Investment funds tax

Out-Law Guide | 05 Aug 2011 | 2:18 pm | 5 min. read

This guide was last updated in April 2014.

An investment fund is a structure that enables two or more investors to make an investment on a pooled basis. The resulting fund can be used to invest in quoted shares, private companies, property and many other assets.

Unit trusts, open-ended investment companies (OEICs), investment trusts, limited partnerships and offshore companies are some of the possible fund structures. The most appropriate structure will depend on factors such as the nature of the assets to be invested in and the type of investor involved.

Main tax issues

The aim of tax planning in relation to fund structures is for the investor to be no worse off as a result of investing through a fund structure than if the investment had been made directly by the investor in the underlying asset.

There are various different levels of possible tax. For example if the underlying asset is company shares, the company will first be subject to tax on its profits. There could then be a tax charge when the company distributes profits to the fund, and then a further possible tax charge when the fund distributes income to the investor.

Sometimes when income is distributed, the person making the distribution has to deduct tax from the distribution and pay it on to the tax authorities. This sort of deduction is referred to as a withholding of tax. It can be particularly unattractive for the recipient of the income, who effectively has to pay the tax upfront.

In addition to possible tax liabilities in respect of the income from the underlying investment, the capital gains tax position will also need to be considered – both of the fund and of the investor when the investment in the fund is cashed in.

This rest of this guide focuses on UK tax consequences of various different UK resident fund structures for the fund itself and for a UK resident individual. The tax treatment of offshore structures is different, and is not considered in this guide.

Authorised unit trusts and UK open-ended investment companies

A unit trust is a trust which holds a pool of investments on behalf of its investors, who are called unit holders. Unit trusts are 'open-ended', which means that investors can freely buy and sell shares in the fund which then grows or shrinks accordingly. The value of units held in a unit trust will always therefore represent the value of the underlying assets held in the fund.

Authorised unit trusts are unit trusts that have been authorised by the Financial Services Authority. They are frequently used by individuals to hold shares and other investments, and are therefore heavily regulated.

Open-ended investment companies (OEICs) are companies which are similar to unit trusts because they are also open-ended, so that the company grows and shrinks as investors buy and sell shares in it. However as they are companies, the investor holds shares rather than units. Like authorised unit trusts, OEICs can be sold to the general public and are therefore heavily regulated.

Authorised unit trusts and OEICs are exempt from capital gains tax on disposals of investments.

An authorised unit trust is treated as a company for UK tax purposes in relation to income, and the unit holders are treated as shareholders in the company. An OEIC is a company, and so it is treated in the same way.

Authorised unit trusts and OEICs are subject to corporation tax on their income, but at the basic rate of income tax (currently 20%) rather than the normal rate of corporation tax. However, by April 2015 the rate of corporation tax is expected to be 20% for all companies.

Dividends received by the unit trust or OEIC from UK and overseas companies are usually exempt from tax, because they will qualify for the dividend exemption from corporation tax.

Interest will be taxable in the unit trust or OEIC, but a tax deduction should be available when interest is paid to investors. The position for the fund should therefore be tax neutral for interest payments which pass straight through the unit trust or OEIC and on to investors.

When disposing of their interest in an authorised unit trust or OEIC, individual investors will be subject to capital gains tax at the usual rates.

Dividends paid by UK authorised unit trusts or OEICs are treated in the hands of the investor in the same way as dividends from ordinary company shares in UK companies.

Interest distributions paid by UK authorised unit trusts or OEICs are taxed as interest in the investor's hands. Interest distributions to UK individuals will have tax deducted from them.

Special rules apply to property authorised investment funds (PAIFs) and funds which fall within the tax electing fund regime (TEF) or the funds investing in non reporting offshore funds regime (FINROF).

Unauthorised unit trusts

An unauthorised unit trust is a unit trust which is not authorised by the Financial Services Authority.

Income arising to an unauthorised unit trust is taxed as the income of the trustee, generally at the basic rate of income tax.

The trustees of an unauthorised unit trust are subject to capital gains tax on the disposal of the underlying investments of the unit trust. As unathorised unit trusts do not benefit from a capital gains tax exemption, they are generally only attractive to tax exempt investors such as pension funds and charities.

Investors are taxed on the income of the unit trust regardless of whether or not it is distributed by the unit trust. Investors are treated as receiving income which has suffered deduction of basic rate income tax. UK resident investors can set the credit for this basic rate tax against their liability to income tax.

UK resident investors who dispose of their units in the fund are treated as having disposed of shares in a company, and are subject to capital gains tax on any increase in the value of their units.

Investment trusts

An investment trust is a listed company which satisfies certain conditions and is approved by HM Revenue & Customs. Investment trusts are quoted on the Stock Exchange, so the price of shares in an investment trust reflects not just the underlying investments but also the popularity of the investment trust on the market. This means that the price of an investment trust does not always reflect the value of the investments it holds.

Investment trusts are exempt from capital gains tax on disposals of their investments.

Investment trusts are subject to corporation tax on their income at normal corporation tax rates. However, dividend income will usually be exempt as a result of the dividend exemption from corporation tax.

Investors will only be taxed on income which is distributed to them. If certain conditions are fulfilled, the investment trust may designate some distributions to investors as interest distributions. Interest distributions should be tax deductible for the investment trust, and will have basic rate tax deducted from them when paid to UK resident individual investors.

Distributions which are not designated as income distributions will be treated as normal dividends. No tax deduction will be available for the investment trust.

Investors may be subject to capital gains tax if they dispose of their shares in the investment trust to the extent that those shares have increased in value.

Partnerships

Partnerships (whether traditional partnerships or limited partnerships)are transparent for tax purposes, and so the investors are taxed as though they held the investments directly. There is therefore no tax charge at the partnership level.

The investor will therefore be subject to capital gains tax on the disposal of the underlying asset and will be subject to income tax on the income from the underlying investment in the usual way.

Limited Liability Partnerships (LLPs) are treated as tax transparent if they carry on a trade or business with "a view to profit". In that case the activities of the LLP are generally treated as being carried on in partnership by its members and not by the LLP as a separate entity.