Isas and tax after April 6

The scrapping of the dividend tax credit has caused much confusion across the industry. Last March, even the IPPR, one of Britain’s leading think-tanks, was wrong-footed by the new rules, claiming that Isas will provide no benefits for basic-rate taxpayers after the dividend tax credit has been scrapped. In fact, this is not true. All income paid to investors will remain tax-free within an Isa, as will all capital growth. The only thing that will change is that the 10% tax credit that the Government currently pays back to funds on all equity dividends will no longer be paid. To most Isa investors, this credit is currently worth only about £10 a year.
The removal of the dividend tax credit will serve to open up another tax loophole, however – one that has existed since Peps were invented in the 1980s, but which over the past few years has been overshadowed by the advantages of the dividend tax credit.
Any fund with more than 60% in fixed interest or cash has all its income taxed as “interest”. In this case, 20% tax must be deducted from all its income (gross interest less charges plus net dividends), but this is then reclaimable for all Isa and Pep investors in the fund.
However, those funds that have less than 60% in fixed interest and cash have their income taxed as dividends. In this case, the equity dividends have already been subject to corporation tax, while any income from bonds or cash in the fund is taxed at 20%, and in this instance does not qualify for a rebate.
According to specialist financial publisher Taxbriefs, the tax advantage of investing in a fund that has its income treated as interest payments is around £30 a year to someone who uses their full £7,000 Isa limit. However, there is no disadvantage to holding two separate equity and bond funds, rather than holding a distribution fund, which combines both asset classes in one portfolio.
The table below shows the tax saving between funds that have their income taxed as interest and those that have their income taxed as dividends. Both models are based on a £7,000 Isa invested 60% in bonds and 40% in equities after April 5, 2004. Gross bond yields are assumed to be 6%, while net equity yields are assumed to be 3%. The fund’s annual charge is 1.25%.Interest-paying fund (£) Dividend-paying fund (£)Gross interest income 252 252
UK equity income 84 84
Total Income to fund 336 336
Management expenses (87.5) (87.5)
Income before tax 248.5 248.5
Corporation tax on bond N/A (32.9)
income @ 20% (dividend-paying fund)
Income tax on all income
@ 20% (interest-paying fund) (49.7) N/A
Net income to Isa/Pep 198.8 215.6
Tax payment/reclaim 49.7 N/ATotal for Isa/Pep 248.5 215.6Source: Taxbriefs