Going for gains, not income

Private investors are increasingly looking to fill their portfolios with funds that aim to generate growth, rather than income, as the reduced tax rate on capital gains can significantly enhance returns.

So wealth managers are working on a number of strategies for clients looking to take advantage of the new 18 per cent tax rate on capital gains, rather than pay the higher 40 per cent charge on income.

The differential between the two taxes means that wealthy investors, particularly higher-rate taxpayers, are taking greater interest in the tax treatment of their investments.

Returns from collective investments such as unit trusts and open-ended investment companies (Oeics) are typically taxed as capital gains. Meanwhile, returns on cash, bonds and other fixed-interest investments are taxed as income. Alternative investments such as hedge funds and private equity funds also typically fall under the income tax regime.

“I think we will see investors move away from income- producing investments in time,” says Karina Challons, head of specialist tax at HSBC Private Bank.

“If they are going to pay 40 per cent rather than 18 per cent in tax, the performance of the underlying assets has to be a hell of a lot better.”

Challons expects a number of interesting products to be launched in the coming months.

Many institutions are looking at creating bespoke wrappers and investment vehicles structured in a way to create capital gains, rather than income.

“There are not many of these products on the market but I think we will see real change there,” says Challons. “For people with between £250,000 and £500,000 to invest, the costs are prohibitive but there is a lot of pressure on institutions to start to rethink the vehicles they are offering to clients.”

The weaker economic environment and higher inflation means investors are more concerned about the preservation of capital than their tax rate at present.

Many are favouring fixed-interest and guaranteed investments that might be liable to higher tax charges, but at least should reduce their risk and generate positive returns.

But advisers believe clients will look to more tax-efficient investment options as the stock market recovers. They say this will become particularly important for higher-rate taxpayers and those with substantial investment portfolios.

“Once sentiment turns, I think we will see a rush into asset classes designed to generate gains rather than income,” says Mike Fosberry, director at Smith & Williamson, the adviser.

New investments could include structured products that could be wrapped around income-producing investments such as hedge funds and private-equity funds to turn the income into capital gains.

“There is definitely a focus on creating capital growth, especially in the alternative asset space,” says Natalie Merrens, head of product advisory at Kleinwort Benson, the private bank.

She says the gap between income and capital gains tax is so much bigger now that it makes investing in hedge funds and private equity less attractive from a tax perspective. “Institutions are looking at how they can wrap these investments in a capital gains environment,” she adds.

Neil Darke, head of wealth management at Collins Stewart, says the group is trying to find a way to make hedge fund investing more tax-efficient.

“This is the big area we are keen to make progress on,” he says. “The ultimate nirvana for retail investors is to provide hedge fund strategies in structures that allow good liquidity and can be taxed as capital rather than income.”

He believes these types of investments could be very attractive in the current volatile market as hedge funds aim for absolute returns.

Fosberry says there could also be renewed interest in investments such as zero-coupon preference shares of investment trusts, which do not pay dividends, so are taxed favourably.

“Some assets that have not been at the forefront of investment planning could come back into vogue,” he says.

He expects more guaranteed growth-type investments linked to bond returns and says structured products could be redesigned to generate capital returns.

“Historically, these have been taxed as income in most cases,” he says. “But I think there will be new structured products coming to the market aiming to generate capital return through an Oeic structure.”

But investors must choose their funds carefully as advisers say the tax regime is still ambiguous. The difference between income and capital gains tax rates is now so great that HM Revenue & Customs is likely to keep a close eye on any new investment structures that may be manipulating the rules.

“Investors have to be very cautious and very careful,” says Merrens. “Structures should be straightforward and robust.”

Advisers say investors should always ask about the tax structure of their investments and consider the implications.

But they emphasise that the tax rate should never be the driving force behind any investment decision.

“Investors must still make their asset allocation decisions first,” says Merrens. “It is then the job of their private banker to think about the tax implications and where it would be best to hold the investments.”

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