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What are unit trusts and OEICs?

Unit trusts and Open Ended Investment Companies (OEICs) are collective investment schemes where investors purchase units or shares in a pooled fund which is run by an investment manager.

Although they have different structures - unit trusts operate as a trust and OEICs are established as a company - they share the same tax treatment.

The tax rules aim to put the investor in broadly the same position as if they had invested in the fund’s assets directly rather than through the fund.

Tax within the fund

OEICs/UTs are only subject to tax within the fund on income received by the fund manager. This means that:

• interest and rental income are subject to corporation tax at 20%. There's no tax to pay on dividends. Some foreign dividends may have already paid tax in the country of origin and this withholding tax may not be reclaimable.
• If a fund distributes interest, not dividend, then the gross interest distribution is relievable as an expense against income of the fund. This ensures that there's no double taxation of interest.
• no corporation tax is payable on capital gains within the fund.

Tax on income

Investors may receive income from their investment in the form of interest or dividends. This will depend upon the mix of the underlying assets within the fund and will determine how income is taxed.

• Where the market value of the fund is made up of more than 60% of cash or fixed interest securities such as gilts or corporate bonds, the fund will be classed as a non-equity fund and income is treated as interest.
  
  Non and basic rate tax payers may be able to receive up to £6,000 (£5,000 starting rate for savings and £1,000 personal savings allowance) of savings income taxed at 0%. Higher rate tax payers can receive £500 (reduced personal savings allowance) of savings income taxed at 0%. But there’s no personal savings allowance for additional rate tax payers. Interest is then taxed at 20%, 40% and 45% (basic, higher, additional rate taxpayers).
  
  
• Where the fund's market value derives from 60% or less in cash or fixed interest, the fund will be classed as an equity fund and income will be treated as a dividend distribution.  
  
  The first £500 of dividend income is tax free (£1,000 2023/24) as it's covered by the dividend allowance. Dividend income  is  taxed at 8.75%, 33.75% and 39.35% (basic, higher, additional rate taxpayers) , for amounts in excess of the £1,000 allowance.  

Accumulation and income shares

Most funds offer a choice of income units/shares or accumulation units/shares. These allow a choice of whether to have the income generated by the investment distributed to you or to be reinvested.

• Accumulation shares may appeal to investors looking for capital growth as no income is distributed. Instead it's automatically reinvested within the fund to increase the value of the existing shares/units.
• Income shares pay income either as interest or as a dividend depending upon on the make-up of the underlying fund. The income generated is paid to the investor. However, they can elect to use the income they receive to purchase further shares in the fund.

The income from unit trusts and OEICs is always taxable regardless of the share class or whether the income is actually taken or reinvested. However, it may be tax free if it falls within one of the allowances (dividend allowance or starting rate for savings/personal savings allowance).

Equalisation payments

Unit trust and OEICs will have fixed dates on which income is distributed. A new investor who invests between distribution dates (but before the ex-dividend date) will still receive the full distribution for the period even though they were only invested for part of the period for which it relates.

The investor is only assessable to income tax on the part of the payment which reflects their period of ownership. The balance is treated as a return of their original capital and is known as an ‘equalisation payment’. This amount is not taxable.

Tax on investment growth

Any capital growth when an investor sells or disposes of units/shares may be subject to Capital Gains Tax (CGT). This also includes fund switches. However, switches between different share classes within the same fund, for example switching between income and accumulation shares, are not treated as a disposal for CGT.

Tax is only payable where gains in the tax year exceed the annual CGT allowance of £3,000 (£6,000 2023/24).   For individuals, the gain is added on top of their total income to determine the rate payable.  Disposals before 30 October 2024,  any part of the gain which falls within the basic rate tax band is taxed at 10% and the balance will be taxed at 20%. Disposals after 30 October 2024, any part of the gain which falls within the basic rate band is taxed at 18% and the balance taxed at 24%.

Calculating the gain

CGT on unit trusts and OEICs is calculated using an average cost basis. So if shares/units have been purchased in the same fund on separate dates and at different prices, all purchase costs are added together and then divided by the total holding to arrive at an average cost per unit/share.

This pooled acquisition cost is then applied to each unit/share to determine the amount of gain or loss when there's a disposal of some or all the shares in the fund.

Shares which are sold and subsequently repurchased within a short period (30 days) don't form part of the pool of shares which use the average acquisition cost. Instead the acquisition cost for the disposal is matched with the share price when they are bought back.

These share matching rules were introduced to prevent what was known as ‘bed and breakfasting’. This was where shares were sold one day and bought back the following day to crystallise a gain up to the annual CGT allowance. No tax was payable and the investor did not need to be out of the market for more than a few hours.

A similar tax outcome can still be achieved if the shares are repurchased indirectly, such as:

• bed and ISA - shares sold and repurchased through the investor’s ISA
• bed and SIPP - shares sold and repurchased through a Self-Invested Personal Pension (SIPP)
• bed and spouse - shares sold and repurchased in the spouse's name

Gains on accumulation units/shares

Income is not distributed but is automatically reinvested within the fund. This reinvested income inflates the share/unit price but has already been subject to income tax. To avoid double taxation, the notional income can be used to increase the original cost of the investment.   

Gains on income shares/units

Income shares/units distribute income as either interest or dividends. As the income is paid to the investor and not rolled up within the fund, no adjustment is needed for CGT.

However, some investors may choose to have their income reinvested and this is achieved by purchasing additional shares in the fund. Each new purchase will be added to the pool of shares and the average cost used when shares are sold.

In addition, any equalisation payments on the first income distribution are a return of capital and will therefore reduce the acquisition cost.

Gains on part disposals

If only part of an investment is sold, this is a partial disposal. The capital gains tax on a partial disposal is based on how much of the original capital is used in the proceeds and how much is capital gain. To calculate the gain on the disposal, the first step is to work out how much of the disposal comes from the original capital, using the following formula:

Capital withdrawn = [ A / (A + B) ] x amount originally invested

where:

A = disposal amount
B = value of part retained

The capital withdrawn is then used as the aquisition cost when calculating the gain.

Tax on death

There is no capital gains tax to pay on death. Unit trusts and OEICs have their acquisition cost uplifted to the date of death value.

Where investments are passed on to beneficiaries of the deceased, they're deemed to acquire them at date of death and the value at that time.

On jointly owned assets the survivor acquires the deceased's share at the market value at death. On any future disposals there will be two acquisition costs used to calculate capital gains tax, their own share being half of the original amount invested and the value of the inherited share immediatley before death. 

If the executors sell the funds to distribute cash to the estate beneficiaries, there will be a disposal for CGT. This will be on any capital growth in the period since the date of death.

The executors will typically have a full annual CGT allowance for the period of administration. This applies in the tax year of death and up to a further two years for complicated estates requiring a lengthy administration period. Any gains before 30 October 2024 in excess of the annual allowance are taxed at 20% (24% for residential property). Gains after 30 October 2024 in excess of the allowance are taxed at 24%. 

Any interest or dividends received during the administration period are taxable upon the executors at basic rate (20% on interest & 8.75% on dividends) with no entitlement to the personal savings or dividend allowances.

Reporting income and gains

Interest is now paid without deduction of tax.  Where interest is taxable, as it's not covered by the starting rate savings band and/or the personal savings allowance, investors will need to:

• contact HMRC to adjust their PAYE notice of coding, or
• submit details on their self-assessment tax return

Investors who have taxable dividends may not need to complete a tax return. This is dependent on the level of dividend income received.

Where the total dividend income received is more than £10,000 investors will need to register for self-assessment.

Those with taxable dividends, where total dividend income is less than £10,000, have the following options:

• contact HMRC by phone
• ask HMRC to amend the PAYE code for dividend income or,
• report via a self-assessment return if they already do one

Whether capital gains need to be reported depends on the size of the gain and the individual's tax return status.

Individuals must report capital gains where the total proceeds of sale exceed £50,000. This is regardless of whether there's an overall taxable gain or not.  

Gains are reported on the self-assessment tax return and payment is usually due by 31st January following the end of the tax year in which the disposal occurred.

HMRC have introduced a real time reporting service for CGT. This can only be used if the individual doesn't normally complete a tax return. It allows those with one-off capital gains to avoid the need to complete a full self-assessment. 

Losses may be carried forward indefinitely but need to be reported to HMRC within four years from the end of the tax year in which they arise.