Insights


ERISA Collective Investment Trusts (CITs) Can Reduce the Tax Burden When Investing Internationally

  • It is tax season: a time of heightened sensitivity to the impacts taxes have on income and investment returns. And while defined contribution plans are typically thought of as tax exempt, that’s only true for domestic taxes and therefore, just part of the story.
  • Here we will take a closer look at international equity funds, the taxes that participants can incur on capital gains and foreign dividends, and the ways those taxes can be mitigated, namely by direct investment in CIT structures.
  • For more information on this topic, contact me directly.

Brendan Curran
Managing Director, Head of U.S. Investment Strategy, DC

Choosing to utilize a CIT over a mutual fund can reduce the taxes paid when investing internationally. In fact, while CITs and mutual funds are similar, key differences, such as how they are regulated, their cost structures and the degree of flexibility that each may offer plan sponsors, can have a meaningful impact. In the case of CITs, their tax-efficiency translates to better long-term results, keeping more money in the fund and, ultimately, in participants’ pockets.

How so? Let’s focus on taxes related to dividends. Mutual funds, as registered investment corporations (RICs), pay higher tax rates on dividends in certain developed countries when compared to ERISA CITs.1

For example:

  • Japan, one of the largest developed markets representing approximately 17% of the MSCI ACWI ex US IMI Index, had a dividend yield of 2.21% in 2018.2,3
  • The MSCI ACWI ex US IMI Index assumes Japanese dividends were taxed at a rate of 27.5%, which represents the highest possible tax rate, reducing the dividend yield above by that amount.
  • Mutual fund investors are able to reduce the tax rate to 10% whereas ERISA CITs are able to reduce the tax rate to zero because of different treatments under the existing tax treaty.
  • As such, an ERISA CIT retains the entire Japanese dividend yield of 2.21% whereas the dividend yield to a mutual fund is reduced by 10% to 1.99% (a difference of 22 basis points or bps). Applied to Japan’s weight in the index (17%), the mutual fund investor pays 3.9 bps in taxes vs. an ERISA CIT investor.

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ERISA CITs are afforded a tax rate of zero in nine countries, which represent 46% of the MSCI ACWI ex US IMI Index. Mutual funds pay a tax rate of 10–15% in these same countries. Based on 2018 dividend yields, this difference in tax rates equates to a cost advantage of 17.5 bps for an ERISA CIT investor over a mutual fund investor.

Said differently, assuming your plan has $100 million in an index fund benchmarked to the MSCI ACWI ex US IMI Index, the decision to utilize a mutual fund over a CIT can cost your employees $180,000 in plan returns. The difference becomes starker when considering CIT indices that include only developed countries where the tax benefit is concentrated.

Next Steps

As a plan sponsor, you should have insight into whether your workplace retirement savings plan is invested in a CIT or mutual fund structure. But buyer beware — some CITs offered by some of the industry’s most widely used managers invest in underlying mutual funds, meaning the investments may not be eligible to deliver the CIT tax benefits described above.

Moving your international equity allocation from a mutual fund to a CIT provides an easy opportunity to reduce your plan’s tax bill and increase your employees’ retirement savings.

Footnotes

1Under certain tax treaties, an ERISA collective investment trust (organized under Rev. Ruling 81–100) is treated as a pension and thus receives more favorable dividend tax rates than a mutual fund may be afforded. For example, see Article 10, Section 3(b) of the Japan Income Tax Treaty (2003) available on the IRS website.

2 MSCI Index Data, published ERISA and RIC Tax Rates, as of Date 12/31/2018.

3 Calculated by dividing the actual dividends paid in 2018 by cumulative stock price.

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