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Plugging a tax leak

Over the past few weeks, I have been looking at the importance of the dividend yield in driving overall returns from equities. With the average yield on the FTSE approaching 4 per cent (and with the chance of capital growth in addition), it is not hard to see why this subject has created so much interest. My focus was on how to minimise the tax on the reinvested income and I investigated the insurance structure, with insurance companies paying no further tax on dividends received.

All good stuff to discuss with clients at a time when “pure” investment stories are hard to find. Of course, events have substantially boosted the case for careful asset allocation as a means of risk reduction. Put simply, don&#39t put all your investment eggs in one basket. Add in some correlation theory and you have the basic components for a risk-reduced portfolio. After all, it is not as if all asset classes have been losing value at the same rate as equities.

The FT reported in its leader on March 12 that the JP Morgan Global Government Bond index is showing a total return of nearly 30 per cent in the past three years. Gold is up by 21 per cent and house prices have risen substantially. However, invest in only one of those asset classes and there would be increased risk. Balance – and constantly adjusted balance – is the thing.

Investors will welcome constant care and attention. Long-term beneficial relationships are founded on communication. Portfolio rebalancing is an obvious and essential way to communicate face to face, over the telephone, in writing or by email. In a balanced asset-allocated and daily-correlated portfolio, the value of minimising tax leakage is true for each asset class.

Subject to charges, while a UK insurance wrapper may be a tax-effective house for reinvested dividend income, it will in most cases not be the most tax-effective wrapper for capital gains. However, an investment in equities is usually made for a combination of the income and the possibility of capital growth. So really careful planning is necessary to minimise tax leakage at both fund and investor level.

Ideally, some relatively simple modelling should be carried out by the adviser to determine which wrapper would be most suitable, based on various reasonable hypotheses on yield, growth and tax rates, both at fund and investor level. These comparisons would usually be made on the reasonable assumption that in an ordinary equity portfolio it will not be possible to split capital growth from income. No discussion here will be made of “splits”.

The simple fundamentals are that, inside a non-insurance (and, of course, non-Isa) environment, capital gains on disposals of equities will be tax-free when made by the fund manager within the safety of a formal outer shell such as an Oeic, unit trust or investment trust.

When the investor realises his interest in the collective investment, this is a disposal for capital gains tax purposes and a gain may arise. There is no indexation relief but there is taper relief and, for the vast majority, the annual CGT exemption. The combination of taper and the annual exemption is extremely powerful for the long-term investor. One would have to ask questions of an adviser who did not, in response to a request for advice on a tax-minimised long-term equity-based investment (who&#39s asking for such a thing these days?) seriously consider a portfolio that was housed in a formal environment that would benefit from taper relief and the annual exemption. Who can afford to give this up?

Gains made as a result of equity sales inside a collective are tax-free. This is not so with a portfolio management service (bespoke or automated, say, on a wrap platform) as there is no formal outer shell. The investments in the portfolio are legally owned by the nominees and the beneficial interest is held by the investor. This means the gains realised by the portfolio manager will be assessed on the investor.

But given that very few investors use their annual exemption, it will be a good thing for many to trigger gains by rebalancing their portfolio. Gains of up to £7,700 per individual (£15,400 for a couple) can be made tax-free in any tax year. So, for many portfolios, rebalancing will have only positive tax consequences through the rebasing of the acquisition price in respect of the rebalanced bit of the portfolio.

For the insurance wrapper – most obviously, a single premium bond – CGT is not an issue. All gains for the investor are subject to income tax. Gains made by the life fund qualify for indexation relief, so investors get the benefit of this indirectly through a lower rate of life company taxation taken into account in repricing the units. However, for an investor who can use his annual exemption and taper, this indirect use of indexation relief is unlikely to compensate.

Which brings me back to my main point, namely, that in a time when extra attention is being focused on every basis point of return, careful tax planning through wrapper choice to minimise tax leakage on income and capital gains can yield worthwhile returns in the shape of an increase to the overall return. One size definitely does not fit all. Ask any adviser.

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