The
New Tax Laws Have Major
Allocation Effects On International Portfolios
By Vivian
Lewis, editor
Global Investing
The
new tax laws have major allocation effects on international portfolios
held by U.S. citizens and U.S. taxpayers. One unintended consequence
will be to favor individual investors who make their own decisions.
They will be better off than mutual fund buyers, including owners
of exchange-traded funds, closed-end funds, and open-end funds
offering exposure to the world. Non-U.S. readers are asked to
indulge me in this bit of insularity, but they should be aware
that the impact of future fund flows as U.S. investors shift
assets will also affect their holdings.
Cosmopolitan-minded
U.S. investors will be better off in American Depositary Receipts
than in stocks sold only on foreign markets. That applies particularly
to foreign countries which do not have a comprehensive tax treaty
with the U.S., among them Hong Kong, Malaysia, Singapore, Taiwan,
most Caribbean centers, Gibraltar, the Channel Islands, and other
"havens" for offshore funds.
That means fund managers
and institutions, which often buy directly in local markets,
will have to convert those shares where this is possible into
ADRs (for a fee). But the new tax law both over dividends and
capital gains will penalize other foreign stocks they hold which
do not have ADRs. That means over time they will be sold. Moreover,
the domicile of many offshore funds means their U.S. owners will
not benefit from the new lower tax rates: beware in taxable accounts
of funds from The Bahamas, Bermuda, British Virgin Islands, Cayman,
Guernsey, Hong Kong, Isle of Man, Jersey, Luxembourg, Panama,
and the Dutch Antilles.
We will interview James
Squire of Baring's, manager of the Asia Pacific Fund hoping
to find a place to put our India money from the dissolution of
India Growth Fund. Squire was quoted extensively by Sarah
McBride of The Wall Street Journal (June 20) on the potential
negative impact of the new U.S. tax laws on Asian high-dividend
stocks. Yet Mr. Squire's fund is heavily exposed to precisely
those countries where the new lower tax will not apply: Hong
Kong (30.6%, with unlisted stocks like Hang Seng Bank, Hong Kong
& China Gas, Hutchison Whampoa, and Cheung Kong alone
accounting for 1/8 the total portfolio), Taiwan (15.6%); Singapore
(11.4%), and Malaysia (6.7%).
That means investors
in his fund will not be rewarded with dividends and capital gains
at the new 15% rate.
We are dropping our
own coverage of CHEUY-OTC since its high yield is no longer competitive
for U.S. taxpayers.
The tax on dividends
and capital gains for ADRs will fall to 15% in most cases, although
there is an even lower 5% rate for the poor. The tax on investments
not meeting the new rules will be 20% on capital gains and 35%
on payouts.
The 2003 tax law will
cause a cosmic shift in the prices of shares. Shares where there
are listed ADRs (on the Big Board, the ASE, Nasdaq, and Nasdaq
Small Cap) or from double taxation-treaty countries, will command
a premium over shares from non-tax treaty countries purchased
directly, or via inactive over-the-counter ADRs. The latter will
not be eligible for the dividend tax break. This will affect
every single investor in ADRs, because the demand for ADRs will
go up relative to locally traded stocks. Since the underlying
shares behind ADRs also trade in foreign markets, and since there
is movement and fungibility between the two, the shares of all
ADR-able stocks on foreign markets will also be in greater demand,
and will also go up against local-only stocks.
The exceptions to this
fungibility are countries, which operate exchange controls, which
limit capital inflows or outflows. Many of the Asian Tiger markets
limit capital flows into their stocks with a ceiling on foreign
investment. This will hinder performance even in those Asian
countries, which do have a double-taxation treaty with the U.S.
The exceptions also
are countries or companies, which keep foreign investors from
buying more than a fixed percentage of their outstanding shares.
In our portfolio, this will affect The Chile Fund and
Ryannair, although most people are not aware that Chile
and Ireland are not exactly open markets.
From countries which
do not have a double-taxation treaty with the U.S., mostly Asian
countries and so-called tax havens, only fully listed companies
will be eligible for the lower tax rate. That means a Panamanian
company like Banco Latino Americano de Exportaciones,
which is on the Big Board, is preferable to almost any other
Panama stock. A company like Arch Capital, listed on Nasdaq,
is more attractive than other Bermuda firms without a U.S. listing.
Most islands, except for Barbados and Jamaica do not have tax
treaties with the U.S. The European countries without such treaties
are Cyrus and Gibraltar. In addition to islands, beware of stocks
from Costa Rica or Belize.
The new tax rules also
favor the owners of stock over the owners of bonds. The owners
of any stock traded in the U.S., including all ADRs and directly
listed foreign stocks, will have to pay taxes on dividends received
at only the 15% level. If held more than a year, these investments
also will pay capital gains taxes at a mere 15%. (There are special,
lower rates of 5% on dividends and capital gains for people who
are very poor, but our readership, and indeed the American investment
community, does not include many people qualified for the lower
rate.)
Note that many dividends
on convertible stocks and preferred stocks are in fact paid out
of trusts under U.S. law, and therefore are taxed as bond payments,
not as stocks. This we learned from our convertibles expert,
F. Barry Nelson of Advent Capital Management of New York.
The ADR advantage does
not apply to foreign company stock, which has been purchased
in a foreign market, even if a U.S. brokerage was used. I will
not attempt to discuss the sunset clauses, because I do not think
we will ever see Congress clawing back the breaks they gave investors.
The payout from bond
funds, even if it is called a dividend, in fact counts as interest
and is taxed at 35%; gains on such funds are taxed at 28%.
Foreign REITs which
trade only occasionally on the over-the-counter market will be
taxed at the lower rate, as stocks, I think, if they come from
a double-taxation treaty country, like Holland. However, because
it is still subject to withholding tax in Holland, Wereldhave
(WRDEF-OTC) cannot be held in a tax-advantaged account (Keogh,
IRA, etc.), because the foreign withholding tax is now greater
than the U.S. taxes that would be payable. Foreign REITS, unlike
U.S. REITs, do not belong in a tax-advantaged account. (U.S.
REIT payouts are not subject to withholding and count as dividends
under the new law.)
Bonds are out of favor
with the 2003 tax law, and given the level of U.S. interest rates,
they are also out of favor with investors in any case. Yet, Yankee
bonds offer an attractive option. If you buy newly-issued foreign
bonds listed in the U.S. and hold them to maturity, you can avoid
capital gains tax (because you buy and sell at par). And moreover,
you will at least earn a higher rate of interest on which to
pay unreduced 35% interest taxes than you would with U.S. bonds
of the same degree of riskiness. Foreign bonds pay like junk
bonds but are not junk.
Individual Yankee bonds
can be purchased in amounts of about $5000, although there are
moves afoot to lower the minimum investment for some corporate
bonds, which I hope will spread to the Yankee part of the universe.
This means our readers can create their own bond portfolios and
gain a tax advantage. Unlike bond funds, which are constantly
reinvesting the take from bonds, and trading them, individual
owners holding bonds to maturity will not be subject to capital
gains tax, only to interest taxes. Moreover, buyers of bonds
can determine in advance what their bond income will be.
On the other hand,
a managed bond fund portfolio is full of individual bonds that
are always maturing and being traded in and out, so you can never
be certain that your investment will hold its worth.
Editor's Note: Looking
for a way to profit from the tremendous investment opportunities
in international markets? Then consider a subscription to the
highly-respected newsletter, Global Investing edited by
Vivian Lewis.
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portfolio of stocks and bonds from around the world without leaving
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