Tax Talk – Unit Trusts

Tax Talk is a series of articles brought to you by FSL’s own Tax specialist, Alex Ranahan.

Here at FSL we often get queries from our clients about unit trusts.  These range from fundamental principles underpinning how they work, to the treatment of accumulations and income, or the equalisation rules.  This blog post is a handy refresher.

One of the most common investments in the UK outside pensions and ISAs, unit trusts hold £161bn or 7.4% of the total market value of UK quoted shares according to the 2020 survey by the Office for National Statistics.

A unit trust is one of the two main types of collective investment scheme as defined by the Financial Services and Markets Act 2000, alongside open-ended investment companies (OEICs).  The idea is simple:  Pool the money together from a large group of investors into a professionally managed fund which in turn invests that money in shares, bonds, funds, currency and so on.  The investor can choose the unit trust based on the objectives of the fund, the profile of risk to reward and any other criteria.

All unit trust are “open ended”.  That is, the scheme may issue and redeem any number of units at any time.  This is as opposed to “closed ended” where, for example, a scheme issues £150 million of units and does not allow the initial investors to redeem early.

The structure of a unit trust is straightforward.  There are three types of person involved.  The first is the trustee, whose job is to check that the unit trust is running smoothly and keeping to its objectives, and pays out income in the fund to unitholders.  The second is the manager, who does the day-to-day management of the investments, buying and selling shares according to the term sheet and objectives.  The third is the investor, who approaches the manager to buy (or indeed sell) units in the trust, and whose money is used to buy the actual assets that the trust invests in.

The key point here is that whilst the level of the unitholder’s investment in the unit trust is measured by their number of units, they are in fact the beneficial owner of the underlying assets.  That is, each unit in the unit trust represents an equal proportion of entitlement to any dividends, interest, or other income yielded from the actual investments made by the fund, be the shares or bonds or anything else.

The price of the units is therefore not based on a business but on the value of the underlying investments.  You can only trade units with the manager of the unit trust.  There is no secondary market for the units.

As well as being a collective investment scheme, a unit trust is an authorised investment fund (AIF).  Distributions made by an AIF are treated as interest payments and not dividends if the fund is itself more than 60% invested in interest-bearing assets such as currency or bonds.  If the AIF is no more than 60% invested in, say, company shares, then it distributes dividends.  Offshore reporting funds are another example of an AIF.

In addition to the dividend vs. interest division, there is another division between unit trust types.  All unit trusts add the income they get from the underlying investments into a pot.  And it is that pot which the unitholders are all entitled to in proportion with the number of units they hold.  There are income (or ‘distributing’) unit trusts, which simply pay out all the income collected in the pot by the end of a distribution period.  And there are accumulation unit trusts, which take that income and instead reinvest it into more of the same underlying shares or bonds etc.

A unit trust often has two sub-funds, one income and one accumulation, two separate pots to pay into (so the accumulation unitholders don’t have their investment income paying for extra underlying for the income unitholders) and one investment strategy.

Holders of both income and accumulation units are taxed to Income Tax on the distribution due to them at the end of the distribution period, since that income has actually built up and they are entitled to it.  But since accumulation unitholders haven’t received any cash yet, as it has been put back into buying more underlying, the amount of income due to them is added to their CGT book cost for any future disposal.

Finally, let’s take the scenario of an investor who has invested in an income unit trust for many years and received a steady stream of dividends.  The last dividend was paid on 15 January and the next dividend will be paid on 15 July, with dividend record dates of 31 December and 30 June.  A new investor who has heard about this great fund decides to get in on the action too, and buys new units on 10 June.

Both the old investor and the new investor have equal rights to income and capital from the fund.  But that means that the pot of money that has built up since the last distribution period ended on 31 December is now going to be split equally between the old and new investor, when the new investor didn’t do anything for that money.  How can the unit trust ensure that the old investor is not out of pocket just because a new investor has come along?  This is where equalisation comes in.

The manager sets the unit price by reference to the Net Asset Value (NAV) and then looks at the amount of income already in the pot due to be distributed at the next dividend date.  They take a bit from the cost paid by the new investor and divert it into the income pot so that, when the next dividend payment date comes around, part of the cash received by the new investor is just part of their original investment cost back.  Remember that both investors receive an equal amount of cash from the pot.

For tax purposes, this amount is not income, so it is deducted from the ‘dividend’.  Since it is a return of book cost, it is only right that the investor’s book cost is also decreased to reflect the fact they have just immediately received some of it back from the unit trust.  Both income and accumulation unit trust investors make these adjustments.

Unit trusts are not the most complex topic but they do still have areas for potential misunderstanding.  I hope this blog post was clear and useful.  Remember that FSL offers CGT training for beginners, those who need a refresher, all the way up to advanced technical courses.

See you next time.