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Taxing Times

Earlier this month Atlas sent out the tax statements for the Atlas High Income Property Fund, and for a relatively straightforward fund with a simple tax structure (income is passed through to investors untaxed), I was surprised at the number of potential categories of income.

As this sparked a few questions in this week’s piece we are going to look at two relatively unique aspects of taxation in Australia and how some companies and in particular listed property trusts, can structure themselves to limit taxes paid.

 

Franking Credits
Franking credits (or dividend imputation credits) allow an investor to get a taxation credit at a personal level against the tax already paid at a corporate level on a dividend. Prior to the introduction of franking credits in 1987, the Australian Taxation Office (ATO) would tax both the company and then the investor on the same income, effectively doubling the tax paid on the same source of profit.  The franking credit regime was further sweetened in 2000, when changes were made that allowed investors on tax rates below the corporate tax rate of 30% to claim surplus credits as a refund. Prior to 2000 the ATO retained surplus franking credits.

The percentage of a distribution that is franked depends on the amount of tax paid by the company in Australia. For companies that earn all of their profits in Australia (such as Westpac for example) will be able to frank their dividends at 100%, whereas pathology company Sonic Healthcare can only provide frank their dividend at 20%. This is because most of Sonic Healthcare’s earnings are sourced from outside Australia. Some companies such as BHP build up large franking credit balances where they pay tax on the profits earned in Australia, but retain profits to fund capital expenditure to build and maintain mines, only returning a smaller amount to shareholders as dividends.  This franking account balance further accumulates when a company like BHP is also listed on a foreign exchange with investors that receive dividends without Australian franking credits.

Franking (or dividend imputation credits) are not a feature of global markets outside Australia and New Zealand, with only Canada, the UK and Korea retaining a partial imputation system.  This system encourages Australian companies to pay high dividends, whereas the tax system in the US encourages small dividends and share buy-backs as a means of returning profits to shareholders.

Why listed property trusts don’t pay franking credits

Listed property trusts such as GPT do not generate meaningful amounts of franking credits because they are structured to minimise the amount of tax they pay. Listed property trusts are a different corporate structure Act to industrial companies such as BHP under the Corporations and as a result they face different taxation treatment.

A company such as BHP is a separate legal entity that can hold assets in its own name. As a result, its shareholders do not own the company’s assets. The company’s board of directors can decide what dividend to declare (if any) on the company’s after-tax profits, after they have decided how much earnings to retain to fund expansion.

Alternatively, a trust such as GPT is a different legal entity where the trustee, holds the ‘legal’ title to their underlying shopping centre and office assets on ‘trust’ for the underlying investors, who hold the ‘beneficial’ title to those same assets.  Unitholders in GPT are thus the beneficial owners of the assets held and are entitled to the income derived from the use of those assets.

Consequently, a trust itself does not pay income tax on profits (rents less outgoings and interest costs), provided that over 90% of the profits of the trust have been fully distributed to the beneficiaries in the relevant financial year. The benefit of a trust structure is that it allows for the distribution of income to investors in a tax efficient manner, as unlike BHP (with its $13 billion-dollar franking credit account balance), a trust is a ‘transparent’ vehicle for Australian tax purposes as no tax is paid (in normal circumstances) by the trust Itself.

More Australian tax gymnastics: Stapled Securities

Continuing on with the theme of listed companies managing their tax, many listed property trusts are also “Stapled Securities”. Stapled Securities involve the binding or “stapling” together of two separate securities such as a share in a company and a unit in a trust which cannot be traded separately. This type of structure is used quite intensively in Australia by property trusts and infrastructure funds to shield their untaxed passive property income from the taxable profits earned by a management company.  Similar to franking credits this is a tax feature that is popular in Australia, but less so globally. Canada stopped the use in 2011 and the US in 1984. The rationale used by governments in North America for stopping stapled structures was to boost the tax take from corporations.

These corporate gymnastics is done for reasons of tax arbitrage. If stapling reduces the total tax bill paid on income generated by a particular business activity, shareholders benefit. Based on the time value of money rational investors would prefer a pre-tax stream of income and then pay tax at a later date on their personal tax rate, to payments that have already been taxed by the government from which the investor has to then apply for a refund.

 

In the above table if you own a unit of a GPT Group this is a stapled security comprises two separate assets for capital gains tax purposes; a General Property Trust unit and a GPT Management Holdings Limited share. These GPT securities are ‘stapled’ together and cannot be traded separately. The trust holds the portfolio of GPT office tower and shopping centre assets, while the related GPT Management Holdings company leases and operates these assets and manages any development opportunities.

In the case of GPT, because the General Property Trust is a “pass-through” trust for tax purposes, the income it receives is not subject to company tax, so long as paid out to unit holders. Stapled securities often make the rental payments by the Company for the use if the Trust’s assets high to minimise the Company’s taxable income (i.e. profits from funds management and developments). If GPT’s management and passive rent collecting entities were merged, GPT’s rental income stream would be taxed at 30%. However, in 2016 GPT paid a mere $14 million in tax on a pre-tax profit of $551 million.

Our Take

Australian investors face a more complex tax environment than is present elsewhere in the developed world.  Whilst as the fund manager it would be nice to provide franking credits on the quarterly distributions paid by the Atlas High Income Property Fund, it is certainly simpler to be able to stream the pre-tax income from both property trust distributions and call options sold to the underlying investors without taking out any tax.  Additionally, investors get the use of this pre-tax cash today, rather having to wait until after they have submitted their tax returns to get a cheque from the government.

Breaking Up

In late September Commonwealth Bank announced both the sale of its life insurance business and that they were looking at floating the bank’s funds management business Colonial First State GAM on the share market. Based on the strong performance of recent spin-offs investors are likely to have a close look at any initial public offering (IPO) of Colonial First State GAM. In this week’s piece we are going to look at the rationale behind spinning off assets to form a new company, and we will review the performance of recent company spin-offs from large companies such as BHP, Orica and Amcor.

What is a spin-off?

A spin-off occurs when a listed company parent separates a portion of their existing company into a second listed company and allots shares in the new company to existing shareholders based on their holdings in the parent company. In some situations, the parent company will also simultaneously issue new shares to new investors to broaden the shareholder base and allow the new spun-off company to begin life with a healthy financial position. In a spin-off, the newly created company takes a portion of the parent company’s assets, employees, intellectual property and debt. For example, in 2012 Woolworths’ spun-off 69 Australian and New Zealand shopping centres into a $1.4-billion listed property trust called SCA Property. Woolworths shareholders then received one unit in SCA Property Group for every five Woolworths shares held.

The ignored child gets a new lease on life

The most common reason cited for a company demerging or “spinning off” a division into a separately listed vehicle is that the smaller new firm will now be run by management totally focused on it. The theory goes that as a result of this increased love and focus and not having to compete with other larger divisions for management attention and capital, the demerged division begins to prosper.

Recent examples of this can be seen in BHP’s 2015 spin-off of South32, Woolworth’s spin-off in 2012 of a portfolio of shopping centers into SCA Property Group, and Amcor’s demerger of its Australian packaging business Orora. These three spin-offs have proved to be very successful with South32 giving shareholders a total return (share price gain plus distributions) of +35% vs BHP’s gain of +16%. Similarly, SCA Property has returned +103% since it was spun out of Woolworths in 2012, against a total return to Woolworths shareholders of 8%. Since listing, Orora (which was viewed by the market as low growth compared to the dynamic world of global packaging) has returned to investors an impressive +198%: a healthy premium compared to Amcor’s still strong +68%.

From meeting with the new management teams of following their demergers, it was clear to me that they exhibited a great deal of pride in the results of their own smaller companies. Furthermore, as stand-alone companies they were able to make acquisitions to grow their businesses or buy back their stock on market. Such moves probably would not have been approved if they were still competing with Woolworths and BHP’s much larger Australian grocery and global mining business for capital.

Sum of parts worth more than the whole

In many cases the value of the two separate businesses is greater than the old combined business, even after accounting for additional costs such as a separate ASX listing and board. This is a benefit for shareholders of the parent company, as the more attractive “core” business is now re-rated upwards by the market and valued on a higher multiple. The sum of the two parts becomes greater than the original whole.

Looking at Commonwealth Bank and its fund manager Colonial First State GAM, the bank as a whole is currently being valued at 13.6 times the profits that it generated in 2017. Here the market is valuing the funds management earnings as if they were bank earnings, despite their higher margin. However, the market values stand-alone fund managers such as BT Investment Management (trading on 22 times earnings) and Janus-Henderson (trading on 15 times earnings) on higher multiples, reflecting the higher profit margins and low capital requirements for fund managers.  Using a mid-point of these valuations, Colonial First State GAM would be valued at $4.5 billion, an uplift from the $3 billion that their profits from 2017 are currently being valued as part of Commonwealth Bank.

Spinning off a management headache?

Whilst the above more recent spin-offs have all outperformed their parents, it would be wrong to see that all spin-offs from large companies make great investments. In some situations, a spin-off can be prompted by management foreseeing that a division of their business is likely to face issues in the future, that may spill over and impact their core business.

Arrium

BHP has previously spun off divisions in the past that they deemed less desirable. In 2000 BHP demerged their long steel division (Arrium née OneSteel), and in 2002 their flat steel division BlueScope. This was motivated by the view (which proved to be correct) that greater returns could be made from digging ore out of the ground and directly shipping it to China, compared to manufacturing commodity steel in Australia. Furthermore, BHP was able to “spin-off” the industrial relations headaches that are a feature of the heavily unionised steel manufacturing sector.

From listing up until 2008, BHP was criticised for letting go of their steel manufacturing businesses. It might face similar opposition to spinning-off South32, however often the genius behind this course of action does not become apparent for several years. Arrium was delisted in 2016 after a well-publicised insolvency. Whilst BlueScope has performed well over the last few years it still remains 74% below the issue price courtesy of dilutive capital raisings in 2011, and in 2009 required  to keep the wolves from breaking down the steelmaker’s doors.

PaperlinX

In 2000 Amcor spun off PaperlinX (now called Spicers) their stodgy printing papers division. However by 2003, Amcor was being criticised in the press after PaperlinX’s share price had risen from $3.17 at listing to $5.40. Concurrently, the PaperlinX was expanding globally after paying $1 billion to buy Europe’s largest fine paper merchant and became the world’s largest paper merchant.

The following decade was particularly unkind to PaperlinX investors as the paper business consistently shrank globally with the growth of electronic communication and document transfer technologies. Currently the company’s share price sits at 3.2 cents and one could make the case that Amcor’s management team, in spinning off a low-growth declining business, removed a division that would have consumed both shareholder capital and management attention. These negative factors ultimately would have arrested Amcor’s share price growth over the past ten years had they held on to their paper business.

Our Take

Whilst the above suggests that spin-offs can unlock hidden value for shareholders, there are downsides. Two separately listed companies result in the additional costs of maintaining two separate listings on the ASX such as two separate boards and management teams. We are likely to have a close look at any initial public offering (IPO) of Colonial First State GAM, especially on price weakness if a number of shareholders sell their entitlements just after listing. Unlike steel making or printing paper, funds management in Australia is a robust business and Colonial is a significant player with a powerful brand.

 

Monthly Newsletter September 2017

  • The S&P/ASX 200 A-REIT index posted a small 0.5% gain over the month of September, slightly ahead of the wider ASX200 which was unchanged, as commodity prices and the AUD were weaker.
  • The Fund gained had a solid month gaining +1.6%, outperforming the index as our strategy of preferring recurring rent collectors over developers was successful.
  • Additionally, the bulk of the options sold last quarter ultimately expired worthless at the end of September. This strategy added value, as it converted uncertain future gains (which ultimately did not occur) into certain income.

Go to  Monthly Newsletters for a more detailed discussion of the listed property market in September and the fund’s strategy

Why Institutional Investors avoid Residential Property

One of the misconceptions investors have is that the $123 billion dollar listed property index is primarily exposed to residential real estate. In fact, residential property comprises a small part of the index, with only 4% of the value of the index coming from trusts exposed to residential property. Further, this exposure primarily comes from developers selling finished apartments or home and land packages, not from actually owning housing real estate that is rented out.


 

 

 

 

 

 

 

Last month Mirvac announced they will be bringing Australia’s first major build-to-rent apartment development to market in a move that could potentially address housing affordability issues. In this week’s piece, we will look at why institutional investors have shied away from investing in residential developments, unlike in the US and the UK where this sector is a growing part of the Listed Property indices.

Residential property has attracted little interest from institutional investors as it is an area where retail investors have an investment edge. In the below chart, the grey bars show that exposure to residential real estate comprised 4% of the S&P/ASX 200 A-REIT index in September 2017, or $4.7 billion. This is dwarfed by the value of the discretionary retail ($59 billion), industrial ($25 billion), and office ($22 billion) real estate assets listed on the ASX. In comparison in the US, the residential sector accounts for around 25% of the $US2 trillion in institutional property investment, placing the sector just behind office.

 

Whilst the smaller transaction size of buying a two-bedroom apartment is attractive to retail investors (compared to an industrial warehouse or an office tower which may be valued in the tens to hundreds of millions), there are three structural reasons why retail investors dominate residential property investment.

Capital gains tax “crowds out” corporate investors

Although the domestic rental sector exists  in LPTs in the US and Europe, in Australia the tax-free status of capital gains for owner-occupiers selling their primary dwelling has had the effect of bidding up the purchase prices of residential real estate. For example, when a company generates a $500,000 capital gain from selling an apartment, they would approximately be liable to pay approximately $108,000 in capital gains tax, whereas the owner-occupier pays no tax on the capital gains made on a similar investment. This discrepancy in the tax treatment allows the owner-occupier to pay more for the same real estate assets, and thus has contributed to the low yields mentioned below.

Negative gearing

Similarly, individual retail investors benefit from the generous tax treatment in Australia that allows them to negatively gear properties. There are three types of gearing depending on the income earned from an investment property: positive, neutral and negative. A property is negatively geared when the rental return is less than the interest repayments and outgoings, placing the investor in a position of losing income on an annual basis. However, under Australian tax law, investors can offset the cost of owning the property (including the interest paid on a loan) against other assessable income. This incentivises individual high-taxpaying investors to buy a property at a price where it is cash flow negative in order to maximise their near-term tax returns and bet on capital gains. Whilst companies and property trusts can also access taxation benefits from borrowing to buy real estate assets, a rich doctor on a top marginal tax rate of 47% has a stronger incentive to raise their paddle at an auction.

Yields on residential property too low

At current prices, the yield that residential property offers are not very attractive for listed vehicles. At the moment, the ASX 200 A-REIT index offers an average yield of 5%. This compares very favourably with the yields from investing in residential property. SQM Research reported recently that the implied gross rental yield for a 3-bedroom house in Sydney of 3% with a 2-bedroom apartment yielding  4% in July 2017. After borrowing costs, council rates, insurance, and maintenance capex, the net yield is estimated to average around 1%. With listed property investors focused on yield receiving on average ~ 5% from property trusts investing in office towers and shopping centres, such a low yield would only be accepted if it was offset by high and certain capital gains.
Mirvac’s new “build to rent” fund

In August Mirvac announced their intention to develop a build to rent fund with assets based initially in Sydney. This fund is likely to be targeted at institutional investor, rather than retail investors, who generally already have a significant exposure to residential real estate. This looks to be an opportunity for Mirvac to access both development profit (profit margin +25% in FY17) and also an ongoing funds management fee on the completed assets. However, we would be surprised to see much of Mirvac’s own capital invested in the fund. In 2017 Mirvac generated a 18% return on the $1.8 billion of capital invested in its residential development business (ROIC). Mathematically it is hard to see how investing in their own finished product will generate returns higher than the trust’s average cost of capital.

Our take

Whilst the residential sector is a large part of the overall stock of Australian real estate assets, without significant taxation concessions it is hard to see this sector garnering much interest from institutional investors, especially for income-focused investors such as Atlas Funds Management. The Atlas High Income Property Fund’s strategy of populating the portfolio with higher quality domestic rent collectors combined with a derivative overlay strategy to enhance income should continue outperform in a property market that is trading sideways. We see that the majority of returns over the next 12 months will come from distributions and income from writing call options over existing holdings, rather than spectacular capital gains.