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Dividend tax cut causes income fund headache for IFAs

The government has slashed the dividend allowance, forcing advisers to alter their strategies for clients who own a business or use dividends as a form of investment income.

Dividend tax cut causes income fund headache for IFAs

The Treasury’s latest grab over the dividend allowance is causing problems for advisers, as it is not only hindering their own remuneration, but forcing their hand over clients’ portfolios.

The forthcoming general election means the clause introducing the cut to the tax-free allowance has been dropped from the final bill.

However, speaking in the House of Commons financial secretary to the Treasury Jane Ellison said the Conservatives would look to legislate for all measures it dropped as soon as possible if they won the election in May. As the party currently has a significant lead in polls it seems likely this is a delay rather than the end of plans to cut the allowance.

Most advisers have clients who are the directors of small businesses, who often use dividends to pay themselves. These clients will be hit financially next year when the dividend allowance is brought down again.

But some advisers have based clients’ investment propositions around the hugely popular income funds, and the latest pinch by the chancellor is causing a rethink for these IFAs.

Once again it appears a government stealth tax is adding a layer of complication for advisers and their clients. 

Dividends disaster

In this year’s Spring Budget, chancellor Phillip Hammond announced plans to cut the tax-free dividend allowance from £5,000 to £2,000 from April 2018. Going over the allowance can leave clients with a hefty tax bill, with a tax of 32.5% on dividend income above the allowance for higher rate earners.

The Treasury justified this latest reduction by trying to reduce the ‘tax differential between the self-employed and employed, and those working through a company, to raise revenue to invest in public services, and to ensure support for investors is more effectively targeted’.

This policy, although widely unpopular, did not create enough fervour for Hammond to perform a U-turn, but it has left many advisers with a bad taste in their mouths.

Broadly speaking there are two categories of clients who will be hit: clients who own a business and clients who are heavily invested in income funds.

Income funds have proved popular for IFAs, with many preferring them to the absolute return option. (Frank Talbot, Citywire’s head of investment research, summarises how income funds are faring at the bottom of this article.)

But for advisers who love income funds, they may be forced into some rebalancing when the latest cut comes into effect next year.

One adviser who anticipates making changes is Darren Lloyd Thomas (pictured above), managing director of Pembrokeshire-based Thomas and Thomas Finance.

Lloyd Thomas said he was attracted to income funds because of their ability to smooth out fluctuations in the market. ‘I’ve always been an income fan in terms of reinvesting and not paying out income,’ he said.

‘Pound cost averaging in reverse as I call it. In other words, dividends are being reused to purchase units when markets fall. It’s a good tactic to buy more units in the same fund.’

But Lloyd Thomas sees the latest allowance cut as an obstacle to
this strategy. ‘These changes are going to mean we can’t have as many of those income funds and it is going to cause a lot of problems for clients with large portfolios,’ he said. ‘You don’t even have to have a big portfolio to get caught by these new changes so it is an issue for us.’

The only solace Lloyd Thomas had about the situation was the recent increase to the ISA allowance, which rose to £20,000 for the 2017/18 tax year, up from £15,240 for the last tax year.

Savings saviour

With the ISA allowance at such a high, this is a way for advisers to shelter their clients from the dividend allowance grab, according to Vince Smith-Hughes, director of specialist business support at Prudential.

Smith-Hughes said IFAs should consider moving open client portfolios into other wrappers such as a pension or a bond, as this
would shield them from the latest dividend cut.

However, one thing that should cause advisers to be cautious is the upcoming general election.

‘We don’t know what is going to be in manifestos [at the time of writing] for the election, so advisers need to be mindful we may see some further changes,’ he said. ‘If there is a Budget immediately after the election, it may have some tax consequences, so advisers will need to have one eye on that as it could impact their decisions.’

Derbyshire-based Red Circle Financial Planning director Darren Cooke said he had some clients in income funds and may have to move some out of those funds if their portfolios are large enough to hit the ISA limit.

Cooke said he was considering moving some of these clients into bond wrappers but added he was mindful of being hit by capital gains tax (CGT) if share portfolios were sold.

‘If the money is in a general investment association and you need to sell it down to put into a bond, you could incur CGT on the current investment when you put the bond wrapper around it,’ he said.

Scott Gallacher (pictured above), director of Leicester-based Rowley Turton Private Wealth Management, said his firm’s investment strategy came prior to any tax considerations, so he would not be moving away from income funds, just rearranging these funds into other formats.

‘It won’t affect the income funds we have because we are conscious the investment approach should outweigh the tax approach,’ he said. ‘It is how we hold those funds that will change. That will be more about holding those funds in ISAs and investment trusts, and trying to avoid holding higher yielding funds outside of ISAs.’

Another consideration for advisers is clients who are owner-managers of small businesses. For these clients who use dividends as a key part of their pay, Smith-Hughes said advisers should think about moving them to higher pension contribution as this is a ‘tax efficient way of releasing capital’.

Ramping up pension contributions is fine for those approaching retirement, but if any benefits have been taken through the pension freedoms, the money purchase annual allowance cut from £10,000 to £4,000 comes into effect this month, adding a further dilemma for advisers.

For advisers who have clients that own a business, they not only have to figure out how to rebalance their pay, but manage their expectations and explain to them the government is looking to tax them more.

Jim Clancy (pictured above), partner at Hexham-based Access Wealth Management, said using dividends for pay ‘was a good loophole’ but now it has been closed there is nothing advisers can do about it other than explain the situation to their clients.

‘The genuine small business owners have accepted it. They don’t like it, but they have accepted it,’
he said.

But Clancy said it was inevitable the government would introduce more tax-making measures, it is something governments will always do, and managing that is part of an adviser’s job.

‘This notion of income is a technical term used by HM Revenue & Customs so they could tax it.

What you should be looking at for funding your lifestyle is money,’
he said.

Income funds overview

Frank Talbot, head of investment research, Citywire

Equity income remains one of the most popular investment sectors in the UK. Historically, it has been home to some of the best outperformance rates for active managers anywhere in the world. Over five years up to the end of February 2017, 58 of the 68 managers (85%) Citywire were tracking over that period outperformed the FTSE All Share index. The past three years were less impressive, with 39 of 87 outperforming the same index (44%).

One of the concerns with funds in this area has been strict yield targets can occasionally come at the expense of capital preservation. This is particularly true during prolonged periods of flat or downward markets and all the numbers above assume income is reinvested.

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