Taxing times

We all know that the Isa season has started and managers&#39 discounts are starting to appear in the press. But with the stockmarkets at such low levels and only one more year of being able to reclaim the 10 per cent tax credit that attaches to dividend payments from UK equities, the question regarding tax incentives and whether they are really worth it must be asked.

After my conversation with the Inland Revenue there seems to be no plan to relent on the five-year incentive from the Chancellor despite numerous lobbying groups.

When Isas superseded Peps in 1999, Chancellor Gordon Brown said that for five years Isa managers would be able to reclaim the now 10 per cent tax credit. The ability for Isa managers to reclaim this will be removed with effect from April 2004. How much difference will it make? Will Isas still be a viable investment for the general public and should we be concentrating on more pressing and wider issues?

Recently, my desk has been covered with Isa manager literature, expecting equity Isa take-up this year to be down – and no one can blame them. Rightly or wrongly, property and cash seem to be more tempting propositions, regardless of the tax treatment.

Many Isa managers are also suggesting that cash could be held within the equity Isa, just to make sure the annual Isa allowance is not lost. However, with holding cash inside a stocks and shares Isa component comes a 20 per cent flat charge on interest received. This interest received by the Isa managers is then remitted to the Inland Revenue as a charge and not a tax.

Cash can be held in the stocks and shares component of an Isa only for the purpose of investing in acceptable investments and not for the purpose of sheltering interest from tax. This 20 per cent charge effectively makes a basic-rate taxpayer worse off because of the Isa managers&#39 charges on what is effectively a deposit account with capital gains tax benefits.

For non-taxpayers, the situation is worse because the 20 per cent cannot be reclaimed, unlike the situation with cash deposits and cash Isas. The reverse of this is that cash can then be reinvested into equities and the Isa allowance is not lost for that tax year. But, if an investor wants equity investment for the medium to longer term, surely now is the best time to invest with markets being so low and equities undervalued.

Equity Isas really do not benefit basic-rate taxpayers, if this was ever intended in the first place. However, basic-rate taxpayers do currently get a marginal benefit over directly holding equities but the charges levied by the Isa manager could still outweigh those benefits.

From April 2004, the only benefit will be from the capital gains tax angle, especially if the Isa holder uses their capital gains tax allowance each year. But, let&#39s face it, what proportion of the basic-rate taxpaying public actually do this?

For non-taxpayers who hold equity Isas, the only benefit they will gain is being able to reclaim the tax credit until 2004. However, this benefit is so small to them that the suitability must be questioned, again in the light of charges.

However, when it comes to higher-rate taxpayers, the Isa dilemma moves swiftly over to the positive side. For these people, no longer having the ability to reclaim the 10 per cent tax credit will also only have a marginal effect. However, holding equities directly would result in an equivalent additional tax charge of 22.5 per cent on dividend payments. There are also the capital gains tax benefits, which lend themselves more to higher-rate taxpayers that use their annual capital gains tax allowance.

The higher the rate and the more tax that people pay on income and gains, the more valuable that Isas obviously become.

Even though the tax credit reclaim system will stop, Isas are still valuable in terms of being able to hold equities without having to report them or the income from them to the Inland Revenue. Paperwork is also cut down for investors. However, the scale of the hit when the opportunity to reclaim is removed will depend on how heavily weighted an Isa is to UK equity income stocks, and the level of dividends those stocks pay.

As I write, there is increased speculation that the 5 per cent withdrawal facility will be removed on bonds, the 10 per cent tax credit reclaim looks certain to go, the Government&#39s savings gateway appears to be a failure, as is the stakeholder pension. You then have to factor in the bomb which has yet to explode on post-97 occupational pension rights.

The current actions of the Chancellor have so far done nothing except worsen the ever widening savings gap. Are these cuts a blatant move to encourage demand for property, thus swelling Government coffers with inheritance tax, capital gains tax on second properties and stamp duty? What about the clamour for new issue gilts that is soon to come?

With unemployment and growth projections down, it is unlikely that direct taxes will be increased. So, come on Mr Brown, what is the hidden agenda? Are you betting on a boom to increase revenue indirectly? We will find out soon enough, I am sure.