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Nice little earner

The Budget brought some positive news for income investors, with corporation tax cuts potentially boosting company payouts and forthcoming regulations to add income flexibility to investment trusts.

Added income relief for enterprise investment schemes and the reintroduction of the NS&I’s retail price index-linked savings certificate are other initiatives targeted at providing investment choice against rising inflation.

The Budget announced a planned reduction in corporation tax from 28 per cent to 26 per cent from April 2011 and to 23 per cent over the longer term.

Ben Yearsley, investment manager at Hargreaves Lansdown, feels the cuts are positive for equity income investors. He says: “Dividends are paid out of profits after tax, so a cut in this tax means more is available for dividend seekers.”

Even though the new rate is applicable in April, the impact may not be felt immediately but Yearsley says it could be translated into shareholder payouts in six to nine months’ time. There is no guarantee companies will use this saving to reward shareholders but even if it goes to shore up balance sheets, he says the impact would be good news for investors.

The other big income event in the Budget was for investment trusts. The Government is looking to remove an existing restriction that limits how much income can be derived from sources that are not shares or securities.

This rule has meant until now that investment trusts must receive the majority of their income from dividends or other acceptable types of interest, such as that paid on gilts. Interest from bank deposits or even property income could not exceed a certain proportion of the trust’s income. Of course, there are property investment companies at the moment but real estate investment trusts follow different rules and others are domiciled outside the UK.

Association of Investment Companies director general Ian Sayers says the restriction was formed in the 1960s and is less applicable in today’s investing climate, which possesses greater diversity in interest-bearing investments.

Under existing law, if a trust derives more than 30 per cent of its income outside of company dividends or other acceptable interest sources, its entire tax status could be lost. The consequences to investors are huge as the trust would be taxed on all its capital gains. As a result, most trusts hold well below the threshold limit to prevent the possibility of accidentally going over the line. On average, 95 per cent of income in most trusts comes from shares and securities, highlighting how far away boards and managers like to keep from that line.

The end result of revising these rules is not about changing the taxation of alternative streams of income as there would be no change there for investors. Instead, the removal of the restriction gives added investment flexibility to existing trusts.

It may also prompt launches into new areas as they will no longer have to worry about losing their tax status by generating too much income from sources other than shares and securities.

One change that may arise is a greater use of derivatives. Similar to how Ucits III allowed wider application of derivative strategies in the open-ended world, the altered rules could enable trusts to use such instruments to obtain higher income levels. Other developments could include mixed asset trusts or single hedge funds structured as a closed-ended vehicle, instead of the current method of using a feeder fund structure or a funds of funds.

Sayers says it is difficult to predict how the industry will develop after the rules are revised but he is positive on the impact it will have. The exact details of the Government’s planned changes are unlikely to be released until later this year so it may not be until the start of 2012 before any developments are seen.

The Budget also confirmed the Government’s intention to continue allowing investment companies to hold 15 per cent of income in revenue reserves. There was a question over this capability as it could have been interpreted as a way to shelter income from taxation.

However, the AIC was successful in its representations to HM Revenue & Customs, says Sayers. The AIC’s research showed trusts across the sector distributed almost 100 per cent of their income. The whole point of reserves is to build them during the good times and pay them out in the difficult times, which is what they have done, he says. With income demand high from investors, this capacity to take income to reserves has heightened the appeal of income trusts, with many stand- ing at premiums to net asset value.

Among the other income investment changes in George Osborne’s Budget was an increase in the amount of tax relief available under EIS. For the 2011/12 tax year investors can get 30 per cent income tax relief in these vehicles, up from the current 20 per cent.

Yet another positive step for income seekers is the announcement that NS&I intends to re-introduce its index-linked savings bonds for general sale, having been withdrawn almost a year ago.

Only savers with maturing investments in these vehicles can currently continue to roll over their investments for a further term. With the retail price index hitting 5.5 per cent, the move to bring back the RPI-linked bonds was welcomed by many commentators.

It is the higher inflation picture that has led to the rising need for investments that can contend with such an environment. Equity income investors certainly stand a better chance than bank accounts these days.

Martin Colwill, manager of RLAM UK equity income says equity income strategies are well placed as he believes many companies are in a strong enough position to grow dividends at a higher pace than inflation. Still, the additional changes Osborne has made in some product areas may enhance the capability of income strategies and provide wider choice for investors in this matter.

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