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Tony Wickenden: Dividends in the mix

Extreme volatility in equity markets is undoubtedly one of the key factors influencing the flow of funds into (and out of) retail investment products and, for funds invested, across asset classes. The crisis in Europe and the uncertainty over what the outcome is likely to be is, of course, a major contributor to volatility.

The volatility in equity values reminds us that it is reliance on capital growth only as the driver of equity value that introduces the greatest risk to equity values in a portfolio. Recently, I saw a piece in the FT by Allianz Global Investors co-head and global chief investment officer Andreus Uterman that reminded me of this.

The author made the point that, over time, the performance of equities has become increasingly equated with the rise and fall of stock prices at the expense of a focus on dividends, a trend exacerbated by indexation and companies’ preference for share buybacks as a means of capital return.

He makes the point that this could be influenced by, or has influenced, the fall in the proportion of dividend-paying stocks from 93.8 per cent of S&P companies in 1980 to 72.6 per cent by the end of 2009.

Despite this, there is strong and continuing evidence that equities are a much more attractive long-term investment proposition when one looks at their ability to generate dividend income. For example, over the period from the start of 1970 to the end of 2011, so the author states, dividends contributed 43 per cent of the overall, annualised return of the MSCI Europe index.

Most will have read at some point in their investing life that research points to the value of dividend investing, particularly in OECD economies, where continuing low interest rates, disinflation or low to modest inflation and low economic growth is expected to persist for a prolonged period.

Generally speaking, it seems that there is a case to be made for concluding that, from a portfolio perspective, investing in dividend-paying stocks is a key part of the equity component of the asset mix. It seems that not only do they have a good chance of outperforming over time, they often exhibit lower volatility in the process. This, according to Uterman, is perhaps not surprising considering that, contrary to popular belief, there is evidence that companies with high payout ratios tend to exhibit strong (future) earnings growth.

All this investment-centred commentary is, of course, essential to the decision-making process in relation to determining the extent to which equities should be included in the asset mix and then which equities to invest in.

So, in relation to dividend-producing equities, what wrapper would deliver the optimum outcome? Well, especially for higher and additional-rate taxpayers, the registered pension and Isa are no-brainers. Of course, there are other factors that need to be taken into account in determining optimum wrapper choice for investors but from a pure tax stand-point, this cannot be denied.

If we leave aside investing through an Isa and a pension, for basic-rate and non-tax-payers dividends from direct equities or collectives suffer no tax at fund or investor level, whether taken or reinvested. This, together with (for most basic-rate taxpaying investors) access to the annual CGT exemption to cover any capital gains means there is no obvious tax advantage to investing through an investment bond, onshore or offshore, in relation to dividend-producing equities. Indeed, it could well be tax detrimental to the extent that the capital gains accruing inside a UK life fund (to the extent that they exceed indexation) bear tax at fund level and in an offshore bond to the extent that emerging gains, driven by capital gains and otherwise untaxed income, suffer basic-rate tax when a chargeable event gain arises. And, with an unwrapped investment, the risk of a final capital gains tax liability can be minimised by regular use of the annual exemption, perhaps even through simple rebalancing exercises.

Naturally, the bigger the investment and the greater the capital growth, the greater the chance that a realised gain will exceed the annual exemption and trigger a tax charge. But this will only be at 18 per cent for basic-rate taxpayers based on current rates. There is also the fact that reinvested income under a collective increases the “acquisition cost” for CGT purposes.

For higher-rate and additional-rate taxpayers, though, dividend income received directly from an equity income fund will suffer tax at 32.5 per cent (higher rate) or 42.5 per cent (additional rate) on the grossed-up amount (with the tax credit then taken off), leaving an effective rate of 25 per cent on the net dividend for a higher-rate taxpayer and 36.1 per cent for an additional- rate taxpayer. These rates will be suffered regardless of whether the income is taken or reinvested.

For these categories of taxpayer, it may pay to hold the equity income funds inside a UK or offshore investment bond, especially if the aim is to reinvest to drive growth. In either case, there will be no tax on income reinvested. Which wrapper will turn out to be the most tax attractive will depend on a number of factors, including (most important) the tax position of the investor when benefits are taken and how benefits are taken. There will inevitably be a number of variables to take into account in each particular case to determine whether a UK or offshore bond is likely to be a more tax appropriate “home” for an equity income fund investment.

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