Tax consultations important for modernisation of trusts

The last week of July always seems to be an eventful week as the "powers that be" issue a string of consultation papers and proposals before the August holiday season.

This year has proved no exception with the launch of the government's consultation on the reform of financial regulation on Monday, a string of tax consultations on Tuesday and the FSA's proposal to widen its remuneration code to investment managers on Thursday. However, it was one of the tax consultations, the modernisation of investment trust companies rules, that particularly caught the attention of the investment company industry.

This tax consultation is an important step in modernising the rules for investment trusts which have stayed largely the same since their introduction in 1965. Traditionally the tax rules have meant investment trusts have focused on equity investment. This has been the case despite the marketplace changing and the introduction of new listing rules giving investment companies much more investment flexibility.

These new rules offer the opportunity for investment trusts to diversify and offer new means of generating shareholder returns. Specifically the new rules will clarify that investment in loans, futures, options, CFDs, swaps, warrents, foreign exchange, units in collective investment schemes and carbon emission credits are all permitted for tax purposes.

The reform of these rules should also help reduce ongoing administrative costs as it will move investment trusts to a new system of ongoing self-assessment and away from a requirement for annual approval of investment trust’s tax status. This will reduce the bureaucracy involved with maintaining an investment trust’s tax status and bring the sector into line with other collective investment products.

So under the new rules if an investment trust was to inadvertently breach the tax rules and then remedy the mistake immediately, there should be no adverse tax consequences for that investment trust.

The proposed new rules also remove the obligation for investment trusts to hold no more than 15 per cent of the portfolio in any one company, and instead creates a characteristics-based approach. This approach is to be based on the current Listing Rule requirement for an investment company to produce an investment policy which demonstrates that it has a policy of spreading risk. This should allow a broader range of investment strategies to be adopted.

The proposed new rules will remove the current income test for investment trusts which states that 70 per cent of an investment trust company's income must be derived from income from shares and securities.

Investment trusts currently can retain up to 15 per cent of such income to boost their revenue reserves but the proposals would only allow 10 per cent of total income to be retained, potentially a reduction of up to one third. This proposal is concerning because the investment company sector has an enviable track record of dividend increases which is supported by investment trusts' ability to retain some of the income they receive each year and transfer this to their revenue reserves.

Retaining income is a structural benefit for investment trusts as open-ended funds are required to distribute all their income each year. Investment companies, however, can build up their revenue reserves during the good years to allow them to pay dividends in difficult years which is known as 'smoothing dividends.'

Topping the list of companies who have increased their dividend every year is City of London who have increased their dividend payments for an impressive 43 years in a row. Following closely behind are Alliance Trust, Bankers Investment Trust and Caledonia who have all increased payments for 42 years.

While for most part the proposed tax changes are very positive for the industry, care will have to be taken to ensure that the transition to a new tax regime takes account of all investment trusts. The AIC look forward to working with officials to fine tune these proposals to ensure the best possible result for the industry.

Annabel Brodie-Smith is communications director at the Association of Investment Companies. The views expressed are her own.