In as short series examining the effect on investments of the UK's recent budget, top City law firm Norton Rose examine the reform of taxation of collective investment schemes.

Although the relevant Inland Revenue press release is headed “Reform of Taxation of Collective Investment Schemes”, most of the changes will be of very limited significance, either because they simply give statutory authority for an existing practice or because they only apply in relative rare instances.

At present, an unauthorised unit trust, the units in which can only be held by UK persons who are exempt from capital gains tax (such as pension funds, charities and investment trusts) are themselves exempt from tax on capital gains. The law is being changed so that this exemption will not be lost if:

· life insurance companies or friendly societies hold the units, provided that the holding is referable to a category of the company’s business which is exempt from corporation tax on chargeable gains; or
· the manager of the unit trust temporarily holds units in its capacity as manager.

These changes will apply for the tax year 2005/06 and later years.

If units or shares in an Authorised Investment Fund (AIF), i.e. authorised unit trusts (AUTs) and authorised open ended investment companies (OEICs), are held in a PEP or ISA, distributions are generally paid gross. However, if the PEP or ISA account becomes void (for example, if the investor dies) the manager of the PEP or ISA has to account for the tax. From 6 April 2005, the tax charge will fall on the investor (or his estate).

Where AIFs have more than 60 per cent of their investments in debt instruments (bond funds), they can pay out distributions to investors in the form of interest distributions which are deductible in computing the taxable profits of the fund (as opposed to dividend distributions which are not deductible). Practical problems can arise due to the requirement to test the percentage of debt assets held by the AIF on a daily basis.

The Finance Bill 2005 will include powers to change the tax rules relating to AIFs and the Inland Revenue intend to open discussions as to whether the daily test should be abolished. The intention would be that an AIF could pay interest distributions and dividend distributions for a period in proportion to the interest income and dividend income which it receives in that period. A fund would be able to pay all its distributions in the form of dividends if it so chooses.

The AIF regime provides tax benefits to investors who choose to invest in these regulated products, AUTs and OEICs, which are managed independently of the investor. Under the new Qualifying Investor Scheme (QIS) regime, there will be greater flexibility for the investor to influence management decisions and the Inland Revenue are concerned that this will offer scope for tax avoidance.

Accordingly, the Finance Bill 2005 will contain provisions allowing the Inland Revenue to make regulations to tax investors differently if they own “a substantial proportion” of a QIS. Where these provisions apply, the investor will be taxed, as income, on any annual increase in the value of the investment. Unrealised gains which are reflected in the value of the investments will not be taxed on an annual basis but will be held over and treated as chargeable gains when the units or shares are sold. Exempt investors, such as pension funds, charities and certain life insurance companies, will be excluded from these provisions. Again, the Inland Revenue intend to discuss these changes with interested parties prior to implementation.

This article is a general guide only and is not intended to be definitive advice which should be sought as appropriate in relation to a particular matter. If you would like to discuss a particular matter, please contact John Challoner, tel: +44.207.444.3389 or Louise Higginbottom, tel: +44.207.444.3393.