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Authorised investment funds for individual investors: the facts

Author Image The Technical Team
7 minutes read
Last updated on 6th Apr 2019

Overview

An overview of what authorised investment funds are and how they are taxed.

Key points

  • AIFs can take the legal forms of authorised unit trusts or open-ended investment companies.
  • Unit trusts and OEICs allow investors access to professionally managed portfolios by pooling their assets.
  • They can be held by individuals, trustees and companies with a huge range to choose from allowing portfolio diversification.
  • An AIF will distribute dividends or interest unless accumulation shares are held in which case income is reinvested. 

What are Authorised Investment Funds?

Authorised investment funds (AIFs) are collective investment schemes – a form of investment fund that enables a number of investors to 'pool' their assets and invest in a professionally managed portfolio of investments, typically gilts, bonds, equities and perhaps property. There is a statutory definition of a collective investment scheme in S235 Financial Services and Markets Act 2000. The definition is further refined by means of supplementary regulations made by the FSA that provide for specific inclusions and exclusions. Whether or not arrangements constitute a collective investment scheme is in the first instance a matter for the FSA and ultimately the courts.

AIFs may be constituted under two different legal forms:

  • Authorised unit trusts (AUTs), and
  • Open-ended investment companies (OEICs) 

An investor may therefore own units or shares in an AIF. For the remainder of this article, the terms 'unit' and 'unit holder' should be read as equally referring to 'share' and 'shareholder' in an OEIC. 

It is necessary to consider not only the taxation of the investor but also the taxation of the scheme itself. Personal tax planning aspects are considered in our Authorised investment fund for individual investors: planning ideas article.

Taxation of the scheme

Whilst an AIF can have two different legal forms (trust or corporate), in either case it is subject to corporation tax and is treated, for tax purposes, in the same way, as an investment company. The tax treatment is set out in chapter 2 of the Corporation Tax Act (CTA) 2010. 

The normal corporation tax rates do not apply to AIFs, instead a special rate applies equivalent to the lower rate of income tax, which is currently 20%. No tax is payable on chargeable (ie capital) gains, as they are simply not subject to corporation tax. Instead, the investor is potentially liable to capital gains tax on disposal of units. No corporation tax is payable on UK or overseas dividends received. 

An AIF may claim relief for management expenses.

Distributions

The amount of any distribution from an AIF will be shown in its distribution accounts, and will then be distributed as dividends or interest. 

The AIF may make an interest distribution only if it satisfies the qualifying investments test throughout the distribution period. Where this test is not satisfied, dividends will be paid instead. An AIF satisfies the qualifying investments test if at all times throughout the distribution period the market value of its qualifying investments exceeds 60% of all its investments. Qualifying investments either yield interest or, whilst not being interest, give returns whose economic substance is of a similar nature. 

Broadly therefore an equity fund will pay dividends and a corporate bond fund will pay interest. 

If an investor owns accumulation units, then income will not be distributed but instead reinvested and added to capital. The distribution however remains income for income tax purposes. To avoid double taxation, the notional distribution is treated as allowable expenditure for capital gains tax purposes on subsequent disposal.

Taxation of the investor – income tax

Individual investors are taxed on interest distributions and dividend distributions as savings and investment Income (Part 4 of Income Tax (Trading and Other Income) Act (ITTOIA) 2005.

Dividends

Dividends received are treated in the same manner as any other UK company dividend. See Individual rates and order of taxation.

Interest

AIFs pay interest gross to the investor.

The taxation of interest received by an individual is also explored in Individual rates and order of taxation.

Taxation of the investor – capital gains tax

A disposal of units in an AIF may give rise to a charge to capital gains tax. The normal capital gains tax rules which apply to shares will apply. 

An umbrella fund (in the case of an OEIC – an umbrella company) is a type of AIF that has a number of sub-funds and under which unit holders can exchange units in one sub-fund for units in another. 

For tax purposes each sub-fund is treated as a separate AIF. If a unit holder switches out of one continuing sub-fund into another, there is a disposal for capital gains tax purposes. This is on the basis that the unit holder disposes of an interest in one company and replaces it with an interest in another. If however one sub-fund disappears on being merged with another, rollover treatment (Taxation of Capital Gains Act (TCGA) 1992 may apply.

Interest paid gross to individuals

An AIF now pays gross interest to all individuals, so there is no longer a need for the R105 form. This now makes things simpler for the AIF provider and the individual holder alike.

Taxation of the investor – inheritance tax

S6(1A) Inheritance Tax Act (IHTA) 1984 states that holdings in AIFs are excluded property if held by an individual who is not domiciled in the UK or are comprised in a trust that was created when the settlor was not domiciled in the UK ('excluded property' trust). 

The term "excluded property" as its name implies, covers property of certain types, which is effectively outside the charge to IHT – subject to certain conditions. The exclusion applies to property transferred in lifetime, or owned at death by individuals and to property held in a settlement.

Equalisation

Equalisation is a mechanism that features in many AIFs. Its purpose is to ensure that the value of existing units is not affected by the issue of further units or the redemption of existing units. 

New investors are not entitled to any share of the unit trust's income which arose before they bought their units. However, at the end of each distribution period the manager allocates the same amount from the income of the fund to each unit. Accordingly an equalisation payment is added to the cost of new units representing income that has arisen up to the date of purchase. In view of the fact that these payments are included in the amount available for distribution, they are effectively repaid to the purchaser. 

A unit holder who has purchased units during the period will therefore receive a distribution made up of two amounts: 

  • income which has accrued from the date of purchase, and
  • capital which represents the return of the equalisation element. 

The effect is that income is distributed to unit holders in proportion to the time of ownership of the units in the distribution period. 

Returned equalisation is not part of the income distribution and is a capital receipt which should be deducted from the cost of the units for capital gains tax purposes when computing the chargeable gain on eventual disposal. 

A unit holder who sells units will receive a single capital sum which will include an amount in respect of the income accrued to the date of disposal.

Example

A trust has two unit holders A and B.

The capital value of the trust is £1,000 and income accrues at 8% per annum throughout the distribution period, which is six months. 

After three months C decides to purchase a unit and the price to be paid is £510. (This is made up of £500 capital value plus £10 reflecting the accrued income – £1,000 x 8% x 3/12 x 1/2 = £10.) The £10 is the 'equalisation' payment and this amount is paid by the manager to the trustee and retained in the distribution account. 

At the end of the distribution period the amount available for distribution is £60 made up of £50 income (£1,000 x 8% x 6/12 + £500 x 8% x 3/12) and £10 'equalisation'. 

Each unit holder receives £20 but A and B each receive £20 income having held their units throughout the distribution period and C receives £20 of which £10 is income (reflecting the three months which C held a unit) and £10 is the returned 'equalisation', a capital sum. 

Note that in practice calculations would be done on a daily and not a monthly basis.

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