Withdrawals from investment companies

It is said that wealth itself has no value – it is the possible uses of the wealth that create value. In the management of long-term assets, many are concerned with maintaining the purchasing power (real value), of the funds over time, while others think of the assets as something to use for, for example, their pension – and thus use it over time. We therefore see that several asset owners need to assess “fiscal rules” for withdrawals, for example to maintain the real value, or to drain the assets over a period of time. The most famous parallel in Norway for “fiscal rules” is probably the Government Pension Fund Global – or the oil fund – which has its well-established fiscal rule. The organisation and structure around the management of, and withdrawals from the Norwegian oil fund, enjoy many praises and often admiration in the world around us. The management of the fund is based on a clear structure and, not least, the implementation is characterised by discipline and consistency. At DNB, we also try to provide access to investment solutions where we strive for a clear structure, discipline and consistency. We also believe that over time, it’s more important to focus on establishing and implementing a good and well thought out investment strategy, rather than using a lot of resources on short-term tactical decisions. However, we see that our customers have a slightly more complicated landscape to move in than the oil fund. This is especially true when considering withdrawals of funds and the preservation of real value, or withdrawals for pensions over time. An important difference is that tax must be taken into account. We have therefore created a model that shows how value growth can look like different types of "fiscal rules", shielding basis and portfolio composition. However, this is a purely descriptive model; no advice is given on tax adjustments.

Many investors have the funds organised in a private limited company. A private limited company pays tax on the company’s profits, and the personal owners pay tax on any dividends. The owners also pay wealth tax on the assets of the company, after deduction of a share discount. If you have paid-in capital (shielding basis), in the company you can draw on it first by writing down the paid-in capital (shielding basis) without paying tax. If you plan to withdraw all or parts of the funds in the company over time, you should have a concept of expected return, but it is also important to include tax in the calculations. An investor who, for example, wants to maintain the purchasing power of the portfolio may think that real returns can be taken out – i.e. the return on the portfolio minus inflation. However, this assumes that no tax will be paid. If the tax position is taken into account, the picture is complicated.

To elucidate this, we consider an investor who owns a company at a value of NOK 100 million. We also assume that the investor will establish a fiscal rule where she will withdraw 2.5 million (2.5%) after tax in the first year, and then we adjust the annual amount with an inflation of 2.5%. In other words, our investor takes out the same real value every year.

Every year, our investor has to withdraw funds to pay wealth tax on the value of the company, in addition to having to withdraw funds to meet her desired fiscal rule. We assume that the investor will first use the annual shielding deduction to withdraw funds tax-free. If the shielding deduction is not sufficient, she will then withdraw paid-in capital to cover the need for funds tax-free. If this is not sufficient, she must take out dividends to cover the remaining need (see the calculations in the box at the bottom for more details).

We consider two possible starting positions for our investor: one where the paid-in capital (shielding basis) constitutes 50 per cent, and one where the paid-in capital is 1 per cent. Furthermore, we can look at a portfolio composition with what we consider to be medium risk; 50 per cent Shares and 50 per cent in Fixed-Income Securities (government securities and so-called investment-grade bonds). We also assume that such a portfolio has an expected return of 5.1 per cent (2.6 per cent real return), and that the return will come every year, without fluctuations. Neither is any capital added to the portfolio over time.

If we simulate how the market value of our investor’s company will develop, given the above conditions, the progress of the market value of the company will be as shown in the figure below.

We see in the figure above that a withdrawal of 2.5 in the first year (which is adjusted over time) means that the company is emptied after just under 30 years and 40 years – depending on how much paid-in capital it has (shielding basis).

If you’re save for a pension in the company, you must not forget tax

Another way to look at this is to consider a person who regards the assets in their company as their pension savings. There may be entrepreneurs with bad pension schemes, who sell a company and think that the funds will be used for a pension. Or it may be an independent business owner who has allowed the profit (after tax) of the company to be built up over time as pension savings. Both will typically have almost 100 per cent of retained earnings, and thus a low shielding basis. We therefore use the example with 1 per cent of paid-in capital over. We see that if these two have 10 million of retained earnings in their company and want to withdraw NOK 250 000 for a pension after tax during the first year, and the inflation-adjusted amount of this in the years to come, they can withdraw funds for about 30 years. In practice, many will be more careful with risk during a disbursement period. If, for example, they have 20 per cent in shares in the disbursement period, the number of years they receive disbursements in will fall to about 26 years. Since are assuming that the expected return is attributed to each year, actual market fluctuations in practice may cause the 10 million to produce disbursements over fewer years if one is unfortunate. In other words, we need to take into account that 10 million will sometimes last for less than 26 years.

How can we adapt to maintain real value?

In other words, the wish/need for withdrawals from a company must be considered in the context of several components. Investment strategy (desired risk), expected return and any desire to maintain real value/buying power is significant. In the examples above, we see that withdrawals just below the expected real yield mean that the company is will be emptied over a few decades. But what can be taken out if the goal is to maintain the purchasing power – or real value – over time?

The answer to this obviously depends on several components, including portfolio composition, expected return, paid-in capital and shielding basis). If we use the assumption of our portfolio above, with 1 per cent of paid-in capital, we find that a withdrawal of just over 0.5 per cent (0.5 per cent of 100) initially, which then increases with inflation over time, allows the real value of our company to be maintained, see figure 2 below

There are many interchangeable sizes here, and we have, among other things, assumed there is no variability in returns from year to year. We also assume that all equity exposure goes under the tax exemption model and that the company pays tax on interest income annually. Over the last few years, we have also seen that tax rules and rates can change quickly, and this will of course affect the picture to a greater or lesser extent. However, we believe this simple approach provides useful insight – and not least, the examples remind the company and its owner of the importance of considering the wish/need for withdrawals in light of how cash flow (including tax) and value fluctuations will affect the company and owner together.

Details of the calculations:
We’re looking at an investor who owns a company at a value of 100 million. Every year, our investor has to withdraw funds to pay wealth tax on the value of the company, in addition to having to withdraw funds to meet her desired fiscal rule. We assume that the investor will first use the annual shielding deduction to withdraw funds tax-free, if the shielding deduction is not sufficient, she will then draw on the paid-in capital (the shielding deduction) to cover the need for funds tax-free. If this is not sufficient, she must take out dividends to cover the remaining need.

Let’s first look at the wealth tax. This is calculated on the company value, less 20 per cent, i.e. the wealth tax is calculated on an asset value of 80 million. The tax rate for assets is 0 per cent up to 1.7 million, 1 per cent from 1.7 to 20 million and 1.1 per cent over 20 million. We assume that our owner has assets of 1.7 million in other assets. In this case, the rates for what she has to pay are; 1 per cent on the first 18.3 million, and 1.1% on the last 61.7 million. Total wealth tax will then be 1 percent * 18.3 million + 1.1 percent * 61.7 million = 0.86 million. If we set the fiscal rule at 2.5 million, this means a total withdrawal of 0.86 million for wealth tax and 2.5 million for the fiscal rule (spending); a total of 3.36 million. But how are these 3.36 millions taken out?

Firstly, we assume that the company has paid-in capital (shielding basis) of 50 million (50 per cent). We also assume that the shielding interest is 2.5 per cent. The shielding deduction - the owner of the company can take out each year tax-free - is equal to the shielding basis multiplied by the shielding interest rate. The shielding deduction for the first year will then be 50 million * 2.5 per cent = 1.25 million, which can be taken out tax-free. Since the paid-in capital (the shielding basis) is 50 million, the remaining 2.11 million to be taken out can be removed as write-downs of paid-in capital (the shielding basis). This means that the total amount of 3.36 million can be withdrawn without tax in the first year, but at the same time the paid-in capital ( shielding basis) is reduced from 50 million to 47.89 million. In year two, the shielding deduction will be somewhat smaller; 47.89 million * 2.5% = 1.2 million, and our investor has to withdraw slightly more from the paid-in capital. Over time, therefore, paid-in capital (the shielding basis) will disappear, and our investor must after a few years take the withdrawal as a dividend.

What if the company has paid-in capital (shielding basis) of only 1 million (1 per cent). The shielding deduction will be: 1 million *2.5 per cent = 0.025 million. The asset value and wealth tax are the same as above. The shielding deduction means that 0.025 million of the total 3.36 million they desire to take out can be taken without tax. In addition, our investor has paid-in capital (shielding basis) that can be written down, but now this is only 1 million. In other words, a total of 0.025 million (shielding deduction) + 1 million (depreciation of paid-in capital) = 1.025 million of the 3.36 million can be taken without tax. The remaining 2.235 million must be taken out by taking dividends. But to get 2.235 million out into the owner's hands, a dividend of 3.596 million must be taken out (3.596 million in dividends, charged at 37.84 per cent or 1.36 million in dividend tax, thus leaving a return of 2.235 million after tax by taking 3.596 in dividends). In other words, it is necessary to withdraw 1.025 million (without tax) + 3.596 million (as dividends) = 4.621 million, to cover wealth tax and the desired fiscal rule. At the same time, paid-in capital (the shielding basis) is reduced from 1 to 0. This means that when withdrawing funds to cover wealth tax and the desired fiscal rule in year 2, the whole amount is taken as a dividend which is taxed at a dividend tax rate of 37.84 per cent. In other words, the amount that must be taken out in order to cover wealth tax and fiscal rule must be multiplied by 1/(1-0.3784) = 1.61. If a total withdrawal of 3.36 is desired, a yield of 3.36 *1.61 = 5.41 is required. At that point, 2.05 (37.84 per cent) of the 5.41 will go to paying dividend tax, and the owner ends up with the remaining 3.36.