Clock ticks on tax shelter

The future has a habit of becoming the present all too quickly. When the Government announced in 1998 that an important element of the tax break on Peps and Isas would disappear in 2004, the change seemed a long way off.

In a piece of fiscal wizardry similar to that which has robbed pension funds of their tax break, dividends from Isas and Peps will be subject to the equivalent of basic-rate tax in two years' time.

This means that investors using these popular tax shelters to hold income-producing shares or stock market funds may receive little or no benefit from doing so. This is the peak time of year for sales of Isas, as investment managers try to persuade investors to use their annual tax-free allowance. Anyone considering investing in an income fund now should consider whether this is worthwhile, given the change that is on the horizon.

Two years is a short time for investors trying to plan for the long term. Some well-informed individuals, such as Jill Wright of Market Harborough, are becoming concerned about what the change might mean to them.

'As a fiftysomething, self-employed person in an expensive personal pension plan, I have tried to spread the risk by also investing in single-company Peps - the idea, of course, being that I would receive some tax-free income from these in retirement.

'But to add to the misery of low annuities, Gordon Brown is removing the tax-free element of Peps and Isas. I am surprised that there has been no fuss from the investment industry. What use is a Pep or an Isa to the ordinary man and woman if there is no tax-free income?'

Ian Millward, of independent adviser R J Temple, says: 'She's absolutely right. For the vast majority of people the benefit is income tax and that will be removed completely.'

Mike Warburton, of accountant Grant Thornton, likens the change to the Chancellor's 'raid' on pension funds; the funds were stripped of their right to reclaim tax at a cost of £5bn a year. 'The raid of pension funds was much bigger but it has the same effect.'

At present, any profits, or capital growth, within Peps and Isas is free of capital gains tax. But since many small investors do not use their annual capital gains tax exemption - currently £7,500 - because they do not make enough profit on their investments, this aspect of tax benefit in Isas and Peps is window-dressing.

The chief attraction is the tax break on income. Until 5 April 2004 Isa and Pep managers can reclaim the 10 per cent tax charge on dividends. From that date, the concession is withdrawn.

Advisers say there will still be advantages in keeping money in Peps and Isas, but many investors will have to consider switching their investments to make the most of these.

Returns on Peps and Isas do not have to be declared on tax returns. Many plans charge no more for holding shares in a Pep or Isa than if they were held outside the 'wrapper'. Some even charge less. So investors would be no worse off by receiving their income through the Isa or Pep than direct from shares or a fund.

For people who are investing long term, the freedom from capital gains tax may eventually become useful even if it is irrelevant in the early years.

Don Clark, of adviser Torquil Clark, says: 'CGT is an awkward old tax. Once you have a lot of CGT liabilities it is difficult to do anything about them. I still think they (Peps and Isas) are good products.'

Millward says that someone investing in Pep or Isa plans that levy charges - and single company Peps usually do - should review their holdings.

Graham Hooper, marketing director at independent adviser Holden Meehan, says: 'Question why you want it. If it's purely for income, have a serious think about it.'

If you want to buy into a traditional income fund now, look for a management company that has a range of other funds and will allow free switching. Probably the main option for people seeking income will be to switch into corporate bond funds, where the income is classified as interest and therefore entirely tax-free.

Millward says: 'Come 2004, corporate bonds will be the most tax-advantaged investments.'

He foresees the development of new types of funds, investing in a mixture of shares and bonds. To qualify for tax-free status in an Isa, a fund needs to have 65 per cent of its money in corporate bonds. Fund manager Jupiter recently launched an income fund that will hold 65 per cent in corporate bonds and 35 per cent in shares.

At present, investors have around £1.1bn in equity income Isas.

Share prices could slump if investors dump equities and there could be galloping increases in the price of corporate bonds; this could be an argument for moving into corporate bond funds now.

Then again, the Chancellor may be persuaded to call off his tax dogs before 2004. Millward thinks investors and fund managers will begin to protest as the date draws near.

Industry and individuals were slow to realise the impact of the £5bn loss of tax breaks on pension funds, which has been exacerbated by tough new accounting rules. But the realisation has left small investors in no mood to see another important tax break disappear.

The new rules

The arithmetic is complicated, but the
important fact to grasp is that, from 2004, for
basic-rate taxpayers shares held in a Pep or Isa
are effectively taxed at basic rate. There will still
be an advantage for higher-rate taxpayers, but
less than in the glory days of Peps, which were
replaced by Isas.

Mike Warburton of accountant Grant Thornton
gives the following example of how the system is
changing. Until 1999, a ?100 dividend paid into a
Pep gave a 25 per cent credit, so the return was
?125. From 1999 the same dividend became the
equivalent of one ninth of the payment, giving a
return of ?111.10. From 2004, it remains at ?100.