Interest Deduction against FIF income

[lou]

I guess that would partially offset the disadvantage of having to pay tax on recovering your original capital in subsequent years.

Do you have to pay tax on recovering your capital? I thought under the FIF regime you end up paying 5% tax on your opening book value then and that was it (FDR rules assuming your investments are increasing in value).

I would say the worst part of your plan is the 100% margin loan. I believe the underlying investment (overseas shares, or for that matter any shares) is too volatile for this to work in the medium term. I would describe a 20% margin loan as extremely aggressive.

It would not be margin loan but a loan over personal property. While the FIF investments would be purchased using 100% debt financing, the global view would reveal a conservative debt ratio.

Think of it this way. All sharemarket listed entities have a responsibility to their shareholders to be 'capital efficient'. A well run company will borrow money to achieve this. What you are really saying by borrowing money to invest in shares is that you believe the underlying shares are not optimally 'capital efficient' and that you can borrow more money against the fixed income stream from the underlying share to achieve a better result. On rare occasions you might be right. But in the general case you are saying that you know more about how the underlying business than management do. To me this kind of thinking is a bad bet.

The other-way of thinking about it is that I am arbitraging the cost of debt and cost of equity. Since the cost of debt is < the cost of equity in the long run you should make a profit. The cavet to this is "Markets can remain irrational a lot longer than you and I can remain solvent."

The FIF regime is I believe negative from an NZ investor return perspective. If you can find a high growth index included company for example in Australia (not subject to FIF) that is growing faster than some investment in the US (or whatever FIF country you care to substitute) from a post tax perspective you are likely to be better off by putting your money in that Australian company. To me it now makes sense to get international exposure by looking at NZ/Oz exporters (the are some locally listed companies that earn almost all of their income outside of NZ/Oz) rather than trying to buy into some FIF overseas growth story.

I may be wrong however. My understanding is that under the FDR rules you will pay a 5% of your opening book value as FIF income. So if you have an Australian company that returns a net dividend of 10% you will have to include the full 10% in your tax return. If that same company was a US company you would only include 5% FIF income in your tax return. I guess if your Aussie company pays no dividend you will be better off. In the long run it should balance out.

[Snoopy]

Do you have to pay tax on recovering your capital? I thought under the FIF regime you end up paying 5% tax on your opening book value then and that was it (FDR rules assuming your investments are increasing in value).

Lou, on a one year basis your understanding is mostly correct. My comment was more in relation to a multi-year overview. At some point you may have a negative overall return on your FIF investment over a year. You will not pay any FIF tax directly if you lose money. However, any tax deducted at source from your FIF dividends will not be recoverable and cannot be carried forward to offset against any FIF tax liability in future years.

The second point is you will have lost capital when in this position. For the next year your capital base resets to the 'opening balance' of the new tax year, even if this is less than the capital you originally put in. Therefore you can be in the irksome position of paying tax while you are still recovering your original capital, and you are in net loss position.

Finally one thing that is less irksome than you assume.
"You end up paying 5% tax on your opening book value." is not right.

In fact you pay tax at your marginal rate on 5% of the opening book value, which is not the same thing.

SNOOPY

[Snoopy]

I may be wrong however. My understanding is that under the FDR rules you will pay a 5% of your opening book value as FIF income. So if you have an Australian company that returns a net dividend of 10% you will have to include the full 10% in your tax return. If that same company was a US company you would only include 5% FIF income in your tax return. I guess if your Aussie company pays no dividend you will be better off. In the long run it should balance out.

The FIF regime does have a 'loophole' of sorts if you can find a very high yielding share. Let's say you find an FIF share that yields 10%, and the exchange rate adjusted share price does not move during the year (to keep things simple for this example). The amount of FIF tax you would pay is based on 5% of your opening balance. If your marginal tax rate is 30% then the amount of tax you will pay is 0.3 x 5% = 1.5% of the opening balance.

If as an alternative you found an Australian index listed share that paid a 10% yield, and again the exchange rate adjusted share price did not move during the year (to keep things comparable with part 1 of this example) then the amount of tax you would pay is 0.3 x 10% equivalent to 3.33% of your opening balance.

If you can find a high yielding share under FIF, then in this instance on a one year basis, FIF will deliver a better after tax result for you.

However, the reason FIF was introduced was that, in general, shares outside of Australia and New Zeland have much lower yields than other sharemarkets. So finding an FIF share or shares that behave as I have described may in practice prove difficult. If you can do it let me know though because I am looking too!

SNOOPY

[Snoopy]

It would not be margin loan but a loan over personal property. While the FIF investments would be purchased using 100% debt financing, the global view would reveal a conservative debt ratio.

Ah so you borrow money on your house to ostensibly put in a new kitchen, but instead put that money into the sharemarket? Ok I agree that sounds much better from a global view debt ratio perspective. I would just be careful that this would still work if your house fell say 20% in capital value.

SNOOPY

[Snoopy]

The other-way of thinking about it is that I am arbitraging the cost of debt and cost of equity. Since the cost of debt is < the cost of equity in the long run you should make a profit. The cavet to this is "Markets can remain irrational a lot longer than you and I can remain solvent."

With a well run company the cost of debt does tend to be less than the cost of equity - true. But this rule is not so black and white as you make it out to be. There are companies out there where the cost of equity is greater than the cost of debt.

You also should consider why using your logic a well run company has any equity, or in the extreme might run $1 of equity to $99 of debt. The answer is to deal with the unexpected. You need to plan for the unexpected too.

By running a 100% debt funded investment which nevertheless has a 90% chance of performing to plan (because you only invest in good companies, right?) then you might consider that you have a 90% chance of pulling your investment plan off. Unfortunately the actual answer is that if on an annual basis your investment plan has a 90% chance of success, the chances of you losing all of your investment capital over your investment timeframe (say 30 years) is virtually certain. The reason you are almost certain to do your dough is that each investment year viewed on its own is not what is called in statistical terms 'an independent trial'. Put simply the amount of capital you have to invest at the start of any investment year is fully dependent on the capital you have at the end of the previous investment year.

I personally find it quite frightening that there are a whole load of investors out there who do not understand the statistical mathematics of this.

SNOOPY

[lou]

Thanks Snoopy. They are some very good posts

[lou]

The FIF regime does have a 'loophole' of sorts if you can find a very high yielding share. Let's say you find an FIF share that yields 10%, and the exchange rate adjusted share price does not move during the year (to keep things simple for this example). The amount of FIF tax you would pay is based on 5% of your opening balance. If your marginal tax rate is 30% then the amount of tax you will pay is 0.3 x 5% = 1.5% of the opening balance.

If as an alternative you found an Australian index listed share that paid a 10% yield, and again the exchange rate adjusted share price did not move during the year (to keep things comparable with part 1 of this example) then the amount of tax you would pay is 0.3 x 10% equivalent to 3.33% of your opening balance.

If you can find a high yielding share under FIF, then in this instance on a one year basis, FIF will deliver a better after tax result for you.

However, the reason FIF was introduced was that, in general, shares outside of Australia and New Zeland have much lower yields than other sharemarkets. So finding an FIF share or shares that behave as I have described may in practice prove difficult. If you can do it let me know though because I am looking too!

SNOOPY

The other loop whole is you can't not be a trader under the FIF regime. I am not planning on being a trader, but it simplifies the compliance process a we bit. No need to justify why I bought/sold shares

[lou]

With a well run company the cost of debt does tend to be less than the cost of equity - true. But this rule is not so black and white as you make it out to be. There are companies out there where the cost of equity is greater than the cost of debt.

You also should consider why using your logic a well run company has any equity, or in the extreme might run $1 of equity to $99 of debt. The answer is to deal with the unexpected. You need to plan for the unexpected too.

By running a 100% debt funded investment which nevertheless has a 90% chance of performing to plan (because you only invest in good companies, right?) then you might consider that you have a 90% chance of pulling your investment plan off. Unfortunately the actual answer is that if on an annual basis your investment plan has a 90% chance of success, the chances of you losing all of your investment capital over your investment timeframe (say 30 years) is virtually certain. The reason you are almost certain to do your dough is that each investment year viewed on its own is not what is called in statistical terms 'an independent trial'. Put simply the amount of capital you have to invest at the start of any investment year is fully dependent on the capital you have at the end of the previous investment year.

I personally find it quite frightening that there are a whole load of investors out there who do not understand the statistical mathematics of this.

SNOOPY

Position sizing and risk management is one of the keys to a successful investing strategy and it is outstanding how many investors don't understand it.

[Sauce]

I agree, well articulated Snoopy.
Regards,
Sauce

[Snoopy]

Position sizing and risk management is one of the keys to a successful investing strategy and it is outstanding how many investors don't understand it.

I am not sure I quite got my point about risk of investment plan failure across, so here are the numbers I had in mind. Let's say you devised a leveraged investment strategy that delivered excellent growth per year every year, but with a one in ten chance every year of total capital loss.

The chances of you holding onto your nicely growing capital for one year is 90% (or a probability of 0.9). But to come out ahead you need to do this for ten years in a row. Because each year of investment is dependent on the results of the previous year (in probability theory this means they are what is termed 'dependent variables'), that means you have to multiply the probabilites together to garner the multi-year picture.

After one year the probability of holding onto your fast growing fortune is 0.9.

After two years the probability of holding onto your fast growing fortune is 0.9x0.9= 0.81 (or 81%)

After ten years the probility of you holding onto your fortune is:

0.9x 0.9x 0.9x 0.9x 0.9x 0.9x 0.9x 0.9x 0.9x 0.9= 0.349, or approximately 35%

Or looked at another way you have a 65% chance eventually of losing everything after ten years has elapsed, even though on a seductive one year basis you have a 90% chance of single year success.

SNOOPY