Secret Taxes – How tax-free funds pay tax & how taxpayers get taxed twice

 In Tax

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I frequently see letters from people who are horrified that a situation has arisen where it appears that the same money is going to be taxed twice, but look at the position of the poor wage earner.

Spending some of your hard earned money on a pint down the pub may seem a suitable reward for your efforts. Let us look at the tax position?

 

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    1. Your client was charged Vat on the bill for the work you did.
    2. Your Employer has to pay employers NICs on your salary
    3. You pay income tax on your salary.
    4. You also pay employees NICs.
    5. You pay duty on the alcohol you consumed down the pub.
    6. You also pay Vat

If your reward for providing advice costing the client ten pounds was a swift drink down the pub, by my count that is six tax charges on the same money. When it comes to investment, tax is simpler but tax still arises at several points in the system and is sometimes paid when you don’t even realise that it is happening. Withholding tax is the obvious example.

Withholding Tax

Withholding tax is levied in the country of the issuer of the security. Whether there is withholding tax will depend on the nature of the income involved and on the relevant double tax treaty. Interest and coupon is different from dividends for these purposes.

The USA, Canada, Australia, New Zealand and much of Europe levies withholding tax at 15% as a matter of course on dividends. FATCA means that, for the US, rates of withholding tax might be higher. Withholding tax on bond interest has a tendency to be lower but it is not lower in North America.

Although withholding tax is normally not reclaimable, it is offsetable against a UK tax liability for a UK taxpayer. If the owner of the asset is non-taxpaying, there is no tax against which any withholding tax can be offset and it is therefore lost.

This is much more significant than it might seem at first sight. Most collectives, for example unit trusts, are non-taxpayers, ETFs are frequently companies incorporated in Ireland or Luxemburg and pay no tax. Dividends from these may be taxed as dividends either UK or foreign, but any withholding tax suffered in the underlying portfolio is lost.

However, if the trust is a charity there is no tax liability against which any withholding tax can be offset anyway and so it makes no difference whether the investment is held directly or through a collective.

Essentially, if a taxable trust fund is big enough to justify owning a portfolio of foreign shares directly, there are tax benefits to doing so.

The peculiar case of UK dividends!

Under the old system a dividend came with a tax credit which grossed up the dividend at the basic rate and normal tax rates were applied to that grossed up dividend. The tax credit was then offset against that liability.

Under the old system

A dividend of £360 would come with a tax credit of £90 giving a gross dividend of £450 for tax purposes.

  1. A non-taxpayer could actually reclaim the £90 tax credit
  2. A basic rate taxpayer would be liable to tax of 20% of £450 pounds, in other words £90 which would be exactly met by the tax credit.
  3. A 40% taxpayer would be liable to tax of 40% of £450 or £180 of which £90 would be paid with the tax credit leaving £90 more to pay.
  4. A 45% taxpayer would be liable to pay tax of 45% of the £450 or £202.50 leaving £112.50 still to pay.

Under the current system it’s completely different, or is it?

A dividend of £360 comes with a tax credit of one ninth or £40 giving a gross dividend of £400.

  1. A non-taxpayer is unable to reclaim the tax credit of £40 and so it is lost.
  2. A basic rate taxpayer is liable to income tax at the reduced rate of 10% and so has a liability for tax of £40, met from the tax credit.
  3. A 40% taxpayer pays tax at the reduced rate of 32.5% and so has gross tax liability of £130 of which £40 is met from the tax credit leaving £90 to pay
  4. A 45% taxpayer pays tax at the reduced rate of 37.5% and so has a liability to pay tax of £150 of which £40 is paid from the tax credit leaving £110 to pay.

For taxpayers the practical effects of the old and the new systems are virtually the same and HMRC collects virtually the same amount of tax. What is different is that under the old system a tax free fund would have got £90 back but the new system means that it now gets nothing back while making that loss appear to be only £40 (as against £90).

It is worth pointing out that most foreign dividends are effectively taxed in the same way as UK dividends, as they too get a notional tax credit of one ninth.

Offshore insurance bonds are popular with trustees because funds roll up tax-free but trustees should appreciate that tax-free doesn’t quite mean what it used to mean, certainly when it comes to equity dividends. Offshore insurance bonds provide short term tax benefits but those benefits are not what they were, and they have to be balanced against future tax costs.

Different investments are taxed differently and this means that the relative attractiveness of those different investments will vary depending on the tax treatment of the investor. That always was the case, and it still is the case. This leads to the idea of optimising a portfolio for the tax position of the particular investor, which will be the subject of a future article.

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