All investors want to grow their capital, but the high growth associated with investing in equities is accompanied by increased risk exposure. The protect-to-grow strategy uses a Protected Equity Loan (PEL) to leverage the growth potential, with some potential tax benefits, while providing capital protection at a point in time (eg at maturity of the investment loan).
Who is this strategy for?
A protect to grow strategy using a Protected Equity Loan (PEL) may suit the following types of clients:
- An individual or SMSF investor seeking to invest in Australian equities who wishes to receive dividends and associated franking creditsclients wishing to reduce their initial capital outlay through borrowing (which is capital protected at maturity)
- Clients wanting to borrow to invest in equities but avoid the potential of margin calls
- Investors with strong cash earnings and who seek a tax effective investment strategy
- The minimum aggregate amount of your loans under the Westpac PEL is $50,000 (with a minimum loan amount of $10,000 for each loan), but these minimum amounts may be waived or reduced by us at our discretion.
What are the potential tax benefits?
- Interest deductibility (subject to capital protected borrowing rules)
- Entitlement to franking credits (conditions apply)
- Capital Gains Tax management
How the PEL works
- We advance a separate loan for each parcel of securities the client wishes to buy. The securities are held by the trustee and we take a mortgage over each parcel.
- A protection level is set based on the loan amount divided by the number of securities in that parcel.
- At maturity, your client is protected from falls in the security price below the protection level.
- Performance is measured at a parcel level, not a portfolio level. Since each investment parcel is treated separately from a capital protection perspective, a positive security value return in one parcel cannot be used to offset a capital shortfall in any other parcel, before capital protection is applied.
- After 1 year, the client may continue with the investment strategy by rolling over the investment. SMSF customers may choose to extend the terms of the loan.
- Where interest is paid in advance for the PEL term, a credit assessment or guarantee is not required (and the investor may benefit from a tax deduction on the prepaid interest).
Scenario 1: Growth strategy
The investor is seeking the return potential of Australian shares but wants a level of capital protection at maturity.
After an investment in Australian shares, the accompanying table shows the after-tax cashflow during the life of a 1-year PEL facility with 70% gearing and capital protection.
|Indicative Annual Cashflow||% of Loan Amount|
|Pre-tax annual cash flow|
|Loan interest/borrowing cost||($47,083.18)|
|Pre-tax gain (loss)||$4,288.15||0.61%|
|Total assessable income||$73,387.61|
|Deductible borrowing costs||($47,102.99)|
|Taxable income/(loss) for tax purposes*||$26,284.62|
|Net tax receivable/(payable)*||$9,793.93||1.40%|
|After tax position||$14,082.08||2.01%|
Assumptions: 1. Indicative interest rates as at 27 March 2014 which are subject to change. 2. Interest paid annually in advance and annually resetting for the investment period. 3. Shares selected TLS, NAB, WOW, ANZ, WBC, WES and TAH. 4. The Capital Protection Fee is included in the interest rate. 5. Brokerage and application fee is not included. Note: if one year PEL is selected and interest is paid annually in advance, a credit assessment is not required.
The table shows a potential positive cashflow of 2% pa for the 70% protection portfolio. By contrast, a portfolio with 5-year time horizon and 100% capital protection at maturity would result in a negative annual cashflow of -2% pa. An investor should consider their own situation and financial needs and decide whether the benefit of more capital protection at maturity outweighs the incremental cost.
Scenario 2: Diversification, growth and protection
The investor has a concentrated holding in one ASX listed security. They would like to diversify and grow their equities portfolio using their existing equity holding to fund the strategy. (This approach is not available to SMSFs.)
1. The investor lodges a PEL Security holder application and extracts cash (the loan amount) from the existing holding and sets a protection level.
|PEL Security holder application|
|70% protection - 1 year|
|$40,000 market value - WBC shares|
|$29,000 loan amount earning 6.9% pa interest|
|$4,000 annual interest cost on loan|
2. The investor then requests a second PEL facility known as a Cash application, and the investor can use the cash proceeds from the Security holder application to supplement the loan amount for a new PEL over additional securities.
|PEL Cash application|
|70% protection - 1 year|
|$50,000 market value - eg BHP, WOW|
|$29,000 loan amount earning 7.1% pa interest|
|$40,000 annual interest cost on loan|
Using the example illustrated above, the approach succeeds in delivering the following for the client1:
- Diversification – the portfolio increased to five shares across five different sectors
- Exposure – the portfolio exposure has grown from $40k to $90k
- Protection – capital protection at maturity of 70% on each individual share
- No capital required – the equity from the WBC holding is used to build the new portfolio and pay interest costs (on both facilities) up to maturity, and no additional funds are required
- Income – client receives potential dividends and franking credits
- Tax – potential deductibility of the interest payments and subject to the capital protected borrowing rules.
There are no margin calls with this approach and after 1 year, the investor can choose to sell securities, rollover the facility or pay out the loan and take delivery of the shares.
Steps to set up a PEL:
- Your client selects the ASX listed securities to invest in (ordinary shares or ETFs).
- Your client selects their preferred loan amount (50–100% of the security value) in line with their risk profile. This will correspond to the capital protection level at maturity.
- Your client can choose the term that suits their time horizon (up to five years).