Thoughts about OEICs and Unit Trusts
Open ended investment companies (OEICs) and unit trusts 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.
Back to basics
There are many different ones to choose from in a wide variety of sectors. A client will buy units in a unit trust or shares in an OEIC however they are both taxed in the same way for an investor.
How is the income paid?
Depending on the type of asset that the fund is invested in, it will typically either pay out dividends or interest. If the investments comprise 60% or more in interest yielding assets it will be an interest OEIC or unit trust. The income is classed as savings income for tax purposes.
How is the income taxed?
In the hands of an individual dividend distributions are taxed as follows –
The first £2,000 of dividends are taxed at 0% then-
- 7.5% for dividends in the basic rate band
- 32.5% for dividends in the higher rate band
- 38.1% for dividends in the additional rate band
Interest is paid gross and is taxed as savings income as follows –
A 0% starting rate applies to savings income up to £5,000 (it does not apply if an individual's taxable non-savings income exceeds their personal allowance plus £5,000)
There is also a tax free personal savings ‘allowance’ of £1,000 (reduced to £500 if any of the individual's income is taxed at the higher rate). After that the rates are -
- 20% for basic rate tax payer
- 40% for higher rate tax payer
- 45% for additional rate tax payer
Income or Accumulation?
Income shares pay the distributions as income out to the client, even if the client has indicated on the application form that they want the income re-invested. All that happens is that the income is distributed (and tax is potentially due on the income payment) and that income is used to buy further shares in the fund.
While accumulation shares wrap up those distributions and reinvest them in the fund, to increase the capital value of your clients investment.
Capital Gains Tax
A disposal of shares in an OEIC or units in a unit trust may give rise to a charge to capital gains tax (CGT). Every individual is entitled to the annual exempt amount (AEA) each year (including children) which currently stands at £11,700 and it is only gains above this amount which will be subject to CGT.
Rates and annual exemption
The rates for CGT in 2018/19 are:
- 10% for individuals where total taxable gains and income are less than the upper limit of the basic rate band (£34,500+£11,850 = £46,350)
- 20% for individuals in respect of gains (or any part of gains) above that limit.
When a person dies there is no CGT charge. Instead there are special rules. In broad terms, the assets which were owned by the deceased at the date of death are treated as though they had passed to the personal representatives at the date of death, at their market value on that date. When the administration of the estate has been completed and the assets remaining in the estate are passed to the beneficiaries, they are treated as though they had passed to them at the date of death at their market value on that date. This establishes their CGT cost for a later disposal.
Taxation of the investor – inheritance tax
On death the value of your client’s holding will form part of their estate for inheritance tax purposes. However if they are 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) they will not form part of their estate.
As interest from OEICs and unit trusts is taxed as savings income, it makes sense (from a tax perspective) for non-tax payers or those on modest incomes to consider such investments to maximise the income tax savings. The income generated can be set against unused personal allowance, the 0% savings rate and the personal savings allowance which means OEICs and unit trusts may form part of an individual’s overall portfolio of investments to maximise usage of the available allowances.
Every individual is also entitled to the dividend nil rate which is currently set at £2,000 per year thus investments which generate dividends (e.g. equity OEICs) should also be considered in order that this can be fully utilised.
As the AEA is an annual exemption it makes sense to dispose of capital assets each year to maximise this exemption. It used to be common practise to advise clients to sell holdings and buy them back the same day to utilise the AEA without adversely upsetting the client’s portfolio. This practice was called “bed and breakfasting” but due to anti-avoidance legislation this is no longer available to clients. A client will now have to wait 30 days before they can buy back the same type of shares that they previously disposed of.
However the 'bed & breakfasting' anti-avoidance rules do not apply in the following situations:
- Repurchase after 30 days
- Repurchase of a non-identical fund
- Repurchase made by spouse
- Repurchase within an ISA, pension or bond
This gives your clients opportunity to take advantage of their AEA by using the above methods.
Remember if a client is considering the disposal of assets that will generate a gain larger than their AEA, they can consider an outright assignment of some of those assets to their spouse/civil partner to potentially make use of both exemptions.
Where the spouses or civil partners are living together, any transfer of an asset between them is treated as giving rise to neither a gain nor a loss to the person transferring it.
Making a gift into trust allows an individual to get an asset out of their estate after 7 years. It is also common place for trustees to use OEICs and unit trusts as part of the overall investment strategy. These investments are taxed in different ways in the hands of trustees in respect of capital gains tax and income tax as follows –
- Income assessed on the beneficiary (if non parental settlement).
- Capital gains assessed on the beneficiary
Interest in possession Trust (IIP)
- For income tax the trustees are taxed at 20% basic rate on interest and 7.5% on dividends. The trustees must pass all of the income received, less any trustees' expenses, to the beneficiary who is then taxable accordingly. The beneficiary has a right to the income meaning that it retains its character such that the beneficiary can utilise the Personal Savings Allowance or £2,000 dividend nil rate as appropriate. To simplify administration, the trustees can mandate trust income to the beneficiary
- For CGT purposes, trustees are subject to CGT at 20% for gains above the trustees' AEA (normally half of the individual rate)
- A standard rate band of £1,000 applies with dividends taxed at 7.5% and interest at 20%. For trust income over £1,000 then dividends are taxed at 38.1% and interest taxed at 45%. Where trust income is paid to a beneficiary at the trustees discretion it's treated as having already been taxed at the trust rate of 45%. Income received by a beneficiary is treated as trust income meaning that the Personal Savings Allowance or £2,000 dividend nil rate cannot be offset against that income. If the beneficiary is a non-taxpayer, or pays tax at 20% or 40%, they can claim some or all of the tax back. Trustees are not entitled to the Personal Savings Allowance or the £2,000 dividend nil rate.
- For capital gains tax trustees are subject to CGT at 20% for gains above the trustees' annual exempt amount (normally half of the individual rate)
Thus OEICs and Unit Trusts can be useful investments to hold in an individual’s overall portfolio to efficiently maximise their available allowances i.e.
- AEA – for CGT purposes
- Funds that generate dividends which can be offset against the dividend 0% rate for individuals
- Funds that generate interest which can be offset against the PSA and the £5,000 0% savings rate for individuals
- Income can be set against any available personal allowance for individuals
- They can be used by trustees as part of the overall investment strategy.
Finally, please remember that this article has simply focused on tax issues, and it may be that the particular fund identified as being suitable for the investor might not be available within the OEIC/unit trust wrapper.
You can find more information on OEICs and unit trust if you click the links below –
ARTICLE by The Technical Team
Lifetime Allowance (LTA): Q&A
Questions from advisers answered on the lifetime allowance, including queries about protection, LTA excesses, pre A-day benefits, LTA on death and other general questions.
ARTICLE by The Technical Team
Pension death benefits: Q&A
Answers to some common questions we’re asked on the topic of pension death benefits,including options for how these may be paid, how payments are taxed, if a lifetime allowance test applies etc.