As the New Year approaches there are many institutional and private investors who are in for a nasty shock. They are just about to give away chunks of their investment performance alpha to a whole bunch of foreign governments. The sad thing is that they probably don’t even know they’re doing it. Ignorance, in this case as with so many others, is not bliss.

Foreign Governments – Give Them A Gift This Holiday Season

While double tax treaties provide the legal basis for an entitlement to recover over-withheld tax, it’s the actual underlying procedures – different in every market – that provide the mechanism for these refunds to actually happen. If you were lucky enough to get relief at source then you’re already over this problem, but many markets, including Switzerland for example with a tax rate of 35%, don’t have relief at source. Many investors never get relief at source because of their own structure or because they’re using omnibus, nominee or prime brokerage accounts. If you’re over-taxed, you have to go physically claim it back.

The important thing to understand about these underlying mechanics is that they are time limited. You only have a certain length of time, starting from the pay date, in which to file your claim. This is the ‘Statute of Limitations’. Not only is it different for each market (usually anything from one to five years or more), but each can have one of four ways to calculate when that fateful day arrives and what you thought was your money suddenly becomes someone else’s.

Free Gift Time

Some Statutes are calculated as a number of years from the date of the payment, others are calculated using the financial year of the source country. However, many markets have ‘the end of the nth year after the pay date’ as their calculator. In other words, for many markets December 31st is ‘time for free gifts’ for lots of tax authorities.

Now, as I write this, it is December 14th. The fact is that, if you’re reading this and have suddenly woken up to the problem, for this year at least, it is already too late. There’s almost no chance that you’ll be able to get all the materials you need in one place and get claims filed in time to beat the Statutes. This could cause more than just financial losses of course, as some types of institutional investors have fiduciary responsibilities, some of which are enshrined in regulation such as ERISA in the US. While ERISA, for example, does not explicitly say that inaction on tax issues is a breach, its pretty clear to the average person that knowledge of such things would be ‘reasonable’ and ‘expected’ for a professional investor to know and therefore to act upon – particularly when failure to act leads directly to quantifiable financial loss.

Outlook – Cloudy With A Chance Of Windfalls

Is there a way to mitigate these losses? Well, no. Some think that they can offset these losses (foreign taxes paid) on a domestic tax return. The unfortunate reality is that many countries, including the US, provide in domestic law that only the irrecoverable portion of foreign tax over-withheld is deductible domestically. So, as an example, if you haven’t claimed on the 35% tax you suffered on a Swiss dividend that paid in 2012 by the end of THIS year, you’ll only be able to claim the treaty rate (mostly 15%) as a deduction on your tax return – because the other 20% was recoverable under the tax treaties… and that’s what you were supposed to do. I mention just one example here, but of course this issue would apply to the entire portion of the portfolio that was invested cross border, so the financial issue could be much larger.

So, the reality is that any professional investor, from a simple financial perspective if not a fiduciary perspective, should be reviewing tax reclaim performance in September each year, at the latest, to make sure that any and all outstanding entitlements that are coming near the hard statute deadline in that year are already in process and filed. Most custodians will tell you that if you haven’t got your claim ‘in flight’ by November, there’s no realistic expectation that you’ll meet the deadline.

Of course, if you do have entitlements that are that close to Statute, it begs the question of why you let them get that close in the first place and what others may be clouds on your horizon. It speaks not of a one-off mistake, but of a potentially systemic weakness in your portfolio management. That said, for those investors each year who come to the dawning realisation of the performance they are foregoing, there is the very bright outlook that they’ll be able to fix it for next year AND start going back over all the intervening years to clean up the issue. That can result in a windfall of performance uplift of up to 250 basis points.

So, next year, it might be you opening the free gifts!

Happy Holidays.

Image Credit: Daniel Spiess