Pension funds and charities are benefiting from the increase in split-capital type investment trus...
Pension funds and charities are benefiting from the increase in split-capital type investment trusts being launched offshore.
While on the surface the trusts offer higher yields at the expense of a higher hurdle rate, retail investors receive limited benefits as they are required to pay income tax on any gross income they receive from the trust. However, certain institutional investors are exempt from this.
Over the past year split capital trusts have been set up offshore by groups such as Legg Mason, Exeter, CI, BFS and Edinburgh. Geoff Miller, fund manager of the Exeter Equity Growth & Income investment trust said: "Most of the split capital vehicles, which were established last year were registered offshore."
The reason behind moving offshore is to compensate for the losses investment trusts have suffered since the abolition of the tax credit act two years ago.
Previously, investment trusts could claim back their management costs from the tax they paid on income from their investments. Offshore they do not pay the tax in the first place.
Tony Reid, fund manager at BFS, said: "If a company is set up offshore, it does not have to pay tax on gross income.
"By setting up offshore, a company can aim to produce enough income to pay all its costs, it follows through that the yield which reaches its investors is increased because the management costs have already been paid."
Onshore investment trusts, on the other hand, must pay tax on revenue received from unfranked income, that is any income sourced anywhere other than from UK dividends.
The offshore trusts are also benefiting from a recently discovered loophole in international accounting standards.
According to UK accounting standards, a company must charge at least 25% of its management charges and administration costs to the revenue account.
However, by setting up offshore and adopting international accounting standards, the trusts can charge up to 100% of their costs to the capital account. According to John Korwin-Szymanowski, investment trust analyst at UBS Warburg, the weight which is lifted on the income stream eases the pressure on the fund manager to find high yielding stock, and allows him to concentrate on quality instead.
While the higher yield and consequently the slightly higher hurdle rate may appear unattractive to potential capital shareholders, Korwin-Szymanowski argues that the freedom to invest in quality stock provides enough potential for growth to make up for the burden on their capital.
Miller backed up this view. He said: "If you are designing a structure with the intention of charging costs to the capital account, part of your task would be to find a way of financing that drain. These funds are structured to ensure the capital account grows with enough strength to support the costs which are taken out of it."
There is some concern though, that this type of vehicle has a higher risk. According to Miller, this might not necessarily be the case, he said: "If you are going to charge costs to capital, hurdle rates are naturally going to increase because if you increase the amount of money coming out of capital, it has to increase its growth accordingly. This doesn't make the fund any better, or worse than its onshore peers, it would simply be structured differently."
Nigel Sidebottom, fund manager at BFS Investments, said the effect of structuring a fund to charge its costs to capital would come close to cancelling out the risk inferred by the higher hurdle rate.
He said: "One could argue that a trust which charges all its expenses to capital, while pushing its hurdle rate up, will not be under the same pressure to find high income. Instead, because it draws costs from the capital account, the duty of the fund manager would be to find quality stock which would grow fast enough to maintain those outgoings."
Sidebottom said the way in which the offshore vehicles are structured aims to reduce the risk that may arise from the higher hurdle rates. The capital account usually makes up about two thirds of the offshore split capital portfolio, with the remainder devoted to income, he said.
"For the growth element of the portfolio, we invest mainly in the shares of other closed end funds. This give us a wide scope for investment, and the expertise of the fund managers who run the trusts we hold adds value to the portfolio."
Capital shares can also be used to provide geared growth that can boost performance when markets are going up. Sidebottom said the income aspect of an offshore portfolio will often be focused on fixed interest securities to take advantage of tax opportunities.
Securities such as Eurobonds which pay gross can be used to pass on tax free income to investors because of the offshore status of a fund.
Sidebottom believes tax conditions are a major factor in the drive to locate offshore. He said: "With UK based investments, income tax is paid at source, before the income has gone into the hands of the investor. This tax is unredeemable, which can mean certain institutions, such as charities or pension funds, are paying tax which they do not need to pay."
Investments of this kind are also designed, according to Miller, for private investors who want to avoid paying tax. They are open to Isa holders and he expects they will become available to Peps after this year's Budget in which Pep and Isa rules are to be aligned.
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