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INVESTMENT TRUSTS AND COMPANIES
Investment trusts and investment companies can provide an excellent way to achieve a diversified portfolio of shares within one simple investment. In this respect, investment trusts/companies resemble unit trusts or open-ended investment companies (OEICs). But there are some important differences. General investment trusts have a history stretching back into the 19th century, but they are thoroughly modern investments and have a number of valuable uses for investors. Investment companies have become more common in recent years and are usually based offshore.
Remember that investment trusts and most investment companies are equity-based investments whose value can go down as well as up and that past performance is not a guide to future performance. You should bear in mind that tax rules can change. The Financial Conduct Authority does not regulate tax advice.
Basis of investment trusts and companies
An investment trust is a limited company, whose activities are confined to investment in its broadest meaning. The tax position of investment trusts is as follows, although you should remember that tax rules can change.
• Investment trusts are authorised by HM Revenue & Customs (HMRC) and enjoy the same freedom from capital gains tax (CGT) on internal dealings as an authorised unit trust or OEIC does.
• Income from an investment trust is currently taxed in the same way as other UK dividend income. So, unless you are a higher or additional rate tax payer, you will have no further tax to pay on the dividends. In 2014/15, higher rate tax payers have to pay tax at 25% of the dividend they receive. If you are subject to 45% additional rate tax, you will have to pay 30.56% of the dividend you receive. Unlike unit trusts and OEICs, investment trusts are generally not subject to specific investment
restrictions.
Investment companies are not HMRC-authorised, but by being established offshore they enjoy a similar freedom from CGT on internal dealings. The treatment of their dividends is the same as for investment trusts.
Gearing
Investment trusts and companies can borrow to enhance their performance, something that is not possible for unit trusts. This borrowing, known as ‘gearing’, may be in the form of loans, preference shares, debentures or bank facilities. The aim is always the same: to make a greater return for the shareholders.
Gearing is designed to benefit the investor, but if the trust manager makes a wrong decision, the gearing will work in the opposite direction to reduce gains or even increase losses.
Prices, discounts and premiums
The prices of investment trust and investment company shares are determined in the stock market, just like any other share. This can mean that the share price stands below the share’s net asset value (NAV), i.e. the actual value of the assets underlying the shares.
In other words, the total value of the shares owned by the investment trust after deducting the gearing is typically greater than the total value of the investment trust itself as measured by its capitalisation (i.e. the number of the investment trusts’ shares issued x the share price). This shortfall, known as the discount, is expressed as a percentage of NAV and is regularly shown in investment trust price listings. A few investment trusts are in the opposite position and show a surplus over net assets, known as a premium.
One advantage of the discount is that it can boost the dividend yield from the underlying shares. A possible drawback is that the discount can sometimes widen and increase the potential losses by more than the reduction in the value of the underlying shares.
Types of share
A small number of investment trusts can have several different classes of shares. The main classes of share in the investment trust sector are:
Ordinary shares
Usually, these are entitled to all of the income and capital of the trust, subject to any borrowings with a prior charge that the trust may have undertaken.
Split level shares
In a split level trust, there are usually at least two classes of shares, possibly including zero dividend preference shares (see below):
• Income shares There are two main types of income shares, with significant differences in capital
entitlement. Certain shares can give rise to substantial capital losses at redemption. The traditional income share – now a rarity – gives a right to income with a fixed redemption price, subject to sufficient assets remaining in the investment trust after repaying any debts and the other
preferred classes of share at redemption – at a fixed date in the future when the investment trust will be wound up. Other issues have no fixed redemption date for the shares (although there will be for any associated preference shares or loan stock).
• Capital shares These usually only entitle the shareholder to the capital remaining at redemption
after all other classes of share and borrowings have been repaid.
Zero dividend preference shares
Traditionally, zeros were often used to generate a relatively secure and predictable capital gains for investors. However, the structure of some of the investment trust issues of the late 1990s and beyond was more highly geared, creating a greater risk of a shortfall at maturity.
The zeros have redemption dates, a predetermined rate of return, and participate in the capital performance but not the income of the investment trust.
The redemption price is the final redemption value of the zero at the liquidation date. Zeros are issued at an initial asset value rising by a compound growth rate to the final value.
Zeros are taxed as capital and not income, and may be attractive to investors not subject to capital gains tax, or those who use the annual CGT exemption.
Zeros were once regarded as low risk investments because little or no growth from the trusts was needed
to cover the final redemption price and the shares had a prior equity charge on the available assets. However, the zeros in some highly geared split capital trusts proved to be anything but low risk, because the zero shareholders ranked behind lenders who were prepared to force the trust to wind up or
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Package units
A few investment trust and investment company issues have bundled together ‘packages’ of capital, income and zero preference shares to create what is the equivalent of an ordinary share. The aim behind this is to reduce or eliminate the discount that may apply to the ordinary share alone.
Warrants and subscription shares
A warrant is not a share but a right to buy a share at a fixed price at either a predetermined point or within a specified period in the future. It produces no income and represents a geared investment with a potentially high level of risk and reward. Some investment trusts and companies have issued subscription shares rather than warrants. While subscription shares offer similar purchase options, their share
structure means that they can be held in a new individual savings account (NISA), whereas warrants are usually ineligible as NISA investments.
Buying investment trust and investment company shares
Investment trusts and companies may be bought through stockbrokers and via some investment platforms. Some groups offer regular and lump sum savings plans and NISAs that can be arranged through financial advisers.
How we can help
• We can review your existing investment trusts to ensure they fit in with your risk profile and your financial aims.
• We can recommend a suitable spread of investments over the various asset classes.
• We can advise on investments that are appropriate to your tax position, including helping you to make the best use of your annual CGT allowance.
• We are able to arrange the sale and purchase of investment trusts and companies and, if necessary, recommend a special adviser in this area.
Past performance is not a guide to future performance. The value of investments and income from them can go down as well as up, and you may not get back the original amount invested.
Levels and basis of, and reliefs from, taxation are subject to change and depend on your individual circumstances.
This publication is for general information only and is not intended to be advice to any specific person. You are recommended to seek competent professional advice before taking or refraining from taking any action on the basis of the contents of this publication. The Financial Conduct Authority (FCA) does not regulate tax advice, so it is outside the investment protection rules of the Financial Services and Markets Act and the Financial Services Compensation Scheme. This publication represents our understanding of law and HM Revenue & Customs practice as at 10 November 2014.
Thank you for your interest in this Essential Guide. For further information or if you would like to discuss any aspect of the guide, please contact us.
EA Financial Solutions Ltd 869 High Road Finchley London N12 8QA +44(0) 208 4463231 Email: info@eafsolutions.co.uk
