Taxation of OEICs

In common with unit trusts, OEICs are a collective investment scheme for the purposes of the Financial Services and Markets Act 2000.  However, OEICs are not trusts but corporate bodies for all purposes, including taxation. An investor will own shares in the OEIC, and the OEIC will own the underlying investments. This contrasts with an authorised unit trust scheme (AUT) where the investors have beneficial ownership of the underlying investments of the AUT.

A change in the law was required before OEICs could be established in the UK, principally because UK companies were not, by law, allowed to purchase their own shares on a regular basis, which a mutual fund must be able to do.

OEICs are incorporated under the Open-Ended Investment Companies (Investment Companies with Variable Capital) Regulations 1996, which came into force on 6 January 1997. They are funds satisfying the requirements of the UCITS (Undertakings for Collective Investments in Transferable Securities) Directive, which can be constituted as securities companies, warrant companies or umbrella companies whose sub-funds are securities companies or warrant companies.

AUTs offer only income or accumulation units. An OEIC is able to offer a variety of share classes which may carry different rights, or which may be denominated in different currencies. Shares may be income shares, net accumulation shares and gross accumulation shares. The single pricing structure applying to OEICs is another difference between them and unit trusts.

Because of the perceived advantages of OEICs over AUTs some unit trust managers have converted their funds to OEICs. Therefore an understanding of the taxation regime applying to OEICs will be necessary for financial advisers.

The direct tax regime for OEICS is provided for by the Open-Ended Investment Companies (Tax) Regulations 1997. Subject to some modifications and exceptions these regulations specify that the tax provisions applying to AUTs also apply to OEICs. So although OEICs are UK corporate bodies the taxation regime that applies to other companies, including investment trusts, is not totally replicated for OEICs.

The tax legislation applying to AUTs is modified in the following areas for the purposes of OEICs:

1. Most references to the manager of an AUT have effect as if they include references to the authorised corporate director (ACD) of an OEIC.

2. Section 75 ICTA 1988 (deduction for management expenses) applies to an OEIC whether or not it is an investment company within the meaning of section 130 ICTA 1988.

3. Each of the parts of an umbrella company are regarded for the purposes of the Taxes Acts, except where the context otherwise requires, as an OEIC and the umbrella company as a whole is not so regarded, and is not regarded as being a company for the purposes of the Taxes Acts.

4. Section 272 TCGA 1992 (valuation) is modified to take account of the single pricing.

An OEIC is a company structured as an umbrella investment scheme with one or more different funds (known as sub-funds). But, as stated above, for tax purposes it is the sub-fund that is treated as an OEIC and not the umbrella company.

An OEIC could be structured as follows

Taxation

(i) OEICs are investment companies with an automatic exemption from tax on capital gains. This exemption applies to what could be described as ‘authorised OEICs’. It is possible that there may in future be ‘unauthorised OEICs’, in which case the capital gains exemption may well depend on the tax status of shareholders in much the same way as the capital gains exemption for certain unauthorised unit trusts depends on the tax status of unitholders, eg charities and pension funds.

In any case the capital gains exemption is automatic for ‘authorised OEICs’ and does not require the satisfaction of annual tests such as is the case for investment trusts.

(ii) OEICs pay corporation tax at 20%, being the current lower rate of income tax applicable to savings income. This 20% rate of corporation tax is payable on corporation taxable income less management expenses and interest payable.

(iii) OEICs receive UK dividends and pay dividend distributions without having to account for tax.

(iv) An OEIC is able to underwrite share issues and hence receive underwriting commission. Where no shares are taken up such commission is taxable. Where shares are taken up the underwriting commission can be deducted from the cost of the shares and is hence effectively tax free.

(v) The OEIC tax regulations apply the provisions of FA 1996, s 98, 10 Sch so that an OEIC is not within the ‘gilts and bonds’ tax regime that applies to loan relationships.

(vi) An OEIC is exempt from tax in respect of profits on futures and option transactions.

(vii) Each sub-fund of an umbrella OEIC is treated as a separate corporation tax payer. In other words, if an umbrella OEIC has ten sub-funds there are ten corporation tax computations to prepare.

An OEIC which invests as to more than 60% in interest-bearing investments is able to pay an interest distribution which is deductible for corporation tax purposes. This mirrors the provisions that apply to bond AUTs. In effect such a bond OEIC will then give rise to no UK corporation tax liability. On the payment of a distribution to UK shareholders, income tax at 20% will be withheld. Any such distribution paid out of eligible income, that is income of a type that can be paid gross to non-residents such as bank and building society interest, may be paid gross to non-resident shareholders.  Until 15 October 2002, in order for an investor who is not ordinarily resident in the UK to receive the distribution gross, a valid declaration of non-residence would need to be completed.  From 16 October 2002, provided that the investment is in a special class of unit that is not marketable to UK residents, and the investment is made through reputable local intermediaries, the necessity for overseas investors to provide a valid declaration to receive income distributions gross is removed.

(viii) Of great importance for this type of distribution is that tax deducted at source can be reclaimed by non-taxpayers.  This should be compared with dividend income where the tax credit cannot be reclaimed by non-taxpayers.

(ix) An OEIC may pay its distributions to shareholders as a dividend distribution or as an interest distribution.

So far as distributions are concerned, there is a fundamental issue here for OEICs, and that is that whereas an OEIC may have more than one share class, each of its share classes must pay the same type of distribution. In other words, where an OEIC has A shares and B shares it will not be possible for the OEIC to pay a dividend distribution to A shareholders and an interest distribution to B shareholders for the same distribution period. This is an extension of the provisions of ICTA 1988, s 468I(7) which provides that for AUTs there must be no discrimination between unitholders as to the type of distribution that is paid.

So far as an AUT is concerned each unitholder receives the same type of distribution and the same rate per unit distribution. For an OEIC, because of the flexibility of different charging regimes for different share classes, it is possible for share classes to receive a different distribution rate per share.

As a general principle, and as already noted, where an OEIC has different share classes it may charge different levels of expenses per share class and account for expenses differently across share classes. It is possible that a combination of differing rates of expenses and accounting treatment could materially affect the rate of distribution paid to different shareholder classes from the same pool of investments in an OEIC.

Regulation 12 of The Open-Ended Investment Companies (Tax) Regulations 1997 (the tax regulations) extends the concept of discrimination as between shareholders to the rate per share paid to different classes.

Provided an OEIC is able to show (to the satisfaction of HMRC that:

(a) the differences between the amounts of the charges or expenses apply for bona fide commercial reasons; and

(b) the differences between the treatment for accounting purposes of the charges or expenses apply for bona fide commercial reasons

it will satisfy the ‘relevant condition’ as that term is referred to in ICTA 1988, s 468I(10) as that subsection is inserted for the purposes of the tax regulations.

Taxation of Individual Investors Income

The taxation of distributions will depend on the type of distribution received. Where the distribution is an interest distribution (as outlined in the Fund Taxation section above) it will have 20% tax deducted at source which will be available as a credit against the taxpayer’s personal liability. The consequences for taxpayers are as follows:-

(a) Interest distributions

· A non-taxpayer can reclaim the tax credit to the extent that the grossed-up distribution falls within his personal allowance.

· If the taxpayer’s liability falls within the 10% rate band then 10% tax can be reclaimed.

· For a basic rate taxpayer the 20% tax deducted satisfies his liability.

· A higher rate taxpayer will be liable to tax at 40% on the grossed-up distribution. For this purpose savings income is treated as the top slice of income (but below dividend income). As there is a tax credit of 20% a further 20% of the gross distribution will be due in tax. For instance if the shareholder received a distribution of £80 there would be a tax credit of £20, giving him gross income of £100. The tax liability at 40% would be £40, but as the credit equals £20 only a further £20 would be due.

· An additional rate taxpayer would be taxed at 50% on a similar basis to a higher rate taxpayer (above).

(b) Dividend distributions

Following the abolition of ACT from 6 April 1999 the tax credit attaching to dividend distributions was reduced, from that date, to 10%. The tax credit is notional, as it does not represent tax actually paid by the OEIC. The consequences for the taxpayer are:

· Non-taxpayers are not able to reclaim the tax credit.

· Basic rate and 10% taxpayers have no further liability.

· Higher rate taxpayers pay tax at the rate of 32.5% of the grossed-up distribution. This reduction in the tax rate from 40% is designed to leave such taxpayers in no worse position than in 1998/99. Therefore if a dividend of £80 is received a 10% tax credit of £8.89 would give a gross dividend of £88.89.  Tax at 32.5% would be £28.89, and as there is a credit of £8.89 only a further £20 tax is due, leaving net income of £60, as in 1998/99.

· An additional rate taxpayer would be taxed at 42.5% on a similar basis to a higher rate taxpayer (above).

Capital Gains Tax

For the purposes of CGT OEIC shares are treated like any other shares. A disposal (sale, gift etc) can be an occasion on which CGT becomes payable. When a share is disposed of it is necessary to identify which share among a shareholding of shares of the same class has been disposed of. The identification rules for shares of the same class disposed of by the same person in the same capacity are as follows:

(1)  A share(s) disposed of is firstly identified with a share(s) purchased on the same day

(2)  Any shares sold not identified with shares as in (1) are identified with shares purchased within a 30 day period after the disposal

(3) Any shares not identified within (1) and (2) are ‘pooled’

Pooling is a simple method whereby the shares of the same class are given an average weighted base cost.

Example 1

Peter bought the following shares in ABC income OEIC – 1,500 for £2,500 on 8 August 2008. Then 2,500 shares for £5,000 on 9 December 2010 and 1,000 shares for £3,000 on 17 September 2012. The total number of shares is 5,000. The total cost is £10,500. Therefore there is a pool of 5,000 shares costing £10,500. The average cost is therefore 210p per share.

If Peter had sold 500 shares on 1 September 2012 they would have been identified with the 500 of the 1,000 shares acquired on 17 September 2012. Therefore the base cost for the sale of the 500 shares sold would have been 300p per share.

If the 500 shares sold fetched 3.04p per share his gain would be 4p x 500 = £20. This is far less than it would have been if the 500 shares where identified with the pool in existence at 6 April 2010. This would have given a gain of £582.50. It is in this way that the 30 day rule is designed to deny a taxpayer the use of his/her annual exemption through short-term trading.

Example 3

If, instead, Peter sold 250 shares on 14 November 2012 they would be treated as coming from the pool of shares as at 17 September 2012 and so have a base cost of 210p per share.

If the 250 shares where sold for 310p each Peter’s capital gain would be 310p – 210p x 250 = £250.

If a capital gain has been made by an investor is taxed at 18% on total gains for the tax year that exceed his/her annual exemption.

Where shares are acquired through a regular savings scheme the pooling method makes it far easier to identify the cost.

Where an investment is in accumulation shares the shareholder is charged to income tax on the deemed distribution.  The distribution, not grossed-up, is treated as a further investment and so increases the base cost of the holding. If the income that is reinvested purchases additional shares this also increases the base cost and the new shares will be pooled along with existing shares.

Taxation of Trustee Investors

The trustees of an interest in possession trust will have no further liability on either dividend distributions or interest distributions as the tax credit will satisfy their liability.  Ultimately the life tenant will be the one who is assessed on the grossed-up income with the credit attaching.

The situation for discretionary and accumulation and maintenance trusts is very different. The trustees of such trusts are taxed at 50% on interest distributions.  This means accounting for a further 20% tax on interest distributions, considering that there is a credit of 20%.  If income is paid to a beneficiary he/she would have a 50% tax credit attaching and would pay or reclaim tax according to their personal tax situation.

Capital gains are calculated in exactly the same way as for individual investors (described above). The gains are taxed at 28% with the trustee being entitled to half the annual CGT exemption that an individual would be entitled to.

Taxation of Corporate Investors

Income

Corporate investors are not charged to tax on equity distributions (dividends) from other UK companies. However, if the recipient company pays corporation tax at the small companies rate the distributions may affect marginal relief.

Where a company invests in OEIC shares that pay interest they are taxed under the loan relationship rules on the gains or losses that occur in each accounting year. These are calculated by taking into account both the interest received and the change in the value of the investment during the accounting year.

Capital gains

The capital gains of a company are chargeable to corporation tax – at whatever rate the particular company pays. However, the rules for calculating are similar to those applying to individuals. Two differences should be noted. The first is that the 30 day rule for share identification does not apply and the second is that a company is not entitled to an annual exemption. Remember that where the OEIC pays interest the loan relationship rules apply, therefore the capital gains tax rules do not apply.

Taxation of Non-Resident Individuals

There are two elements to consider. Tax on dividends and tax on capital gains. Dividend carry a 10% tax credit. Non-residents have no further UK tax liability and cannot reclaim the tax credit. Non-residents are not chargeable to UK tax on gains from UK assets. Therefore CGT is not a consideration.

Conversion or merger of AUTs into OEICs

Some AUTs have coverted to OEICs (by merging the AUT into an OEIC shell). The simplest example is where one AUT is merged into an OEIC set up for that purpose. The trustee of that AUT will retain:

(a) a distribution fund to pay out income distributions to unitholders for the distributions period ended on the merger date; and

(b) a liquidation fund to meet various liabilities of the AUT.

Otherwise all the investments of the AUT will be transferred to the OEIC.

Tax consequences of merger 

There will be no charge to stamp duty or stamp duty reserve tax on investments transferred on any merger. There is no charge to tax on capital gains on the transfer of investments from the AUT to an OEIC. There will be a charge to corporation tax on deemed sums arising on the transfer of chargeable securities as that term is defined for the purposes of the accrued income scheme. The corollary is that the OEIC will then obtain purchased interest relief in relation to the acquisition of such chargeable securities.

(a) surplus advance corporation tax;

(b) surplus franked income; and

(c) excess management expenses.

Surplus ACT

Any surplus ACT of the AUT as at the merger date, which date is the end of an accounting period of the AUT, will not be available for carry forward by the AUT in terms of ICTA 1988, s 239(4). Instead, it will be transferred to the OEIC and treated as brought forward in terms of section 239(4) into the accounting period of the OEIC that includes the merger date. Since 6 April 1999, the recoverability of such surplus ACT depends on the operation of the ‘shadow ACT’ regulations.

Surplus franked income

Excess management expenses

Any excess management expenses of the AUT as at the merger date are not available for carry forward by the AUT. In practical terms this is not important in the sense that the AUT should not have much in the way of corporation taxable profits for its dual running period ie the period from the establishment of the OEIC to the date when the trustees of the AUT have wound up the AUT. Instead the excess management expenses are treated as brought forward in terms of ICTA 1988, s 75(3) into the accounting period of the OEIC which included the merger date.