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Taxation of Investment Trusts versus UCITs – Blog 160

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Taxation of Investment Trusts versus UCITs – Blog 160

30th November 2020

Paddy Delaney

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Taxation of Investment Trusts is a very topical topic – and one we received a few emails on following our Blog 159 a couple of weeks ago. We’ll reiterate, we have no big issue with Investment Trusts at all – if they work they work. What we do have issue with is seeing people pile into things because they heard that they are great – or fantastically tax efficient or whatever, without having done any due dil on them. In a way, we’re the due-dil police here – and like to think we analyse things with a critical and unbiased eye.

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The below is on the basis of 1% total fees on ‘Exit Tax’ investments and 2% on CGT (they can often be higher or lower) – it assumes lump sums instead of monthly contributions – it assumes zero indexation on purchase costs.

The State of Play: Exit Tax

To recap, the Irish tax arrangements on various types of investments is as mad as a box of frogs! It is massively convoluted and difficult for even smart people to get their head around. Heck, most financial advisors don’t even know it. The biggest issue that many investors seem to complain about is Exit Tax. If you invest in investment funds offered by insurance companies here in Ireland (the likes of the one’s you’ll see or hear advertised on TV and radio by the main insurance providers), you will be subject to this Exit Tax at 41% of any growth when you cash in.

What seems to really get investors’ goat is that if you haven’t cashed-in by 8th anniversary, and your investment is worth more than you invested, the insurance company will calculate the difference between what you invested 8 years ago, and what it’s worth today. They then pay out 41% of that difference to Revenue from your investment as Exit Tax. That’s as per the statute. They are obliged to do so.

If howver you invest in an Exit Tax investment that is NOT held by an insurance company (such as UCITS ETFs etc), there is no insurance company to take the 41% out – you complete the return yourself or via your accountant. This is generally done the year after the 8th anniversary, and by the nature of it, you can use cash from the investment or cash from your own reserves to pay the Exit Tax payable on the 8th anniversary. Of course, if you subsequently encash your investment and your investment is valued at less than it was on the 8th anniversary, you can claim a refund of tax paid.

This 8th anniversary deemed disposal makes Exit Tax investments fairly unfeasible if you are saving regularly. Imagine completing a return every 8th anniversary on every monthly contribution you make! Tracking the value of each monthly installment over 8 years, and completing the return every month 8 years later….Really!? Needless to say, most people who are saving monthly in an equity savings often defer to the insurance company products, as they do the returns for you!

The State of Play: CGT

Seeing all of that as a major flaw with such investments there seems to have been a big surge to Investment Trusts given they are taxed under a different regime, under Capital Gains Tax. In this scenario, you do NOT have to pay tax on any gains on the 8th anniversary. In this way your investment can continue to grow unassailed by the deemed disposal on the 8th anniversary. In addition, many will claim that the fact that the taxation of Investment Trusts is done at the lower tax rate of 33% (41% on Exit Tax) makes it a no-brainer.

The Reality – Net Figures After 8 Years

In a straight drag-race of course Investment Trusts win, given you’ll pay 33% tax on gains instead of 41%. But it ain’t a straight drag-race! I keep harping on about fees and why they are important – here you will see why.

As we explored and shard in Blog 159, Investment Trusts carry annual fees of 2-3.5%. Aiming on the low side and being generous to Investment Trusts we assume you pay 2.1% fees in buying and owning Investment Trusts directly on a low-cost platform or via a wealth manager.

For the Exit Tax account we assume you pay 1% per year in owning UCITS, which is a typical rate for clients we work with, to include all fund, platform and our financial planning services.

Both accounts accounts achieve the same level of return; 6% Gross annual return over the first 8 years:

CGT account value = €1.351m

Exit Tax account = €1.473m

What is the impact of the taxation of Investment Trusts? Well we are now at the 8th anniversary and so the Exit Tax account owes 41% of the gains to date. In this scenario the account holder can either cash-in a portion of their investment or use cash on hand to pay the deemed disposal of €193.3k.

Of course, if you are invested with an insurance company you will have no option here; the insurance company will take the €193.3k out of your investment account and pay it to Revenue.

It is worth observing that if both accounts were cashed-in here on the 8th anniversary, the CGT account would net you €1.235m and the ‘really silly’ Exit Tax account would net you €1.279m, or €44k more than the ‘tax efficient’ CGT account.

The Reality – Net Figures After 14 Years

But in analysing the taxation of Investment Trusts we’ll assume you don’t cash in each investment, you keep both going. We all know that investments don’t grow in straight lines but for this analysis we assume it continues to do so, 6% Gross per year, until the 14th anniversary:

CGT account value = €1.756m

Exit Tax account = €2.065m (a gain of €592k since the 8th anniversary)

Oh!

At 14 years let’s imagine you see that boat or that car or that house that you want to buy for your kids 🙂 so you cash in your chips.

Your CGT account, after tax of €250k = €1.506m Net

Your Exit Tax account, after a further tax of €242.7k = €1.822m Net

So the Exit Tax account results in a Net profit of €822k while the CGT account resulted in €506k profit?! Well not quite, you won’t forget that you also paid tax on the 8th anniversary of €193.2k, so in Net terms:

CGT Net Profit = €506k

Exit Tax Net Profit = €629k

The Exit Tax account has delivered over €110k, or over 20% more net profit for the investor – fact.

The Bottom Line

Nobody said the taxation was a straight-forward topic. The bottom line here however is that a 1.1% fee differential per year will likely more than erode the benefit that most you get from being taxed under Capital Gains Tax (33%) versus Exit Tax (41%) – at least based on the assumptions here.

People will tell you that if you invest via Exit Tax that you are daft, that you are doing it all wrong. That is incorrect. The taxation of Investment Trusts may be lower, but lower tax on exit doesn’t always correlate to better investor outcomes.

Of course, investing in CGT assets does bring benefits that investing via Exit Tax simply can’t give you. Being able to write off consolidated future gains against previous CGT losses can be a big win. Likewise, CGT investments allows you to maximise the annual CGT allowance we all get. Neither of these benefits are available with Exit Tax. However, unless you are actually going to use those benefits, you may well be better off investing via Exit Tax accounts.

Of course, whichever route you pick please ensure that you are invested smartly and in a manner that has delivered the returns you need, that you pay a sensible fee, and that you can hold your nerve during both the good and bad times that will surely visit you and your investment values! Those aspects can often make more of a difference than the taxation treatment being applied!

Happy Investing!

Paddy.

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