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Wrapped attention

Selection of an appropriate wrapper can make a significant difference to the performance of a portfolio.

Some investment commentators appear to be contemplating an increase in interest in growth stocks. Investors will no doubt be encouraged to consider the risks inherent in such investments very carefully, especially after the debacle of the boom, where the focus was on companies reinvesting their earnings – if they had any – on their behalf. Investors are effectively trusting the management to reinvest to grow the company rather than pay out earnings to shareholders in the form of dividends or share buybacks.

Some advocate a focus on companies seeking global growth as opposed to those focused on a single country, the principle presumably being to reduce risk. In this respect, no doubt some will be cautious over companies which rely heavily on the US market for growth.

Financial planners involved in giving investment advice cannot do so without taking more than a passing interest in the comments of other investment professionals and if there appears to be some interest in the future of growth stocks, then no doubt this will be looked into, if only to respond to the questions that may be asked by investors.

This focus on growth is interesting, as the stronger story, over the recent past at least, appears to have been connected with value investing. Past performance, despite being no guide to the future, is hard to ignore in practice.

Investors could therefore be forgiven if they feel in need of advice over the balance between growth and income funds. This is another example of investor choice giving rise to potential anxiety. It is not just around the mix of investments underlying the portfolio but also in connection with portfolio wrappers that choices have to be made which can significantly affect the bottom line.

Let us look first at value/ equity income funds since, even if the growth message is embraced, it is unlikely that all income funds will be jettisoned or ignored. There has been a strong commonsense message put across in favour of these funds that the dividend in the hand is worth more than the growth in the bush, so to speak. In practice, many portfolios generate returns from a mix of reinvested income and capital growth.

The performance of the portfolio is absolutely critical to securing an acceptable level of return but, as I have said on many occasions in the past, the selection of an appropriate wrapper for the portfolio can also make a significant difference.

In connection with equity income funds, all other things including charges being equal, an insurance-based investment wrapper will offer the opportunity of tax-free reinvestment of dividends inside the UK life fund. Naturally, this assumes the dividends are ordinary dividends and not interest distributions. This tax-free roll-up will also be available inside an offshore bond.

It is this that usually grabs the limelight but, with absolutely no axe to grind, it is worth remembering that the UK life fund gives the same tax-free roll-up of dividends and neither fund can reclaim any tax credits on these dividends. That is well known. Only capital gains realised by the UK investment fund will be subject to tax and then after the application of the indexation allowance. However, this general rule is displaced where the life fund invests in collective investments where a deemed disposal would be treated as having been made each year, with the tax liability spread over the next seven years.

As you can imagine, this makes for some fairly complex calculations. Given the prevalence of insurance-wrapped collective investment funds, it is hardly surprising that the effective rate of tax reserved for inside a UK life fund remains a mystery to most outside the actuarial profession and is certainly not made publicly available.

Inside an offshore insurance bond fund, there would be no tax on capital gains. This is based on the assumption that the company is resident in a tax haven. In connection with dividends being reinvested, there would be no tax but, as stated above, no ability to reclaim any tax credit.

When encashment takes place, as is well known, the UK investment bond would deliver a 20 per cent tax credit to the investor, which corresponds to a full tax credit for a basic-rate taxpayer, with no need to gross up the gain. The offshore bond would give no tax credit so that the gain would be subject to tax in full at the investor’s marginal rate. One can see that, when comparing wrappers, one of the key factors is how long the funds remain invested and how they are withdrawn.

When a gain made under a collective investment is realised by a UK taxpaying investor, the substantial benefit of taper relief to reduce taxable long-term gains by up to 40 per cent after 10 years of ownership and the use of the annual exemption (year on year in the context of what may be a rebalancing exercise which would also uplift the base value of the investment, possibly tax-free) could offer an extremely attractive tax outcome to the UK investor investing for growth.

I will look at this in more detail next week.


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