F&C's Mike Woodward says investment trusts can help higher earners caught in the new 50% tax bracket safeguard their wealth
As the clock ticks down towards the start of the 2010/11 tax year on 6 April, high earners who will be caught within the new 50% tax bracket are seeking ways to protect as much of their income as possible from the grasp of Her Majesty’s Revenue and Customs. Helping them to do this will probably be a job for their financial advisers as much as for their accountants.
Recent reports in the Financial Times have highlighted firms rushing through bonus payments to meet the deadline, or looking at restructuring compensation agreements so bonuses are paid in the form of capital. However, the paper also reported some of these measures may ultimately work to the detriment of shareholders if the Revenue subsequently finds ways to penalise firms for ‘dodging’ the tax.
Forward dividend
In the investment trust world, some trusts have brought forward dividend payment dates that would have fallen after the beginning of the tax year. Caledonia Investments, Finsbury Growth & Income, Fidelity European Values, Murray Income Trust and HgCapital Trust have all brought forward their dividend payment dates to beat the tax rise. Foreign & Colonial Investment Trust has also announced it is to pay its final dividend for the year ended 31 December 2009 sooner than scheduled.
But these one-off changes in bonus payment dates and dividend timing offer no longer-term help to those earning over £150,000 a year. So how else can investment trusts help higher earners safeguard their wealth?
Perhaps the simplest answer to this question – as some of the firms alluded to by the FT have obviously realised – is to find ways to achieve capital gains rather than income. The most obvious way in which to achieve this using an investment trust is via the zero-dividend preference shares offered by some split-capital trusts. These pay no dividends (which would be subject to income tax) during their lifetime but offer a predetermined rate of growth at wind-up or maturity, subject to their assets having grown sufficiently.
They are second only to bank debt in the queue for repayment at wind-up. However, in contrast with the split-cap crisis of a decade ago (when for the first time ever many zeros failed to make good on their promise because of falling markets and a complex web of cross-holdings), today’s zeros are more like the ‘traditional’ zeros of the 1990s and earlier than the highly geared versions that took part in the crisis.
Downside
The potential downside of zeros from a tax perspective comes in their fixed wind-up date. At this point, provided the trust has met its target, the shareholders will receive all of their return in the form of a capital gain, which will be taxable if it breaches their annual CGT allowance (currently £10,100). To obviate this problem, many split-capital trusts ‘roll over’ at maturity into successor vehicles, which means the gain can be reinvested in the new company without being crystallised for capital gains tax purposes.
It has taken zeros a long time to repair their tarnished image, and even today they are in relatively short supply, although there are signs the market is now picking up. However, there are other choices available to investors keen to substitute capital for income.
One option offered by some companies, including (at rather different ends of the size spectrum) HSBC and European Assets Trust, is the scrip dividend, where dividends are paid in the form of further shares in the company, rather than as cash. Because there is no ‘income’ from the dividend, no income tax is payable and instead the shareholder simply has a slightly larger holding with which to participate in future growth in the company’s share price. This differs from the dividend reinvestment plans (Drips) offered by many investment trusts, which automatically buy further shares on investors’ behalf with the proceeds of their taxable cash dividends.
Innovation
A more innovative option, such as that offered by the F&C-managed Investors Capital Trust, is to have two classes of share within a single (that is, not split) capital structure. Juxtaposed with splits, this structure arguably offers benefits in that neither share class carries more risk than the other (though as the trust invests in equities, its shares’ value can go down as well as up and returns are not guaranteed). Using Investors Capital Trust as an example, the ‘A’ shares and ‘B’ shares both invest in the same portfolio of income-focused mainly UK stocks and bonds.
The ‘A’ shares pay a conventional dividend, suitable for the many investors (such as basic-rate taxpayers, who have no further tax to pay on dividends beyond that levied on them at source) who are happy to receive an income in this way. The ‘B’ shares pay a capital distribution, which is subject to neither income nor capital gains tax, meaning the only potential tax liability for ‘B’ share holders is if their gain exceeds the CGT threshold when they come to sell the shares.
Of course, investors and their advisers should remember tax rules may change, particularly in light of the current economic situation and the possibility of a change in government, but under the current regime, CGT is levied at a flat rate of 18%, meaning capital gains are taxed more favourably than income for all except non-income-tax payers.
Tax treatment should arguably never be the main factor in an investment decision, but there are enough schemes of various sorts available – from venture capital trusts to Isas and pensions – to indicate it is certainly a consideration. It will be interesting to see over the next month or so what steps those on the verge of a punitive income tax rate are inclined to take.
Mike Woodward is head of investment trusts at F&C Investments
