As we enter the new tax year, the tax relief on Isa income will be abolished. In anticipation of this and, in our view, mistakenly, many fund management houses have been suggesting distribution funds as a means for investors to protect themselves against this change.
Distribution funds – funds with more than 60 per cent of the assets invested in bonds – have been considered by some as tax-efficient, as all the distributable income can be distributed as interest payments.
Investors can therefore reclaim the 20 per cent deducted in tax and, consequently, some have argued that this makes distribution funds extremely tax-efficient.
However, Schroders' calculations indicate that the position is incorrect. Even after April, when tax relief on Isa income is due to be abolished, distribution funds do not offer a tax advantage.
As long as more than 60 percent of a fund's portfolio is invested in bonds and cash, then all distributable income in a fund, including income from equities, can be distributed to unitholders in the form of an interest payment.
The distribution is made net of an income tax deduction of 20 per cent, which can then be claimed back in respect of Isa investments in the fund.
The ability to reclaim the income tax deduction will remain after April when the ability to reclaim tax credits on equity funds is abolished.
Let us look at an example, such as a £50m distribution fund consisting entirely of Isa-holders and with 70 per cent invested in bonds and 30 per cent invested in UK equities. Let us assume a gross yield on bonds of 5 per cent and a gross yield on equities of 3.5 per cent, with total fund expenses of 1.5 per cent. On a £7,000 Isa investment, this would result in a total income of £213.
However, if the £50m were to be placed in a separate bond and equity fund, with £35m in bonds and £15m in equities instead of in a distribution fund, the results would be exactly the same.
On an individual level, the income on £4,900 invested in bonds, combined with the income from the £2,100 invested in equities, £171 and £42 respectively, is £213.
For an Isa-holder, there is neither an advantage nor disadvantage to holding a distribution fund and consequently the decision on which funds to invest in should be made taking into consideration a broad range of factors, such as risk tolerance and time horizon for investment, but not tax. This is because in the latter example, the tax is never actually deducted from the equity fund, while in the distribution fund it is deducted and then reclaimed.
This position is also true for investors who do not pay tax. However, other investors paying either basic or higher-rate tax are worse off.
For example, a basic-rate taxpayer, with £7,000 invested in a distribution fund would have a net distribution of £170.80. On the other hand, with the income on £4,900 invested in a bond fund, combined with the income from the £2,100 invested in an equity fund would total £179.20, or £137.20 from the bond fund and £42 from the equity fund respectively.
It is a similar scenario for a higher-rate taxpayer. In this instance, a £7,000 investment in a distribution fund would result in a net distribution of £170.80, which would be reduced by a further tax charge of 25 per cent to a net income of £128.10.
However, a higher-rate taxpayer with £4,900 invested in a bond fund and £2,100 invested in an equity fund would have a net distribution of £179.20 (as above). This would be subject to a further 25 per cent charge, resulting in a net income of £134.40.
In other words, investors using a combination of UK equity and bond funds are, at worst, in a tax-neutral position compared with investors in distribution funds. If the investment is held outside an Isa and they are basic or higher-rate taxpayers, they are better off.
This has been recognised by the Investment Management Association which has advised members that there is no tax advantage to distribution funds.
What does this mean for investors? In rising equity markets, a potential disadvantage of a distribution fund is that it has to maintain 60 per cent of its assets invested in bonds and investors will miss out on the potential growth in equities as the fund is forced to sell the equity portion when it exceeds this stipulated proportion.
However, by splitting the investment in two funds, investors can still have a conservative portfolio but with the upside of greater participation in any growth in UK equity markets.