Chapter

3 Securities Companies, Investment Funds, and Pension Funds

Author(s):
Howell Zee
Published Date:
April 2004
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Author(s)
John King

This paper discusses issues that arise in designing an appropriate tax regime for three broad types of financial institutions that typically play major roles in securities markets—securities firms, investment funds, and pension funds. The focus is on taxes levied on the income or profits of these institutions, rather than indirect taxes on the financial products that they sell.

The particular forms taken by financial institutions vary quite widely from country to country. They sometimes also change rapidly within a country as changes are made to the national regulations that govern their operations. It is, therefore, difficult to make useful comparisons of the tax regimes applied in different countries to specific kinds of financial institutions. Nevertheless, financial institutions can be classified broadly, according to the particular functions that they perform in the financial system. A distinction is commonly drawn, for instance, between “direct finance institutions” that make up the primary and secondary markets for securities (including various types of brokerage and securities firms) and “financial intermediaries” that channel funds to those markets from individual savers (including banks and nonbank financial intermediaries, such as insurance companies, investment and mutual funds, and pension funds).

The implications of alternative tax treatments of financial institutions depend on the rest of the tax system. Of particular relevance to the treatment of financial institutions operating in the securities markets are a number of features of the broader national tax system:

  • The general tax treatment of capital gains of individuals and companies. Are capital gains on financial assets subject to tax in the hands of individuals and companies? If so, are they subject to the same tax regime as other forms of income (such as interest and dividends), or are there special rules relating to capital gains and losses? How are gains measured for tax purposes?
  • The general tax treatment of interest and dividends. Are interest and dividends received by individuals subject to tax, and if so, at what rates? Are withholding taxes levied, and, if so, are they final or provisional? Does the tax liability of the dividend recipient take account of tax paid by the company on the income that it distributes and, if so, how?

Some other features of national tax systems become particularly important for financial institutions when financial markets are closely integrated with those in other countries—in particular, the system of relief for foreign taxes paid (whether by credit, deduction, or exemption for foreign-source income), the network of tax treaties that has been established with foreign countries, and the particular provisions of those treaties (for instance, with regard to withholding taxes).

Securities and Brokerage Firms

An effective market in financial securities requires market makers who ensure that both new issues and existing securities can be bought or sold at some price in the primary and secondary markets, respectively. The particular institutions that fulfill this role and the regulations that govern their operations vary (although the rapid globalization of financial markets is tending to reduce these variations). These institutions will be subject to tax on their profits like other companies, partnerships, or individuals that engage in business activity. But the tax system may require special rules relating to the measurement of the taxable profits of such institutions. Two important issues that may arise are whether the profits made by these institutions from buying and selling securities are to be treated for tax purposes as income or as capital gains, and how those profits are to be measured in each period of time.

Income and Capital Gains

Every income tax system distinguishes between capital expenditures and receipts, on the one hand, and, on the other, expenditures and receipts that are of a “revenue” nature. Thus, a manufacturing firm’s expenditures on building and machinery are not allowed as an immediate deduction from taxable income, but a deduction for those expenditures is spread out over the years during which the assets are expected to generate income. Similarly, for such a firm, the costs of nondepreciable assets such as financial securities are not allowed as a deduction. However, when capital assets are sold, there may be a tax charge on the capital gain. Thus, a difference arises between the usual tax treatment of capital gains and ordinary income: while ordinary income is normally taxed as it accrues year by year, capital gains are normally taxed only when they are realized—that is, when the asset is sold.

Most income tax systems make further distinctions between ordinary income and capital gains. Some countries do not tax gains at all; others tax them at a reduced rate or spread the tax liability on gains over several years. In recognition of such differences, capital gains and other forms of income are usually placed in separate compartments, and restrictions are placed on the extent to which capital losses may be offset against ordinary income for tax purposes. Thus, if a company incurs expenditures (for example, in the form of wages or rent for its premises) in buying and selling assets and the net proceeds of its trading in assets are treated as capital gains, it might not be able to obtain a tax deduction for its wage and rental costs.

An asset that is of a capital nature for one business may be of a different nature for another kind of business. For example, an enterprise whose business is to sell machinery will count the machinery in its sales rooms as trading stock, even though, for its customers, those same machines will subsequently become capital assets.

Classification of Financial Businesses

In countries (for example, the United States) whose tax system treats capital gains and ordinary income differently, a particularly important question that arises in the context of financial markets is for which businesses are securities a capital asset, and for which should they be treated as trading stock? For tax purposes, the tax code of the United States classifies taxpayers who engage in securities transactions in three groups:

  • dealers are those who regularly purchase securities from (or sell securities to) customers in the ordinary course of a trade or business;
  • traders are those who buy and sell securities in frequent operations on their own account rather than for the accounts of customers, to such extent that they may be said to be engaged in such activities as a business; and
  • investors are persons whose activities are limited to occasional transactions for and on a personal account or persons whose investments are managed by others.

The taxpayer’s classification determines how gains or losses and selling expenses are treated. For U.S. tax purposes, a securities dealer generally realizes ordinary gains or losses from the sale of securities, rather than capital gains or losses (although a dealer may hold some securities for investment purposes and treat those securities as capital assets). A trader’s gains and losses are generally treated as being capital in nature (unless a mark-to-market election has been made, as discussed below). And the gains and losses of an investor are also treated as capital gains and losses (unless there are special rules attaching to the particular asset in question).

Timing and Measurement

The usual measure of the gain or loss on a capital asset, on realization, is the difference between the proceeds of sale and the original acquisition cost.1

Taxing gains on realization, of itself, normally represents a tax advantage for the asset’s owner. Compared with a situation in which tax is levied each year on the gain as it accrues, taxation at the time of realization involves a delay that reduces the tax charge in present value terms. This can create a “lock-in” effect, as those who hold assets on which taxable gain has accrued have an incentive to delay realization.2 Several schemes have been proposed that would adjust the taxable gain, on realization, according to the period over which that gain has accrued, in an attempt to remove the tax advantage.3 These schemes are, however, complex, and the one country (Italy) that has made use of such a scheme in recent years has now decided to abandon it.

However, for assets such as securities that are listed on stock exchanges and for which continuous market price data are therefore available, it is reasonably straightforward to tax gains on an accrual rather than a realization basis. To achieve this, relevant holders of such securities would be required to mark to market for tax purposes at the end of each tax period: they would be taxed as if they had sold their entire portfolio of securities at that time and reacquired it at the same price.

In the United States, dealers in securities are required to mark to market most of their portfolio of securities at the end of each tax year, and the gain or loss that is recognized in this way is then treated as ordinary income rather than capital gain. (The mark-to-market rules do not apply, however, to some part of their portfolio—notably securities that they hold as an investment.) Traders in securities (and also dealers in commodities) may elect to use the mark-to-market accounting method for tax purposes but are not required to do so.

Mark-to-market rules for dealers (and traders) eliminate many distortions that arise from differential tax treatment of realized capital gains and ordinary income. But there may be some problems with them. First, government revenues (and tax payments by the companies concerned) are likely to become much more volatile. Second, the rules cannot be applied to assets for which there are no regular markets; hence, securities firms’ choices between different assets may be distorted. And, third, distortions may also result from a situation in which some firms are required to mark to market, while other firms are not.

Investment Funds

The Organization for Economic Cooperation and Development (OECD) uses the term “collective investment institutions” (CIIs) to refer to publicly marketed, widely held investment funds investing in financial assets.4 Others have used the term “collective investment schemes.” In different countries, the various English titles that are given to such funds include unit trusts (Australia and the United Kingdom), investment funds (Germany), investment trusts (Japan, the United Kingdom, and the United States), and mutual funds (Sweden and the United States). Although their organization varies widely, all of these funds can be thought of as consisting of three components: a management unit, the securities that are held by the fund on behalf of its shareholders or unit holders, and a repository where the securities are actually held.5 Within such funds, a distinction that is often important for tax purposes can be drawn between “open-end funds” that may issue new fund units to investors, using the proceeds to purchase new securities for the fund, and “closed-end” funds in which the number of units is fixed.

Investing in the securities market by purchasing units or shares in such funds, rather than by investing directly, offers several important benefits to individual investors. There are considerable economies of scale in managing a portfolio of securities—for instance, in buying and selling, in researching the potential yields of different securities, and in monitoring the securities’ performance in the market. By investing through a fund, therefore, individuals can reduce their costs. At the same time, small investors can also reduce their risks, because the economies of scale allow the fund’s large portfolio to be more highly diversified than would be possible for the portfolio of a small investor investing directly. And a third possible benefit, for some investors, is that an investment fund can exert substantial “outside” influence over the management of the enterprises in which its investments are made; some funds, for example, insist on the adoption of particular ethical practices with which investors may wish to be identified.

Investment through a fund may, however, have some disadvantages. In particular, there is a risk that fund managers will behave according to their own interests rather than those of the fund’s investors, in circumstances where differences arise. Regulation of investment funds generally seeks to minimize this risk but can never entirely eliminate it.

On balance, one would expect—in the absence of tax considerations—that small investors, in particular, would usually prefer to invest in securities markets through CIIs, rather than directly. The presence of an active investment fund sector can, therefore, greatly expand the scope of securities markets by attracting funds from small investors for whom direct investment would not be an attractive option. Tax rules can, however, powerfully affect the choice between direct investment and investment through funds, in both directions. On the one hand, if the fund is subject (under the general income tax law) to tax as a separate entity, there is a risk that an additional layer of tax will be added between the tax that is levied on company profits and the tax levied on the individual investor’s ultimate receipt of those profits. In this case, the general tax system could make such funds unviable. On the other hand, the use of a CII may allow investors to postpone taxes that they would otherwise have to pay on dividends, interest, and capital gains from the same underlying portfolio. In this case, the fund would act as a tax shelter, and the general tax system would bias investors toward investing through funds rather than investing directly.

For these reasons, countries with active securities markets generally require not only specific regulations to govern the activities of investment funds6 but also a tax regime specific to them.

Criteria for a Tax Regime for Investment Funds

In designing a tax regime for investment funds, a natural starting point is the general tax treatment of direct investment in securities by individuals. Most countries seek to ensure that the tax treatment of investing through an investment fund is broadly neutral when judged against that yardstick—so that investment through such funds is not especially favored or disadvantaged.7

Full neutrality would require that the same total tax be levied on the returns from an investment in securities when the investment is made through an investment fund as when it is made directly (or through another entity such as a pension fund), irrespective of the nature of the investor (in particular, with respect to the person’s exemption from certain taxes, marginal tax rates on various sorts of income, and residency status) or the return from the security (dividends, interest of different sorts, and capital gains).

This neutrality may be reasonably easy to achieve in some situations but virtually impossible in others. For example, suppose that a country levies final, nonrefundable withholding taxes on all interest and dividends paid by companies but does not tax capital gains realized by individuals. If the income of the fund management can be separated out and taxed as appropriate under the general tax law, full neutrality can be achieved simply by exempting the remainder of the fund’s income from tax and levying no tax on its distributions to shareholders. On the other hand, if individuals are subject to tax at their marginal income tax rates on interest and dividends received and are also subject to tax on realized capital gains on sales of securities, it may be extremely difficult to replicate the same pattern of tax liabilities when the securities are held through an investment fund that does not know the particular tax position of each of its individual investors.

Depending on the general tax treatment of investment, therefore, practical administrative considerations may place constraints on how well the tax regime for investment through funds can approximate the treatment of direct investment. Other things being equal, it is much easier for government to levy tax on the investment fund at some representative tax rate than on each of its individual shareholders or unit holders (who may number several million).

Alternative Prototypes for a Tax Regime

Four broad prototypes of a tax regime for investment funds have been distinguished.8

Tax-Advantaged Prototype

The government may deliberately choose to favor investment through collective investment institutions over direct investment by individuals by providing tax advantages to the former. The motivation may be, for example, to increase the size of the securities market or to encourage the use of such funds in a program of privatization. First, the fund may be exempted from tax on dividends, interest, or other income received.9 Gains realized by the fund may also be exempted. Taxes would become payable by investors only when the fund’s income is distributed, or when they dispose of their shares or units in the fund. Second, investors might be allowed an income tax deduction for the amounts they contribute to the investment fund (as in the usual tax treatment of private pension funds, discussed below).

Pass-Through Prototype

In this case, the investment fund is treated as transparent, and all items of income or loss are allocated directly to investors. Investors are taxed as if they earned the income (and gains) directly, irrespective of whether those amounts are actually distributed to them. Broadly, investment through unit trusts in Australia, sondervermogen (investment funds) in Germany, security investment trusts in Japan, and mutual funds in Sweden follow this pattern. In the purest form of this arrangement, the fund acts simply as a reporting mechanism. In a variation of this prototype, tax could be levied on the income (and gains) of the fund, and investors could be allowed a credit for that tax against their own tax liability on the income and gains.

Among the four prototypes, this option comes closest to achieving neutrality between direct investment and investment through investment funds. It may, however, impose substantial administrative burdens on both investors and the taxing authorities to ensure collection of taxes and compliance with tax rules.

Surrogate Prototype

At the other extreme, tax could be levied only at the level of the fund, taking no account of the tax position of the individual investor.

As noted earlier, this prototype can achieve neutrality between direct investment and investment through a fund quite straightforwardly in some situations—in particular, if tax is withheld on all payments of dividends and interest by companies, that tax is final and nonrefundable, and capital gains are not subject to tax. The surrogate prototype might well be preferred in such situations, since it is probably the easiest tax regime to administer. In other situations, however, taxation at the level of the fund is likely to be advantageous for some investors (such as those who would be subject to higher rates of tax on income from their direct investments) and disadvantageous for others (such as privileged investors that would pay no tax at all on income from their direct investments). This approach would, then, distort investors’ choices about how to invest.

Distribution-Deduction Prototype

In the fourth type of tax regime, any income retained in the fund is taxed in the hands of the fund, while distributed income is exempt (but is taxed instead in the hands of the investors).10 The investment fund is thus treated as a taxable entity, but it is allowed to deduct from its taxable income any amounts distributed to investors. Countries following this approach often require funds to distribute a substantial proportion of their income to investors each year (as in the case of mutual funds in the United States). Alternatively, they may require investment funds to treat certain amounts as having been distributed, even though no actual distribution is required (as in the case of some SICAVs in Belgium and unit trusts in the United Kingdom); these deemed distributions could then be treated as having been reinvested in the fund by investors.

Private Pension Funds

In OECD countries, basic old-age pensions are typically provided by the state and financed out of compulsory contributions levied on the wages and salaries of the employed during their working lives (and on the incomes of the self-employed). Increasingly, however, regulated private pension arrangements have been adopted to add a second (or third) “pillar” to the state pension system. The development of such schemes allows the state to focus on providing an adequate minimum pension for all its citizens, while encouraging individuals to supplement that minimum pension according to their particular resources and needs. In most countries, the origins of private pension arrangements lie in schemes developed by larger employers (or occupational groups) to provide pensions for their workers or members, but, in many cases, they have become more widely available—for instance to the self-employed or to mobile workers (in the form of “personal pensions”).

Most of these private pension schemes are “funded.” Individuals (and their employers) make regular contributions to a pension fund that invests in income-earning assets; the pensions received by retirees reflect their original contributions, together with the income earned by the fund on those contributions up to the time that the pensions are paid.11 Such pension funds now hold over one-third of all financial securities in the United States and the United Kingdom.

Standard Tax Regime for Approved Pension Funds

In the absence of private pension schemes, individuals can make their own private provision for their years of retirement by investing directly in financial securities or other assets. In a few OECD countries (including Greece, Italy, and Turkey), there were no private pension funds in the early 1990s. The majority of OECD countries, however, encourage such funds through tax regimes that strongly favor their development. These benefits are provided only to schemes that are regulated (or approved) by the government.

The tax treatment of such funds has three components that need to be looked at in combination: the treatment of contributions by both employees and employers to the approved fund, the taxation of income the fund earns on the securities it holds, and the taxation of pensions. As shown in Table 3.1, the tax regime applied in the majority of OECD countries is broadly as follows:

  • Contributions by individuals to approved private pension schemes are deductible from those employees’ taxable income. Contributions paid by employers are deductible from the employers’ profits for tax purposes and are not included in the taxable income of employees on whose behalf they are made. In general, the total (employee plus employer) contributions that receive this treatment are restricted to a maximum percentage of the employee’s earnings—usually, between about 15 and 20 percent.
  • The income earned by approved pension funds from their investments is exempt from tax. When payments of dividends and interest by companies are subject to withholding taxes, pension funds are often able to obtain a refund for those taxes.
  • Pensions received are normally subject to tax on the same basis as labor income. In some countries, however, special tax relief is provided for pension income (or for lump sums paid out by pension funds to individuals on their retirement).
Table 3.1.Tax Treatment of Personal Pensions in Selected OECD Countries
Deduction for contributionsTax on fund incomeTax on fund assetsTax on pension received
AustraliaCpF (10 percent)Pi
AustriaCpP
BelgiumClAP
CanadaCP
DenmarkCFpP
FinlandCpP
FranceP
GermanyClP
Greece1
IcelandP
IrelandClP
Italy1
JapanPi
LuxembourgClP
NetherlandsClP
New ZealandF (33 percent)
NorwayClP
PortugalClP
SpainClP
SwedenClF (10 percent)P
SwitzerlandClP
Turkey1
United KingdomClP
United StatesClP
Source: OECD, Taxation and Household Saving (Paris, 1994), Table 4.4.Note:—denotes zero.Legend:

AAnnual tax levied on assets of the fund
CIncome tax relief on contributions to the fund
ClIncome tax relief on contributions (subject to limits)
CpPartial income tax relief on contributions
FTax levied on income of the fund
FpTax levied on some elements of fund income
PPensions subject to tax as income
PiTax on the “income element” of pensions

Greece and Turkey had no provisions relating to personal pensions (as distinct from pensions provided through an employer). In Italy, personal pension plans were introduced only in 1993.

Source: OECD, Taxation and Household Saving (Paris, 1994), Table 4.4.Note:—denotes zero.Legend:

AAnnual tax levied on assets of the fund
CIncome tax relief on contributions to the fund
ClIncome tax relief on contributions (subject to limits)
CpPartial income tax relief on contributions
FTax levied on income of the fund
FpTax levied on some elements of fund income
PPensions subject to tax as income
PiTax on the “income element” of pensions

Greece and Turkey had no provisions relating to personal pensions (as distinct from pensions provided through an employer). In Italy, personal pension plans were introduced only in 1993.

There are, however, some exceptions to this pattern. In particular, in Australia, pension contributions are not deductible (although some rebate is provided), and the income of pension funds is subject to a low rate of tax. In New Zealand, contributions are not deductible and pensions are not taxed, but tax is levied on the income of pension funds. Sweden taxes pension funds at a low rate while allowing a full deduction for contributions and levying a full tax charge on pensions.

Implications of the Standard Tax Regime

The effect of the standard tax arrangements can be analyzed using a simple example. Suppose that an individual makes pension contributions of C in a particular year. At that time his marginal tax rate is t1, so the net cost (N) of the contribution to the investor is given by N = C · (1 -t1). In the following year, the fund earns income at the rate a, and this income is taxed at rate t2, so the amount remaining in the fund is C · [1 + a · (1 - t2)]. At the end of the year, the entire amount remaining in the fund is paid to the individual as a pension, which is subject to tax at rate t3. After tax, what the individual receives is therefore a pension of P, where P = C · [1 + a · (1 - t2)]·(l - t3).

What rate of return does the individual achieve on his initial contribution to the pension fund? The answer is given by the expression r = P/N - 1. Substituting the above equations into this expression gives

r = [1 + a·(1 - t2)]·(1 - t3)/(1- t1) - 1.

Three conclusions may be drawn immediately. First, if individuals pay tax on their pensions at the same rate at which they received tax relief on their contributions (so that t1 = t3), the expression collapses to r = a·(1 - t2). Hence, only the tax rate on the fund’s income is relevant: tax relief on contributions “gears up” each individual’s investment, but the tax on the pension cancels this out if it is levied at the same rate.

The second conclusion is that if, in addition, no tax is levied on the fund’s income (so that t2 = 0), then the rate of return to the individual (r) is simply the pretax rate of return on the fund’s investments (a). Overall, the effect of the tax regime in these circumstances is to remove any tax from the return to individual savings that are channeled through approved pension schemes.

Finally, if, in addition to allowing contributions to the fund to be tax deductible, neither the fund’s income nor the pension paid to the individual is taxed (so that t2 = t3 = 0), then the post-tax rate of return [(1 + a)/(1 - t1) - 1] would exceed the pretax rate of return a.

A very similar result to the second conclusion can be achieved by different means. For example, in Germany, most employer-provided pensions are unfunded. However, employers hold reserves against their future pension liabilities, and additions to these reserves are allowed as a deduction for corporate tax purposes. Contributions to the reserves are thus tax deductible for the employer (and are not taxed as income in the hands of the employee). Income earned on reserve assets is, in principle, taxed like any other income; however, as that income is added to pension reserves, the tax liability is cancelled out. When the cumulated income is paid out as a pension, the reserve is reduced and a tax charge on the employer would then arise, but this charge is exactly offset by a tax deduction for the employer’s pension payment to the retiree, which is treated just like a payment of wages. Thus, the overall effect is to levy no tax on income of the pension reserves held by the employer.

The standard tax regime described above clearly treats individuals’ savings through private pension funds much more favorably than most countries’ income tax systems treat such savings in the form of direct purchases of securities by individuals (or savings by them through typical investment funds designed to be reasonably neutral with respect to direct investment).12 This tax discrimination is likely to distort savings choices. The overall effect may or may not be to increase total savings by individuals, but it will certainly be to encourage them to save through approved pension funds (up to any limits that are imposed) at the expense of other forms of savings.

The favorable tax treatment may, perhaps, be justified on the basis that individuals tend to lack foresight and, without special encouragement, would save too little for their retirement years. More fundamentally, for those who prefer to base individual taxation on consumption rather than income, the standard treatment of private pension schemes in OECD countries provides a model of how all forms of savings should be taxed: from this perspective, it is the normal tax treatment of direct investment, rather than the treatment of pension schemes, that would be considered anomalous.

1

In the case of depreciable assets, adjustments must be made for depreciation allowances already given. In addition, some countries adjust the measured gain for inflation by increasing the acquisition cost according to the change in price between acquisition and sale.

2

This effect is particularly strong if there is a possibility that the accrued tax liability can be eliminated (for example, in some countries, when taxpayers die and their heirs inherit the assets).

3

See the paper on taxing innovative financial instruments in this volume.

4

See OECD, Taxation of Cross-Border Portfolio Investment: Mutual Funds and Possible Tax Distortions (Paris, 1999).

5

Mutual funds in Sweden, for example, are not legal entities: they must be constructed in these three parts, in a contractual form.

6

Such regulations typically cover, among other things, the capital structure of the funds; the types, location, and amount of investments that the fund may undertake; disclosure and auditing requirements; and distributions to shareholders or unit holders.

7

Some countries seek, however, to encourage the growth of investment funds and may therefore offer tax advantages. In Eastern Europe, for example, investment funds have been strongly encouraged by governments in the past 10 years or so as a vehicle for privatizing state-owned enterprises.

8

Eric M. Zolt, “Taxation of Investment Funds,” in Victor Thuronyi (ed.), Tax Law Design and Drafting, Vol. 2 (Washington: IMF, 1998), Chapter 22.

9

To achieve this result when such income is subject to withholding, payments of dividends and other income to the fund might be exempted from withholding taxes, or the fund might be allowed to reclaim the amounts withheld.

10

An issue that may arise here is whether the distribution to each shareholder is to be considered to take the form of the particular types of income that were actually received by the fund, or whether it is simply to be considered a dividend. In the former case, rules may be needed to determine which kinds of income are to be distributed first (when only a part of the fund’s income is distributed). These issues do not arise, of course, when all forms of income are treated in the same way and taxed at the same rate.

11

Private pension schemes may be either “defined contribution” in form (where pension benefits reflect each individual’s own contributions) or “defined benefit” (where pensions are generally determined by the individuals’ final salaries and may thus be higher or lower than they would have received based on their contribution histories).

12

However, some countries (including France and the United Kingdom) have special investment funds that are taxed in essentially the same way as pension funds—with tax relief on contributions to the fund, no tax charge on the fund’s income, and a tax charge on income taken out of the fund.

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