Capital Gains Tax: by Paul Kennedy

What was the biggest event of last year and what does that mean for 2009? 2008 was a year when big themes dominated the agenda and gallons of ink will be spilled retelling all the events and crystallising their meaning.

If only to avoid the worst losses, investors have needed to be on the right side of the big bets – oil and financials; emerging and developed markets; and the shifting dominance of the biggest currencies. Finding oneself on the wrong side of those trades would have cost dearly yet, amid the investment turmoil, one of the most significant events of the past year became somewhat forgotten – the introduction of the 18% capital gains tax (CGT) rate. 

Last March, the financial crisis began a new phase as vultures gathered in the skies above Bear Stearns and the US administration orchestrated JP Morgan’s purchase of the stricken investment bank. At the same time Alistair Darling confirmed a new simple flat rate of tax of 18% was to apply to capital growth, bringing an  end to the previous more complex regime where rates could be as high as 40%, reducing down the longer an investment was held.

Of course, there is no connection between these two events except the month they occurred, but both deserve a place in the record of 2008’s significant moments. One will be remembered as a watershed in this financial crisis, the other will have a profound and lasting effect on how investors in the UK approach their fund buying.

The introduction of the new rate of CGT started to bring a real focus to how tax is applied to the two main investment wrappers – investment bonds and collectives. Until last March, many in the industry were at ease with the investment bond’s unofficial default position but afterwards, when the Chancellor had moved the tax goal posts, it became even clearer the same client in the same investment fund could be at a considerable advantage holding their investments in one wrapper rather than another.

The extent of the difference the wrapper can make is as startling as any of the major financial events of the year and it is not hard to imagine that, in the real world, it might make as much of a difference to a client’s end investments as any of the year’s big investment trades.

We performed some analysis – simple mathematics – to establish which type of investment wrapper is better for investors. This found, for example, the return for a higher-rate tax payer investing for capital growth would be up to 70% better if their investments were wrapped in a collective rather than a bond. In any other year this news would have grabbed the headlines, but the other events of 2008 meant it was but a whisper in the wind of the financial storm.

The conclusion of the analysis is that different investors with different investment needs will need to consider carefully their choice of wrapper. Until last March, lump sum investing was a simple ‘one, two, three’ process where the adviser assesses the client’s appetite for risk and their investment needs, then devises an asset allocation before selecting the best funds. But there is now a fourth dimension – tax planning. With such a difference in their client’s ultimate return at stake, it simply cannot be ignored.  So in 2009, as investors gingerly return to the markets and their appetite for risk is rediscovered, advisers will need to establish their process for understanding the implications from a tax perspective of investing in one wrapper or another. This year we must also start to tackle the thorny issue of what do with an existing investment that is palpably now in an inefficient tax wrapper. Whether investors return with new money or not, there will remain a need to review existing wrappers to ensure they remain in the interest of the investor.   

In the past, suggesting one wrapper over another might have been done at the expense of efficiency – a client with a variety of investment bonds and collective investments would be a complex account to manage. But with the rise in popularity and usability of neutral platforms, which offer all wrappers as a simple option after the main investment selection and consolidate them thereafter, the decision is much less, well, taxing.

The platform will also offer clients consolidated tax statements, reporting tools and, now income can be drawn regularly and automatically from capital if required, the option to initiate a regular withdrawal plan. This can be especially useful for investors looking to make the most of their CGT-free allowance each year as part of their income.

For much of the coming 12 months, finance and the dire state of the world’s economy will continue to dominate the headlines. At some point during the year, that will change and more positive news will emerge. Before that, advisers can help their clients with the good, albeit less exciting, news of CGT.

Paul Kennedy is head of trusts & tax planning solutions at Fidelity FundsNetwork