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Unit trust distribution

17 September 2000
Issue: 3775 / Categories:
A small limited company client has purchased accumulation units in an authorised unit trust. A tax voucher is received each year for the dividend distribution but the number of units remains the same:

Does the dividend represent an addition to the capital cost which for tax purposes may be deducted on disposal?
How is the equalisation sum treated for accountancy and tax purposes?
A small limited company client has purchased accumulation units in an authorised unit trust. A tax voucher is received each year for the dividend distribution but the number of units remains the same:

Does the dividend represent an addition to the capital cost which for tax purposes may be deducted on disposal?
How is the equalisation sum treated for accountancy and tax purposes?
The tax voucher states unfranked income 82.82 per cent. Does this mean that that proportion of the dividend and tax credit thereon is liable to corporation tax and can I offset a similar proportion of the tax credit?
Why is my client informed that the trust's net liability to corporation tax per unit is .1782p?
(Query T15,678) Degesc.

Distributions by authorised unit trusts (AUTs) and their corporate equivalent Open-Ended Investment Companies (OEICs) are governed by section 468, Taxes Act 1988. A quid pro quo for some of the tax advantages enjoyed by such vehicles, particularly the exemption from capital gains tax and the 20 per cent corporation tax rate, is that these trusts and companies must distribute all of their available income (section 468I(1)). (This is to prevent taxpayers from using these investment vehicles rather than direct investment as a way of deferring or avoiding tax.)
Many trusts and open-ended companies offer accumulation as well as income units. Here the investor does not receive a cash dividend but the amount due is promptly reinvested on his behalf in respect of his accumulation units (section 468H(2)). The dividend still constitutes income in the hands of the unitholder but the deemed reinvestment is treated as an addition to the investor's base cost for capital gains tax purposes on a subsequent disposal.
The very nature of these investment schemes means that investors are coming in and out of the funds, sometimes on a daily basis. However, the dividend will be paid to all investors on the register at the ex-dividend date. Consequently the price an investor coming into a fund during a period between dividends pays for his units will include an element of accrued income. An appropriate part of the dividend — known as equalisation — is treated not as income but as a part repayment of capital. This amount should be treated both for accountancy and tax purposes as a reduction in the investor's capital gains tax base cost.
Distributions from the trusts or companies to corporate shareholders are governed by section 468Q. Such dividends are divided into unfranked and franked portions — known as 'streaming' — essentially in the ratio of unfranked/franked income received by the trust itself. The dividend voucher has to disclose the unfranked percentage of the total dividend — this amount should be treated as an annual payment received after deduction of income tax at 20 per cent. So if a dividend of £100 is reported as being 50 per cent unfranked:

£50 is franked investment income;
£50 is treated as unfranked investment income net of 20 per cent tax, i.e. £62.50 gross with an income tax credit of £12.50.

In the hands of a United Kingdom corporate investor, the £50 franked investment income is tax-free as per usual, but the £62.50 unfranked investment income is taxable. However, the £12.50 tax can be used as a credit against the investor's corporation tax liability.
Why 'streaming' exists is not hard to deduce without it a company could invest in assets producing unfranked income not directly but via an authorised unit trust or open-ended company and effectively turn taxable unfranked income into tax-free franked income. The streaming mechanism allows the corporate investment in the investment fund effectively to be treated as a 'see-through' for tax purposes.
However, if the investor is in a non-taxpaying position, the Revenue is reluctant to repay in cash all or part of the income tax credit if the trust or open-ended investment company itself has not paid sufficient corporation tax. For distributions made by such trusts or companies since 6 April 1999, section 468Q(5A) states that 'the amount to which the unitholder is entitled to repayment of the tax shall not exceed the amount of the unitholder's portion of the trustees' net liability to corporation tax in respect of the gross income'.
Put simply, the Revenue will not repay to corporate unitholders any tax in excess of the corporation tax they themselves have received from the fund. So tax vouchers issued to corporate unitholders now have to state (section 468Q(5C)) the fund's trustees' net corporation tax liability. (Many fund managers do go on to express the tax figure as a price per unit, although this is not required by the legislation.) If the corporate unitholder is looking to reclaim in cash any part of the income tax credit, then it has to use this information to determine its 'share' (pro rata to its holding of units over total units) of the fund's tax liability and see if it is sufficient to cover the reclaim. If it is not, then the reclaim will be restricted or even eliminated accordingly.
Note that this calculation only applies to cash repayment of tax credit use of tax credit to reduce the unitholder's corporation tax liability is not restricted.
Also note that this restriction only applies to the unfranked portion of dividend distributions made by these trusts and companies. A fund which invests over 60 per cent by market value throughout a period in 'qualifying investments' (essentially interest-bearing investments) — colloquially known as a 'bond fund' — can pay not a dividend distribution but an 'interest distribution' (section 468L). As its name suggests, this is equivalent to an annual payment and is made under deduction of 20 per cent income tax. The interest distribution constitutes 100 per cent unfranked investment income but, although most bond funds do not have any corporation tax liability (essentially because the interest distribution is itself tax deductible), the income tax credit can be used without restriction as regards offset or repayment of the corporate unit holder's own corporation tax liability. — Pippo.

Yes: the dividend, or 'notional distribution', is treated as enhancement expenditure for the purposes of capital gains tax. For corporate investors, it is treated as incurred when the investor first became entitled to it, which is usually deemed to be the ex dividend date.
The rules differ slightly where accumulation units are held by individuals. Notional distributions received prior to 5 April 1998 are treated as described above. However, under taper relief, notional distributions are treated as arising when the units were first acquired.

Unit trusts must distribute all their income at least annually, although most distribute more frequently. Where a unitholder acquires units between ex dividend dates, the price paid will include income accrued since the last distribution. When the unitholder receives its first distribution, it will include an amount of equalisation to reflect this. For tax and accountancy purposes, equalisation is treated as a return of capital, and should therefore be deducted from the cost of the units.

Unfranked income 82.82 per cent
Corporate unitholders in authorised unit trusts receive what are called 'streamed' distributions. This means that rather than being treated as receiving a dividend, they are treated for tax purposes as having received unfranked income and franked income in the same proportions as the distributing fund. This is calculated according to the formula set out in section 468Q, Taxes Act 1988.
The unfranked part of the distribution is treated as having been paid net of 20 per cent income tax, and is subject to corporation tax. The income tax deemed to have been deducted can be offset against the company's mainstream corporation tax liability.

Net liability to corporation tax .1782p
For distributions made in respect of periods ending before 6 April 1999, corporate unitholders could reclaim the income tax deemed to have been deducted if it could not be offset against corporation tax. For distributions made in respect of periods ending after that date, repayment is restricted to the amount of corporation tax the distributing fund actually paid. Section 468Q, Taxes Act 1988 requires that this be disclosed on the tax voucher: many unit trust managers have chosen to show this amount per unit in order to help corporate unitholders to calculate the amount of income tax they may be able to reclaim.

X Ltd receives a net distribution of £100, 82.82 per cent of which is treated as unfranked income. X holds 10,000 units.
Net unfranked investment income = (100 x 82.82 per cent) x 100
Gross = £103.525
Income tax deemed deducted = £20.705
Income tax available for reclaim (if applicable) = .1782p x 10,000 = £17.82

Editorial note. Both these replies are from experts in this industry and I am grateful for the clear and extensive explanations which they have supplied.

Issue: 3775 / Categories:
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