Warranting a closer look – Part 2

Last month we took a look at endowment and instalment warrants and compared the features of each. We found that they have some major differences that in turn can make them attractive to different types of investors.

Now we will consider the various investor situations to help you identify when to recommend an endowment, or when an instalment may be more appropriate.

Endowment warrants

Investment for minors

Most ‘unearned income’ of a child (under 18) is generally subject to a higher tax rate of up to 66 per cent. If dividend yields are high and expected to grow in the future, this can make holding shares in the name of a child unattractive from a tax point of view.

Endowment warrants are ideal investments for parents or grandparents wishing to gift an amount to their children or grandchildren, because they can provide for long-term capital growth in a portfolio of Australian shares or individual shares.

As endowment warrants do not pay an income over the 10-year period, the child will not be affected by the special tax rate.

If, for example, the warrant is purchased when the child is eight years old, when he or she turns 18 there is the option to:

exercise the warrants and receive the shares. As the child is no longer considered a minor, the dividend income they start receiving will be taxed at adult tax rates. Many will be receiving low income for several years and therefore subject to little or no tax on dividends; or

sell the warrants and use the funds to further their career and education. Capital gains tax (CGT) impact should be minimal.

Non-residents

Subject to international double tax agreements and any securities law restrictions, non-residents who invest in Australian shares and managed funds are subject to withholding tax on certain components of their distributions.

As no income is paid throughout the term of the endowment warrant, a non-resident investor is not subject to any withholding tax. Furthermore, there should be no CGT payable if they sell the investment as a non-resident under the current tax law.

Self-managed super funds

Endowment warrants may be suitable for self-managed super funds (SMSFs) because they:

provide one of the few forms of leverage available to super funds into the equity market;

suit the long-term nature of superannuation funds; and

require little administration, which in turn means no costly accounting during the term.

Long-term investors

Endowment warrants are an appropriate investment for investors seeking simplicity and long-term exposure to the underlying shares or portfolio of shares.

They can also be attractive to this group of investors because:

there is no annual tax administration and paperwork throughout the term;

they receive the benefits of leverage with no margin calls.

High marginal tax payers

An endowment warrant capitalises income over the term of the warrant. No income distributions for high tax payers means a tax saving in comparison to holding the shares directly or as instalments, although the investor is still receiving the benefits of the distributions via the reduction of the outstanding amount.

Instalment warrants

SMSFs

An announcement by theAustralian Prudential Regulation Authority(APRA) and theAustralian Taxation Office(ATO) in December 2002 urged superannuation funds to exercise extreme caution in the purchase of instalment warrants via a practice known as ‘shareholder application’ or ‘cash extraction’, that utilises the funds’ existing equity holdings to purchase warrants.

APRA and the ATO have determined that this process involves using shares owned by the fund as a security over the built-in loan portion of the instalment purchase. This therefore breaches superannuation laws, as the fund is placing a charge over its assets. No action will be taken against trustees that have invested in instalment warrants using shareholder applications before December 16, 2002, provided the transaction is finalised within 12 months of that date or at the next reset date, whichever occurs first.

Instalment warrants purchased on the primary market using a cash application or on theAustralian Stock Exchange(ASX) may still be suitable for SMSFs for the same reasons as the endowment warrant in terms of providing leverage and long-term growth.

The dividend yields and franking credits also make instalments an attractive investment for SMSFs. The franking credits can be used to offset tax on other income earned by the fund, as well as contributions tax.

Investors wanting to convert anexisting share portfolio

Investors who currently own shares can convert an existing shareholding to instalments of the same share. This is sometimes referred to as ‘cash extraction’ or ‘shareholder application’.

The investor lodges the fully paid shares with the warrant issuer and in return the issuer gives the investor instalments over the same number of shares that have been lodged. The investor then receives a cash payment of the difference between the current share price and the market price of the instalment.

Medium to long-term investors

Instalment warrants, particularly the rolling instalments, are more complex in comparison to some leveraged investments.

Investors may have to undertake some form of action on an annual basis depending on the movement in the underlying share price.

This makes instalments more suitable for investors who are looking for more active participation in their investments and are prepared to take action on an annual basis for those investing in rolling instalments.

Medium to long-term investorslooking for enhanced income

The enhanced dividend yields can make instalments attractive to investors with a medium to long-term view of the market looking to generate income. Despite the lower initial capital outlay required, investors are entitled to the same dividend payment as owning the underlying share, providing enhanced yields.

Nathalie Bouquet is technicalservices analyst withChallenger .