated the NZX 50 index would have returned 8.0% per annum after tax over the last ten years (ignoring fees and imputation credits). This compares with an annual return of 7.6% from investing directly in the index. A difference of 0.39% each year.

The difference would have been 0.18% each year for an investor in the 33% tax bracket, and just 0.07% for a 30% taxpayer.

Investment decisions shouldn’t be based on tax alone

Potential tax benefits of investing through PIE funds have been thrust into the spotlight, but investment decisions shouldn’t be based on tax alone.

While investment portfolios should be constructed in a tax-efficient way, allowing tax to dictate portfolio strategy can lead to poor investment outcomes.

Establishing your financial goals, investment time horizon, income requirements and appetite for risk are of equal (if not greater) importance to tax considerations.

Once your financial goals and needs have been identified, the time comes to select investments for your portfolio. Holdings could include direct investments, PIE funds or a combination of both.

Using a mix of PIE funds and direct holdings enables us to create diversified and personalised portfolios for our clients. PIEs give us access to asset classes that are difficult to invest in directly, such as property, global bonds and alternatives.

When evaluating a PIE fund, we research the investment strategy, capability of the fund manager, and performance and governance track records.

Fees are another important consideration, as they might exceed any tax benefit of investing in a PIE fund.

If a PIE fund consistently produces returns above its stated benchmark and those returns more than cover the management fees, it could make sense in a portfolio.

How PIEs are taxed

PIE funds are taxed in the same way as direct investments in fixed income, New Zealand shares and most Australian shares. Interest and dividends are taxable, but capital gains on shares are not taxable for many investors.

There are differences when it comes to international equities, which can favour investors who directly hold shares.

The Fair Dividend Rate (FDR) method is often used to calculate tax for PIE funds that own international shares. Under this method, a 5% investment return is assumed based on the average portfolio value for the year.

Investors who directly own international shares can choose to apply the FDR method or Comparative Value (CV) method for calculating tax. The CV method is usually elected if returns are under 5% for the year because it lowers the tax amount to be paid. This tax relief is not available to investors in PIE funds.

Investors who directly own international shares also benefit from an effective tax holiday in the first year of an investment. This benefit is unavailable to investors in PIE funds.

Finally, most direct investors who apply the FDR method can calculate tax based on the opening value of their portfolio each year, rather than the average value. This is beneficial when holdings in international shares are increasing in value.

These distinctions may lessen the tax differential between investing in PIE funds and direct investing.

PIEs managed by Craigs Investment Partners

Craigs operate two PIE funds for the exclusive benefit of our clients.

Both PIEs invest in New Zealand shares and reflect the quality investment philosophy that Craigs Investment Partners is known for.

The Smartshares CIP NZ Core Equity Fund primarily targets large and liquid companies, and has been designed to provide a stable exposure to New Zealand equities.

The Smartshares CIP NZ Yield Equity Fund has been designed to provide investors with a higher-than-market dividend yield. Companies that can sustain and grow their dividends are the focus.

These PIE funds are managed in-house by the specialist team that provides research and investment recommendations for New Zealand equities.

Please contact your investment adviser for more information.

This is an excerpt of an article published in the latest edition of our flagship publication for clients only, News & Views. Craigs Investment Partners clients can view News & Views, including the full version of this article by logging in to the client portal.

Note: We are not tax advisers and this information is not to be construed as tax advice. The comments here are general in nature and no consideration has been given to the personal circumstances of investors. We recommend that you obtain your own independent taxation advice in relation to your tax position with respect to investing in PIEs.

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