Relief for investment companies post Budget

It's now over six weeks since the first day of the new coalition government dawned on 12 May.

Much of the speculation about their future intentions is now over as the emergency budget on 22 June clarified the future. The coalition's plans to raise Capital Gains Tax (CGT) in particular grabbed the headlines prior to the budget but the reality prompted a sigh of relief across the country and the impact on the investment company industry is much less significant than anticipated.

A 10 per cent rise in CGT for higher rate taxpayers to 28 per cent was much better news for investors than the initial announcement that the rate of CGT on non-business assets would be increased to close to the 40 per cent or even the 50 per cent higher rate of income tax.

So in general terms what will be the impact of an increase in CGT on the investment company industry?

Well, investment companies do not pay CGT on transactions within the company so a slightly higher rate of CGT actually improves their tax efficiency in comparison to a portfolio of direct investments in equities. However, it's also good news that the rate of the CGT allowance, currently £10,100, which allows investors to manage the CGT liability on their investments has been maintained.

Over the last eighteen months there has been a resurgence in the issue of zero dividend preference shares (ZDPS) which have been used by investment companies to raise capital at a time when bank debt was hard to come by and expensive.

A significantly higher rate of CGT was likely to dampen investor demand for ZDPs but this has not materialised and there are still clearly valid reasons to invest in ZDPs. Similarly a much higher rate of CGT would have had implications for B share issues such as the issue recently delayed by Perpetual Income & Growth which pay distributions as capital. Now it seems likely these sorts of issues will be a useful investment tool as they allow investors to defer any CGT liability until the shares are sold.

It's certain that ISAs (with a current limit of £10,200) will be even more attractive with a slightly higher rate of CGT. In addition, VCTs which have already increased in popularity due to the 50 per cent income tax rate are likely to benefit as they are exempt from CGT. The change could also increase the popularity of investment company 'umbrella' structures where investors can switch between different share classes without triggering a CGT liability such as JPMorgan Elect.

We were very pleased that the coalition government confirmed in the emergency Budget that they would consult on the reform of investment trust tax legislation with a view to modernising the rules. This is an issue the AIC has been lobbying on as the tax rules for investment trusts have been in place since 1965 and are beginning to show their age. The reform of these rules will allow investment trust managers to adopt a more flexible investment approach and reduce costs for consumers.

Presently, to maintain their investment trust status and their exemption from tax on capital gains, investment trusts have to derive 70 per cent of their income from qualifying income, namely shares and securities. Income from other sources such as rental income from property does not qualify so managers are forced to limit their exposure to certain asset classes to comply with this rule.

Other changes which are likely to be considered include providing greater certainty to managers over the tax treatment of derivatives, which should also provide greater freedom for investment trusts.

These changes should be tax neutral and the AIC looks forward to working with the Treasury on this important review for investment company shareholders.

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