What is the difference between a distribution and a dividend from a collective fund?
Yes, it is something of a trick question: a dividend would be a distribution, but the opposite is not necessarily the case. Payments of income (distributions) from collective funds can take different forms, depending upon the underlying structure of the fund.
The same is true for the income automatically reinvested in the accumulation units or shares of funds. Generally speaking, there are three categories of distributions that matter to retail investors in UK authorised funds: interest, dividends, and property income distributions (PIDs).
Investors need to be aware of the distinction in a world where the tax treatment of interest, dividend and property income has become increasingly differentiated, e.g. as a result of the introduction of the dividend allowance and personal savings allowance.
Whether income is accumulated (such as in 'acc' shares/units) or distributed (in 'inc' shares/units), it remains taxable subject to the different rules for the class of income. Not surprisingly, the existence of three distinct income classes opens up some tax planning opportunities, but also creates pitfalls for the unwary. To see both, it is first necessary to understand the different income streams:
Funds making interest distributions
There has long been a fairly simple rule determining whether a fund is paying its investors (or accumulating on their behalf) interest or dividends. If a fund - OEIC or unit trust - holds more than 60% in cash (other than pending investment), fixed interest securities or related investments (such as derivatives) throughout a distribution period, then its distribution is classed as interest.
Since 2017/18 such distributions have been made without deduction of tax, a corollary of the introduction of the personal savings allowance in 2016/17. Accumulations are also made gross.
When the 60% rule was set, interest rates were much higher than they are today. At the time a fund with 60%+ in fixed interest almost certainly received the bulk of its income from interest-paying securities. In today's world, that may not be true - the UK equity market average yield is about 4.2% while UK government bonds yield under 2%.
In practice the funds most likely to be watching the 60% threshold with care are those in the IA Mixed Investment 20%-60% Shares sector.
Funds paying dividend distributions
With the exception of property authorised investment funds (PAIFs - see below), if a fund does not meet the 60% test, it will be a dividend paying fund.
While UK and overseas dividends pass through such a fund with no UK tax charge, any interest or other income received is subject to a special rate of corporation tax set equal to basic rate tax (20%).
In practice, as expenses can be set against income, the amount of tax levied is likely to be close to (or at) zero unless the fund is an equity/bond fund with fixed interest content near the 40% ceiling.
Most directly invested property funds now operate as PAIFs, having changed from being dividend paying funds (which had meant a 20% corporation tax charge on rental income). A PAIF distribution potentially has three elements, reflecting the various assets it may hold:
1 Property income distribution (PID), paid out of rental income, normally with reclaimable basic rate tax withheld. Real estate investment trusts (REITS) also pay PIDs. Unfortunately, PIDs cannot be set against the £1,000 property allowance;
2 Dividends (typically from property companies); and
3 Interest, which is paid without deduction of tax.
Some property fund managers offer feeder funds which are 100% invested in their PAIFs, but do not themselves count as PAIFs and are thus taxed as dividend-paying funds. As a result, the rental income is subject to 20% corporation tax within the fund.
The planning points that emerge from these classes of distribution can be surprising:
Turning interest into dividends
A higher rate taxpayer has only a £500 personal savings allowance and faces 40% tax on interest above that level. If the taxpayer has any dividend allowance available, tax can be saved by using an equity/bond (mixed) dividend-paying fund, rather than holding separate equity and bond funds, as the following example shows...
Interest into dividends: An example
James is a higher rate taxpayer with no remaining personal savings allowance, but £1,000 of unused dividend allowance. He wants to invest £40,000 split equally between global bonds and global equities.
Assuming a 3% yield on bonds and 2% on equities, he can choose between investing £20,000 in a bond fund and £20,000 in an equity fund, or £40,000 into a single 50/50 bond/equity mixed fund:
||Two separate funds (£)
||50/50 mixed fund (£)
|Fund corporation tax (20%)
|Personal tax (40%)
|Total net income
*covered by dividend allowance
Turning dividends into interest
The opposite transformation – from dividend to interest – can also be achieved by choosing an interest paying mixed fund. This could be useful in exploiting the personal savings allowance and/or the rarely used £5,000 0% savings rate band.
Dividends into interest: An example
Jane has a pension income of £12,500 and dividend income of £2,250. She wants to generate £6,000 of income by investing £200,000 she has just inherited in UK bonds and UK equities, with a two thirds/one third split.
Assuming a 2.5% yield on UK bonds and 4% on UK equities, that could mean either investing £133,333 in bond funds and £66,667 in equity funds, or £200,000 into bond/equity funds with the same investment split:
||Separate funds (£)
||Mixed funds (£)
|Personal tax (7.5%)
|Total net income
*Covered by savings rate band ^ Covered by balance of savings rate band and personal allowance
Turning PIDs into dividends
PIDs are fully taxable as income, not dividends. For higher and additional rate taxpayers who have some dividend allowance remaining, using a PAIF feeder fund is better than opting for a pure PAIF as the effective tax rate will only be 20% (the corporation tax within the fund). Once the dividend allowance is exhausted, the PAIF is preferable.
ISAs and pensions
Ideally, dividend-paying mixed funds should not be used in tax-exempt wrappers because any 20% corporation tax levied on interest within the fund cannot be reclaimed. Interest paying mixed funds are not an issue.
Internal corporation tax point can also be a point to watch on SIPP/ISA-held property funds: a PAIF feeder fund is best avoided in favour of the pure PAIF. However, some platforms will only offer the feeder variant because they are unable to handle the three streams of income from a PAIF.
Once the allowances and ISAs are exhausted
If there is no savings rate band, dividend allowance or personal savings allowance left and ISAs have been maximised, then separation of equities and bonds is the order of the day. Any mixing equities and bonds in a single fund can add to tax liabilities:
A dividend received via an interest paying fund is subject to personal tax at the full rate. For a higher rate taxpayer that would mean paying 40% on the dividend instead of 32.5%.
Interest received via a dividend paying fund suffers a 20% corporation tax within the fund and personal dividend tax on the interest. For a higher rate taxpayer that would mean an effective tax rate of 46% (100% - 0.8 x 67.5%) instead of 40%.
Keeping track of income should not be difficult, even though some investors struggle to see why tax still applies to income they do not physically receive, because it is accumulated. Platforms typically provide income statements six monthly and are required to issue consolidated tax certificates each tax year, which will include accumulated income.
The differing treatments of collective income are not widely understood, but just because they exist does not mean they must be exploited. As ever, tax considerations should come at the end of the investment process and not determine asset mix.
To borrow a familiar phrase, don't let the tax tail - however ornate and attractive - wag the investment dog.
Andy Woollon is a wealth specialist at Zurich