During the market’s boom
years, trustees only had to worry about minimising capital gains tax
liabilities and maximising franking credits to assure a good after-tax performance
for their fund. But with the concept of ‘gains’ long gone, and dividends on
their way down too, harvesting losses is suddenly the name of the game. This article,
by DREW VAUGHAN of administration consultancy Dymonds Foulds

Vaughan, is intended to increase discussion about
issues surrounding the inclusion of future income tax benefits (FITBs) in unit
price calculations.

FITBs have come to the fore In the period since June 2008 investment markets have fallen
substantially in value. These falls have affected investment markets across all
“growth” asset classes. The extent of the fall in value of many investment
assets held by super funds is now so great that the current market value of
those assets is less than the original “cost”. In other words, funds are
carrying forward significant “unrealised losses” on the value of their investments
and these losses are being reflected in financial statements as well as through
the regular unit prices of the fund’s investment options.

When funds carry
forward either actual or net unrealised losses, these losses may also result in
a net unrealised tax loss which may be able to be carried forward for offset
against future capital gains tax liabilities or future unrealised gains. A net
unrealised tax loss that is able to be carried forward to offset against a
future capital gains tax liability is described as a Future Income Tax Benefit (FITB).
FITBs represent an asset, albeit theoretical, of the fund. For funds that
calculate unit prices on a daily, weekly or monthly basis, FITBs need to be
included as part of the net asset valuation from which the unit prices are

However, because of uncertainty about being able to access the FITB at
a time in the future; the difficulty in determining a true value for the FITB;
as well as the irregularity with which FITBs can occur; there has been considerable
debate in the superannuation industry about how FITBs should be valued and
included in unit price calculations. There are three fundamental issues that
need to be considered in relation to FITB’s.

These are: • Identifying if an
FITB has arisen in your fund; • Having identified an FITB, how to determine its
value; and • How to allocate, equitably between members, any value ascribed to the
FITB. Identif ying if an FITB has
arisen in your fun d An FITB can arise when the
current market value of an asset is less than the original cost of that asset.
This loss is “unrealised”, for both accounting and tax purposes, until such
time as the asset is sold or otherwise realised.

Tax is not payable in the
current period on any unrealised gain and, similarly, no tax “offset” arises in
the current period from an unrealised loss. We recommend that super funds carefully
examine the most recent valuation of their investment portfolios to identify
those assets where the current market value is less than the original cost; and
separately identify those assets where the current market value is greater than

This can be a complex process because both types of circumstance may
exist within the transaction history of any asset in the portfolio. Having
identified these investments they should also be classified by investment class
and asset type. There are also other types of taxable loss that a fund can
incur and these can create a result which is similar to an FITB. Examples of these
types of loss are with assets held as trading stock or on income account (where
the current value of the asset is less than its original cost); or where tax
credits arising from imputation income may exceed any liability for tax in
relation to that income (such as with some dividends paid in


further prescient example is with the significant losses that many funds have
recently suffered on their currency hedge positions. Up to 30 June 2008 these
losses need to be classified as either “Australian sourced” or “foreign sourced”
and this classification will dictate the types of income that they may be able
to be offset against. For losses and income derived since 1 July 2008, these
rules have been relaxed.

Therefore, the components of any FITB must be
recognised separately and correctly allocated against matching types of tax
liability, on both a current period realised basis and an unrealised basis. In
turn, this means that FITBs should not be valued purely based on their sum
total, unless it is certain that in the future, sufficient income can be derived
to offset against each constituent part of any FITB. Where your fund uses a
master custodian, they should be able to provide this information (at least) as
at the end of the previous calendar quarter.

Determining the value of an FITB FITBs generally arise in respect of taxable
assets held on a capital basis and therefore they have a “face” value that can
be determined as: (CMV – TAOC) x TR = FITB Where: CMV = Current Market Value of the asset TAOC
= Tax-base Adjusted Original Cost of the asset TR = Tax Rate applicable FITB =
the value by which the fund’s future tax liability may be reduced, if the
relevant assets are realised at the current market value. The Tax Rate
applicable to the asset will vary according to the tax treatment applied to
that asset.

For example: if an investment asset is treated as a capital gains
taxable asset and it is realised within a period of less than 12 months from
the date of acquisition of the asset, it will be taxed at rate of 15 per cent
of the gain. However, if the asset is treated as a capital gains taxable asset
and it is realised after 12 months from the date of its acquisition, only
two-thirds of the gain will be subject to tax at the nominal tax rate (15 per
cent). This means that the equivalent Tax Rate applicable for such assets
reduces to 10 per cent.

The face value of each type of FITB is also influenced
by two factors: • Certainty (or otherwise) of being able to utilise the FITB in
the future; and • Determining how far into the future that utilisation of the
FITB might occur. Certainty of utilisation of an FITB in the future is a
function of: • whether or not the entity will remain a going concern for a
sufficient time into the future to be able to utilise the FITB; and • whether
or not the entity will incur, in the future, sufficient matchingtype tax
liabilities to offset against the FITB and thus reduce the fund’s net tax position.

“Going concern basis” means, in the preparation of a financial report of the fund,
that the entity is viewed as a going concern and expected to: • be able to pay
its debts as and when they fall due; and • continue in operation without any
intention or necessity to liquidate or otherwise wind up its operations. If a
fund cannot be defined as a going concern or there is uncertainty about its
ability to meet that concept in the future, then the value of any intangible asset
(such as an FITB) will be called into doubt.

Such doubt would cause the value
of the intangible asset to be written down and thus also lead to a reduction in
the fund’s net asset value. Most super funds are likely to be virtually certain
that they can meet the going concern test (both today and in the future).
Trustees should however note that whilst the fund as a whole may be able to be
viewed on a going concern basis, there may be potential to see that individual
investment options may not always be able to satisfy the same test.

This is
because members are usually able to switch between investment options at any
time and thus the situation may develop where members seek to switch their
equity entitlements out of one option and those entitlements cannot be realised
in cash from the existing assets (because they are illiquid or intangible). Trustees
should also consider if their fund will be able to earn sufficient income in
the future to offset against any current FITB; and when that is likely to occur.

Of course such a consideration cannot be exact and to that extent it must use a
mix of skill, experience and judgment. In our view trustees should consider (at
least) the following for their fund: • what are the demographic profiles of the
fund’s member base and could that impact cash flow in the future; • what
proportion of cash flow is from a “regulated” member source, versus those from
member rollovers or exits from the fund; • what is the typical time horizon for
assets that comprise the fund’s investment strategy; • what are the historical
and future growth rates used for the funds’ investment strategy; and • how long
might the current economic and investment cycle persist? Depending on the
outcome of these considerations, it may be appropriate that the sum total of
the fund’s FITB be “discounted”.

The size of any discounting factor would need
to assume that today’s value of an FITB will reduce in the future due to the
effects of inflation and positive investment returns (if it cannot be utilised
until a future point in time). A further factor which may affect the value of a
fund’s FITB arises where the fund comprises of both superannuation and a
pension section. Under Section 295F of the Income Tax Assessment Act (1997), a
form of proportional averaging (based on the relative assets supporting the
accumulation and pension sections of a fund) can be used to reduce the taxable income
(and deductible expenses) of the fund.

Given the significant rate of growth of
most funds’ pension sections, this may also effect how the future value of a
current period FITB should be determined. In summary, it is not a simple case
to value an FITB. In many instances deriving the value of an FITB based on the types
of assets, their classification and income types will only be the first step. Trustees
then need to consider future utilisation issues; if the FITBs face value should
be discounted and if so using what rate; as well as the impact of tax legislation
and Australian Accounting Standards Board requirements before reaching a
judgment as to how the FITB should be included in the fund’s unit price (or
crediting rate) calculations and it’s financial statements.

Equitable allocation of the value of an FITB We discussed earlier that FITBs arise in
respect of certain types of assets; and that the future offset of an FITB must
be against taxable capital gains for equivalent asset types. These two factors mean
that trustees must ensure that the value of an FITB can be correctly determined
and fairly allocated across their fund’s investment options related to the type
of assets that generated the original FITB. The process for allocation of an FITB
is not straightforward.

At its simplest, the allocation today of an FITB that
arose from transactions in previous periods may mean that we will be allocating
to members in different proportions than would have been the case if the
allocation had been undertaken at the same time as the FITB was originally
generated. We know that it will not be possible to allocate FITBs as soon as
they occur, because the information that will inform us about the FITB, most
likely, will not be available from the custodian for some weeks or months after
the end of the month or quarter in which the FITB was generated.

This is a
problem all funds face. What many funds do in such cases is that they determine
a breakdown of the FITB by asset and tax type and then allocate the amounts
within the asset classes for each investment option. Whilst this can’t allow
perfect alignment between the generation of the FITB asset and member
entitlements it will, provided that the allocation takes place on a regular and
ongoing basis, mean that any allocation difference should be relatively small. The
availability of this information dictates the timing that should apply to
identifying the existence of an FITB and then the earliest time from which any
determined value for the FITB should be allocated and included in unit prices.

unit pricing models available in the Australian marketplace allow provisions
for tax liabilities (arising from net realised and unrealised gains) to be
provided in unit price calculations. When an FITB exists, the fund will need to
establish a provision for a tax “asset” in the unit price calculation to reflect
the existence of the FITB. Other issues funds face with their tax information
include limitations with the timing and accuracy of intra-year dividend and
income distribution data received for the funds’ investments; revisions of tax
liability (or FITB) positions with subsequent transactions as more efficient
and accurate tax lot allocation models are used by custodians and funds; and
adjustments for changes in deductible operating expenses and changes in
proportional allocations of income as fund pension sections grow.

should also carefully consider the methodologies that the fund custodian is
using to determine and allocate FITBs to ensure that they are consistent with
any policies that the fund uses. A further factor that trustees should consider
is the potential for “negative gearing” to occur when, for unit pricing, an
FITB forms a significant part of the asset base of a specific investment
option. In such cases, if the FITB forms a material part of the investment
option’s net asset value this will mean that an amount less than the total
equity in the investment option will be invested in the underlying assets.

result of which is that the return achieved by the investment option will be
less than that of the underlying assets (because only part of the option’s
assets are invested in the underlying assets). The issue of negative gearing
positions needs to be carefully considered and disclosed to members because it
may affect the return achieved from investing in that option. Again, the issues
of allocation arising from an FITB are complex and time-sensitive. They may
also impact directly on members and therefore require correct disclosure.

Trustees should seek professional advice, specific to their fund, and will need
to exercise judgment to ensure that members will be treated equitably with the
allocation of any FITB that the fund may record as an asset. Conclusions The purpose of this article is to increase
discussion about some of the issues surrounding FITBs and unit pricing. We take
the view that trustees need to be fully informed about these issues in order to
be in the best position to make considered and appropriate policy decisions for
their fund and members.

Our experience is that most funds have not had to
actively consider FITB issues in the past and they therefore have not developed
the necessary formal policies covering the determination, valuation and
allocation of FITBs. Such policies need to consider this issue from the
perspective of required disclosures to members, inclusion and reporting in financial
statements as well as ensuring equitable treatment for members.


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