Investment Road Test: Macquarie Flexi 100

PORTFOLIO POINT: Macquarie's Flexi 100 creates a pathway for tax deducibility that puts it well ahead of the competition.

The tax office has issued two game-changing product rulings in favour of the Flexi 100 investment offered by Macquarie Bank.

The rulings confirm the tax deductibility of interest incurred by investors, who are required by the terms of the Flexi 100 investment to borrow 100% of its cost from Macquarie Bank.

The tax rulings cover the two different forms of investment loan that can be used: interest on the “full recourse” loan is now fully tax deductible and interest on the “limited recourse” loan is tax deductible, up to the level permitted by the capital protected borrowing limit.

The tax rulings did not address a key feature of the investment – the “walk away” feature – so some uncertainty remains in relation to this aspect. This is the first positive tax office ruling for 100% geared investments where the use of a loan is mandatorily required by the issuer. It also raises the bar for similar products created by other issuers, upon whom it is now incumbent to seek their own rulings.

Macquarie Flexi 100 is in its second year of offer, and can be purchased with a menu of underlying assets. It is not issued directly by Macquarie Bank but by Macquarie Financial Products Management Limited as units in a unit trust, which in turn enters into hedging arrangements with Macquarie Bank.

Flexi 100 is 100% capital protected at maturity, with a range of available investments and a choice of term from three to five-and-half years. In the most recent offering of Flexi 100, investors were able to choose between fixed annual distributions, or units with distributions that are contingent on the performance of the underlying assets selected. Final returns at maturity are linked to the performance of the underlying reference asset.

Flexi 100 uses the “bond and call” method to hedge the liability of the issuer. This strategy revolves around creating a zero coupon bond with a significant part of the underlying investment amount so that at maturity the security will be worth at least as much as the initial investment. The balance of the investment is used to purchase call options over the underlying asset, which provide the upside.

As noted, some of the unit classes offered by Flexi 100 also provide for annual distributions, which are contingent on the performance of the underlying asset in each year of the investment subject to a cap, and these are also generated by the use of call options created as part of the hedge for Flexi 100. The “bond and call” components are wrapped up in a hedging arrangement between Macquarie Bank and the issuing vehicle, which thus relies on Macquarie Bank to provide the risk management for Flexi 100.

The tax office product rulings issued in favour of Flexi 100 contain another innovation, in addition to the confirmation of interest deductibility. The rulings depart from previous tax office practice, which denied tax deductibility to synthetic investments like Flexi 100 where the basis for the claimed tax deduction for interest related to the opportunity to receive a distribution linked to the performance of a reference asset.

In a private ruling issued in respect to the ABN-Amro “Elixir” investment issued a couple of years ago, the tax office denied upfront tax deductibility for interest expenses, on the basis that there was no certainty of any coupon being paid. In the “Elixir” tax ruling, the tax office drew a distinction between the relative certainty of receiving income such as dividends on shares or rent from an investment property (both able to support tax deductions) and the uncertainty of receiving income where it was linked to the performance of a market, index or other risky asset.

'¢ '¢ '¢ '¢

Macquarie seems to have used two mechanisms to overcome the “Elixir” ruling.

First, most unit classes offered for Flexi 100 have a fixed distribution component, as well as the potential for a contingent coupon. Importantly, these distributions are set off against the interest liability on their investment loan (ie, they are not paid to investors directly) and also they are not paid to investors who elect to “walk away” from the investment at the end of each year.

The distributions are funded by the release of cash from the zero coupon bond, which is part of the internal hedge for the Flexi 100 investment; ie, they are paid by withdrawing funds from the investor's capital, which has been in turn lent to the investor at the outset of the investment.

The second mechanism is the use of underlying investments, which have a real prospect of generating positive returns, unlike the Elixir investment where the tax office found that the possibility of the contingent coupon being paid (which was linked to an exotic hedge fund index) was too remote.

The interest rates payable on the compulsory loan required to invest in Flexi 100 are set at the start of the product. The full recourse loan rate for the current offer is 8.85% pa and the limited recourse loan rate for the current offer is 9.10% pa. This interest must be prepaid annually in advance. An interest assistance loan is also available, which is repayable monthly in arrears.

The innovation within the Flexi 100 product is that it creates a pathway for tax deductibility for the cost of the call options that are within the investment – different to the capital gains tax treatment for the purchase of normal call options.

The value of the call options is less than would have been achieved if the full cost of the interest was used to purchase them (since some of the investment budget is used to fund the fixed distributions), but this may be seen as a small opportunity cost in return for the tax benefits.

The tax office product rulings have essentially created a “safe harbour” for synthetic investments that involve mandatory investment loans and where returns are linked to the performance of markets, indices or funds.

It requires the use of an interposed unit trust to issue the investment, with the related loan being provided by a related party to the issuer. It also mandates fixed distributions as well as the choice of assets with a real prospect of generating economic returns. Other similar products should now only be considered where they receive their own affirmative product ruling. Well done, Macquarie.

The score: 3.5 stars
0.5 Ease of understanding/transparency
0.5 Fees
0.5 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile/risks
1.0 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services with Alpha Invest but does not receive any benefit in relation to the product reviewed.