Why is the Future Fund in a tax haven?

PORTFOLIO POINT: The Future Fund has two subsidiaries operating in the Cayman Islands, but is reticent about explaining just why.

Future Fund chairman David Murray has been in full flight this week, demanding “full transparency” from the government over payments for the National Broadband Network. As the guardian of the $87 billion fund – including a $3.5 billion holding in Telstra – Murray is right to demand full disclosure.

But he has been less forthcoming about how the government’s unfunded superannuation liabilities – which are expected to reach $40 billion by 2020 – are helped by the Future Fund’s five Cayman Island subsidiaries.

The Future Fund first disclosed details of the Cayman operations in its 2009 annual report, tabled in Parliament last October. The disclosure unhelpfully coincided with the controversy over private equity group TPG’s refusal to pay capital gains tax on its proceeds from the Myer float, which court hearings revealed were made possible by TPG entities being based in the Cayman Islands.

It turned out to be a public relations nightmare for the Future Fund, especially after it indicated in its annual report that it was seeking to reduce its tax burden on offshore investments, triggering a wave of concern about whether the Future Fund was seeking to maximise investment returns by avoiding tax through special Cayman structures.

Eureka Report can reveal that for the 12 months to the end of June 2009, those concerns were misplaced.

Financial accounts obtained by Eureka Report show that the two Future Fund entities, which directly own the Cayman Island companies, paid $47.38 million in income taxes to foreign governments in 2009 even though they posted a combined pre-tax loss of$33.98 million.

The two entities are known as Future Fund Investment Company No.1 Pty Ltd (FFIC No.1) and Future Fund Investment Company No.4 Pty Ltd (FFIC No.4).

Both of these vehicles are used by the Future Fund principally to invest in unlisted assets overseas.

Although it is pretty clear that the Future Fund has not been using the Cayman entities to avoid paying tax, the fund has done a very poor job in explaining to the Australian public why at least $4 billion of its assets are managed through the Cayman Islands.

Notwithstanding more than a week of effort on the part of this publication to get disclosure on how the Cayman entities were established, and the rationale for doing so, the Future Fund refused to furnish such information and said that Murray was unavailable for an interview.

A Future Fund spokesman reiterated the organisation’s commitment to OECD principles on tax transparency, while also asserting that the board did not invest in schemes or arrangements that contravene those principles.

In terms of disclosure, the spokesman said: “We fulfill all of our disclosure obligations and there should be no question about that. We meet all of those disclosure obligations through our annual report.’’

It may be true that the level of disclosure in the Future Fund’s annual report meets a minimum statutory obligation, but the group accounts provide a limited insight into many matters, including investment performance and whether the fund is meeting its tax obligations overseas.

Eureka Report was able to confirm the sovereign fund’s compliance in meeting its offshore tax obligations by inspecting accounts that were not included (in such detail) in the annual report.

Without this important information there was no way of testing assertions made by the board in the annual report on its performance as a tax payer outside of Australia. In other words, the Future Fund’s accounts, as presented in the annual report, lack the same transparency Murray is demanding of the government on managing the federal budget and the NBN.

Most tax experts interviewed by Eureka Report declined to speculate on the Future Funds’s reasons for setting up operations in the Cayman Islands, but they highlighted that the country was a popular jurisdiction through which US fund managers coordinated investments on behalf of non-US clients.

While Perpetual Limited does not use vehicles through tax havens, its tax specialist Michael Brown says the Cayman Islands are commonly used by US funds managers to market big ticket investments to non-US investors.

“If I’m a fund manager based in the US and want to sell my funds management expertise around the world, the intricacy of tax laws across different jurisdictions can get you into issues of paying double tax on the same income stream,” he says.

“In such cases, US fund managers typically set up fund offerings in a zero-tax country and that leaves the non-US investors to pay taxes on capital gains, dividends or other distributions in their home country. Such arrangements mean that investors only have to deal with paying tax in their home jurisdiction. For Australian investors it doesn’t stop you paying tax in Australia, it just creates a neat and simple step to pay tax.”

However, without vigilant adherence to OECD standards on tax transparency, it could be argued that the Future Fund’s activities in the Caymans have the potential to facilitate the minimisation of taxes incurred on the sale of assets outside Australia.

If all of the Future Fund’s income and gains on foreign investments were only payable in Australia, its tax bill would be zero because of its local exemption from paying income tax. That would be an extreme scenario and one unlikely to eventuate.

But there is uncertainty around what precisely the Future Fund is trying to achieve. Because it has not explained the process by which it established the Cayman entities, nor the tangible incentives for doing so, it remains unclear how the Cayman operations are intended to “maximise after-tax returns”.

“The Future Fund’s decision to establish entities in a known tax haven like the Cayman Islands is a bit of head-scratcher,” says South Australian independent Senator Nick Xenophon. “From a governance perspective the purpose of the Caymans subsidiaries should be explained more clearly in the annual report.”

There are certain situations in which it is highly unlikely that tax can be legitimately reduced. For example, the US government levies a 35% withholding tax on foreign investors that make a capital gain on the sale of commercial and industrial property.

However, for equity investments, where the Future Fund would be seen as a passive investor, it would likely pay no tax to US authorities on any capital gains. This would be consistent with the international convention that foreign-based fund managers are obliged pay capital gains tax in their home jurisdiction.

Because the Future Fund is exempt from paying income tax in Australia, it would therefore pay no tax on the sale of New York-listed shares such as Microsoft or Kraft Inc.

If the fund’s tax obligations in foreign countries are clear in this regard, it begs the question: why the Cayman Islands operation? Perhaps the 2010 annual report, due in the next month, will provide an answer.

* Financial accounts used in research for this article were sourced through Dun & Bradstreet.