The Government’s tax consultation – The Modernisation of the Tax Rules for Investment Trust Companies, published in July – has been causing quite a stir.
Proposals to modernise the tax framework for investment trusts may not seem a particularly exciting prospect to outsiders but it is vital for the industry – and also long overdue.
Current legislation has been largely unchanged since its introduction in 1965, yet the investment landscape has changed beyond all recognition in that time. The Association of Investment Companies (AIC) has been pushing for a new framework for a number of years, since the current rules increase cost and prevent investment companies adopting certain investment strategies.
To maintain the status quo is not an option if the sector is to successfully develop its commercial agenda. The Government’s agreement to this review of taxation legislation (and the current consultation arising from it) is a very positive step and should result in a more flexible and attractive regime going forward.
This will be good news for the UK Exchequer too, as a more attractive taxation regime will encourage more UK listings of investment companies – and more tax revenues for the Treasury.
The investment trust rules are designed to allow tax-efficient investment. Investment companies benefit from a corporation tax exemption on their capital gains. Underlying investors therefore benefit from the spread of investments that comes from an investment company portfolio, while avoiding ‘double taxation’ that would occur without the exemption.
However, the regime to maintain this position is currently onerous, costly and overly restrictive.
At present, to achieve and maintain investment trust status, a company must derive at least 70% of its income from shares and securities (‘the income test’) while also not retaining more than 15% of this income (‘the retention test’). There is also an obligation for a company not to hold more than 15% of its portfolio in any one company, in order to spread risk.
Such mechanistic rules are restrictive in terms of both investment strategies as they increase the risk of inadvertent breaches. Traditionally, they have meant investment trusts have focused on equity investment. This has been the case despite the marketplace changing and investors seeking new ways to diversify their risk and secure investment returns.
Reform will enable trusts to compete more effectively with other structures since they will be able to diversify and offer new means of generating shareholder returns.
Specifically, the new rules will clarify that investment in loans, futures, options, CFDs, swaps, warrants, foreign exchange, units in collective investment schemes and carbon emission credits are all to be permitted investments for tax relief purposes. In short, fund managers are going to have more investment freedom without tax issues influencing their decisions.
The proposed new rules will remove the obligation for investment trust companies to hold no more than 15% of the portfolio in any one company, replacing this with a characteristics-based approach.
This is to be based on the current Listing Rule requirement for an investment company to produce an investment policy which demonstrates how it will spread risk within the portfolio.
There will also be a reduction in administrative costs. This is less important to us than the new investment flexibility the tax changes will provide, but could nevertheless generate annual cost savings in the region of £2m. Trusts will move to a new system of ongoing self-assessment and away from a requirement for annual (and time-consuming) approval of tax status.
This will reduce the costly bureaucracy involved with maintaining status and bring the sector into line with other collective investment products. Also, under the new rules if an investment trust inadvertently breaches the tax rules and then remedies the mistake immediately, there will be no adverse tax consequences for that trust.
We have already discussed ‘the income test’ and ‘retention test’ that apply at present. As part of the new proposals, the income test will be removed – this is good news since it opens the door to new investment strategies. However, this change may have knock on consequences for the ‘retention test’ which could be less positive for the sector.
Currently, investment companies can retain up to 15% of their distributable income from shares in order to boost their revenue reserves which allows them to smooth dividend payments through good and bad market conditions. The proposals would reduce this figure to 10% of all income, potentially a reduction of up to one third for trusts which continue to focus on equity investment.
This is concerning because the investment trust sector has an enviable track record of dividend increases which has always been facilitated by its ability to retain some of the income received and transfer this to revenue reserves each year.
Topping the list of companies who have increased their dividend every year is City of London, which has increased its dividend payments for an impressive 43 years in a row. Following closely behind are Alliance Trust, Bankers Investment Trust and Caledonia who have all increased payments for 42 years. This is an enviable track record and the AIC is keen that the sector’s ability to deliver steady and rising dividends to consumers should not be eroded.
While for the most part the proposed tax changes are very positive for the industry, care will have to be taken to ensure that the transition to a new tax regime takes account of the needs of all investment trusts. The Treasury has asked for comments back on the consultation by 19 October and the AIC looks forward to working with officials between now and then.
Ian Sayers is director general of AIC
