Funds push for local execution
Australian superannuation funds are asking banks to offer 24 hour execution from Australia, following concerns that currency hedging losses from trades that are executed overseas may cause funds to lose foreign tax refund claims.
The issue is by no means new - the law in question has been in place since December 2014 with a further clarification issued in 2016 – but it has emerged as a hot topic in conversations between superfunds and investment banks in recent weeks.
The crux of the matter is the Australian Taxation Office’s determination of the tax source of FX hedging gains and losses, as illustrated in PCG 2016/6.
According to the ATO, FX hedging gains and losses are sourced where communication of the acceptance of each particular forward contract - not the International Swaps and Derivatives Association (ISDA) Master agreement - is received. In the event that trades are executed through overseas trading desks, which is often the case, the gains and losses are considered foreign-sourced, even if the trade itself was originated in Australia.
That’s a problem when funds incur large currency hedging losses. The “foreign sourced” characterisation impacts the amount of foreign income tax offsets (‘FITOs’) that a superannuation fund can claim back. FITOs are credits for foreign withholding tax deducted from foreign dividends (and sometimes other foreign income), that reduce the amount of tax paid by superannuation funds or increase the tax refunds they receive from the ATO. The FITO claim is capped at the fund’s tax rate applied to net dividends and other foreign income, which is 15%, and FITOs that exceed this cap cannot be carried forward.
“In years when funds make large currency hedging losses, the losses can reduce or even wipe out other (gross) foreign income, so that the net foreign income cap is low or zero. These tax offsets are effectively lost to the fund,” Raewyn Williams, Parametric's former Head of Research, Australia & New Zealand* told Fund Business. She said the value of FITOs annually is around 20-30bps of a global equity portfolio.
“You’re talking $2-3million a year on a billion dollar global equity portfolio. This isn’t small change and it’s worth protecting,” Williams said, adding that it creates an incentive to locate FX trading desks onshore. “If the acceptance of the forward contract is received locally, FX hedging gains and losses are Australian-sourced, and not relevant to the calculation of the FITO cap,” she said.
Indeed, Fund Business is aware of at least one superfund that is refusing to deal with banks that cannot ensure all trades are executed locally. However, that approach doesn’t work for all funds, not least because at present, the infrastructure and liquidity is simply not there.
While liquidity for developed market pairs is typically more than adequate, once you move outside of G10 currencies, spreads start to widen significantly.
“From an FX swap point of view, with the exception of perhaps the Scandinavian currencies you can do any G10 pair in Australia without any concern, but there are other pairs that you just cannot do without having an impact,” Andrew Fielding, Manager Dealing and Execution at AustralianSuper in London told Fund Business.
AustralianSuper has been running a London dealing desk since the latter half of 2019. While managing the FITO implications has been a major consideration from the get-go, tax is one of many aspects that determines where trades are executed and best execution comes first, Fielding said.
“Best execution comes first at all times. Outside of that, our approach is that we control what we can to reduce the risk of losing the offset, for example by managing the timing and location of FX rolls. Like most superfunds, Aussie dollars make up the largest part of our roll book, so unless there is a really good reason to trade from the UK, we will try to roll all of our Aussie, Asian and Kiwi books in Australia. You are talking 90-95% of rolls, which goes a long way,” Fielding said.
Fielding said that with respect to other trades - such as rebalancing orders or active FX orders - timing of order receipt is outside of the team’s immediate control. However, best execution remains the first priority.
“You have to be cognisant of the market levels, the size of the trade, expected transaction costs, news/data releases, appropriate liquidity periods etc, as well as any direction from the relevant portfolio manager. This all leads to a better result for our members and the market place. As a trading desk, even though we trade 24 hours a day across all asset classes, some of our orders are not received on this desk until 8 or 9am UK time. If we could only trade with a bank’s desk out of Australia, those trades would have to sit on our order book for half a day or more, waiting for those domestic desks to reopen the next day. By that point, it’s likely the markets will have moved, the exposure calculations will need to be re-run etc, all this and more needs to be factor in,” he said.
While there will certainly be a role for offshore desks, the growing focus on tax will likely pose a challenge for global banks keen to attract flow. While some have deemed the ATO’s tax source interpretation “controversial” and have suggested that considering the location of the ISDA Master Agreement as the source would be a more efficient way of managing the issue, the ATO itself has indicated it will not be changing its interpretation – which indeed, has been amended a few times already.
“While the source of income in this context will always depend on the particular facts and circumstances, the place where each foreign currency hedging contract is formed, is the most important element in determining the source of any resulting foreign currency hedging gain. A contract is formed where the communication of the acceptance is received. This is a matter of contract law and further explained in TR 2014/7 - Income tax: foreign currency hedging transactions - applying the foreign income tax offset limit under section 770-75 of the Income Tax Assessment Act 1997,” a spokesperson for the ATO told Fund Business.
“It has been suggested that the appropriate contract to be looking at in these circumstances is the Master ISDA. However, in determining what actually gives rise to the income, it is not the Master ISDA itself (which sets the terms and conditions upon which each individual contract is executed), but each contract entered into under the Master ISDA,” the spokesperson said.
That leaves the ball in the court of the banks. “If the banks value the flow, and they value the fact that others may join, we’ll probably see a few more night desks emerge in Australia,” Fielding said.
The topic of FX execution will be discussed in more detail at the upcoming 4th Investment Implementation Summit. For more information and how to register please click here.
*Williams left Parametric on February 26, 2021 and will be taking a sabbatical.