I am often quizzed on the method of calculating a capital gain or loss on a unit trust or Oeic. What essentially seems to be a straightforward process of deducting the purchase cost from the disposal proceeds is actually quite complex.
For the most part, disposal proceeds are uncomplicated. Usually, it will be the amount received from cashing in or the current market value for an unrealised gain. It is the other side of the calculation, establishing the base cost, where things become more involved.
To establish the base cost of each unit purchased we begin with the price paid, but then adjustments must be made. Units often make an equalisation payment at the end of the investor’s first distribution period. For capital gains tax purposes, this is treated as a return of the initial price paid and is therefore deducted from the actual price paid.
Where accumulation units have been purchased, these will not make any distributions. Instead, the net amount that would normally be distributed is automatically reinvested in the fund. No new units are issued but the value of the existing units is increased. These notional distributions are subject to income tax at the rate relevant to the investor. For CGT purposes, notional distributions are treated as allowable expenditure and are added to the price paid. With income units, where the income is reinvested, this is treated as a new purchase of new units at that time and the distribution does not affect the base cost of the original units, save for any equalisation element. All of this is an ongoing process and hence why base costs can fluctuate over time.
The above gets us to a position where we have established the base cost of each unit. If we add up the total cost of all units, we get the total cost of the holding. That is fine if the whole holding is disposed but where a partial disposal takes place, further calculations are required. Often, units are not all purchased at the same time for the same price. Here, we establish base cost by what is know as a section 104 pool.
In essence, this is an averaging mechanism whereby the total cost paid (duly adjusted as described above) is divided by the total number of units to give an average cost paid for each unit. This average cost is then used as the purchase cost of the units sold to arrive at the gain or loss.
We must be aware of the bed and breakfast rules. If the same investor repurchases the same fund within 30 days, a recalculation takes place. Now, the purchase cost for the units previously sold becomes the price paid for the new units. The s104 pool is then readjusted to put back the units no longer matched against the sale.
There is logic in all this but often many transactions and adjustments can complicate things. I once calculated that a monthly savings plan in six funds could have as many as 12,000 separate CGT transactions over a 10-year period. The launch of our CGT reporting service required us to process about eight million transactions and each year there are many more to add. Assuming each took 10 minutes manually, I calculated we had saved the IFA world about 150 years of work.
More seriously, as the RDR approaches, if fees are being paid by cashing in investments, it will be essential to stay on top of these calculations to understand the effect of fees on the client’s CGT position.
Paul Kennedy is head of FundsNetwork Tax Planning