Cut your tax bill with B shares
Investors wanting to minimise higher-rate tax liabilities, and still receive attractive distributions from investment trusts, should consider the new breed of B shares.
Pioneered in 2007 by Investors Capital Trust, the concept has been taken up by Perpetual Income & Growth Investment Trust.
If the latter's proposed issue proves popular it could be emulated by other large trusts in the UK growth and income sector.
What is a B share?
The B shares are almost identical to a trust's ordinary or A shares: they share the same portfolio, have the same net asset value (NAV) per share, and receive payouts at the same time as, and in an equal amount to, each net dividend paid.
Their attraction is that the payout comes as a capital distribution instead of a dividend.
As a result, whereas dividends on A or ordinary shares may be liable to higher-rate tax if they are not sheltered in an individual savings account or pension, capital distributions on B shares are treated as 'small capital receipts' for tax purposes, so are free from immediate tax and may not need to be included in tax returns.
So what's the catch?
The catch is when the investor sells B shares: an amount equal to the total distributions received must be deducted from their base cost, increasing potential capital gains tax (CGT) liability.
But this may be covered by the holder’s annual allowance, and there is no CGT if shares are held until death.
Also, CGT, at the flat rate of 18%, is less than the potential higher-rate tax on dividends.
The mechanics of the new breed of B shares are outlined in the profile of Investors Capital Trust managed by F&C.
But there is a potential drawback: capital distributions are funded from the combined assets of the two classes so act as a brake on the growth in the mutual NAV per share.
The quid pro quo for the A or ordinary shares is yield enhancement: it is bolstered by income earned on the funds contributed by the B shares.
Dividends on Perpetual Income and Growth Investment Trust's ordinary shares are expected to rise by at least 10% following its B share issue, which could help to lower its discount to NAV.
David Barron, who heads JPMorgan's investment trust business, says B shares seem a sensible option for those wanting returns in capital form, but warns that trusts following Perpetual Income and Growth Investment Trust's example must be large enough to ensure liquidity in both share classes, which indicates minimum assets of £400 million or so.
Spotlight on Investors Capital Trust
Investors Capital has been managed by F&C's Rodger McNair since 1999, but it has changed since its new structure was adopted in 2007, with capital divided into A and B shares in the proportion of three to one.
Shareholders' funds are mostly invested in a concentrated portfolio of large and mid-sized UK equities.
Its 32% gearing is invested mainly in corporate bonds, which yield more than enough to cover the borrowing costs. But the equity/bond ratio is adjusted to take account of investment prospects.
The assets of A and B shares are combined into one portfolio, with all income allocated to A shares. This boosts their potential distribution by 33%, so dividends for the year to 31 March will total 5.35p, giving a yield of 6.7%.
In return, the B shares will receive capital distributions totalling 5.35p paid out of the trust's combined assets.
This reduces the mutual NAV per share, but as only a quarter of the capital is in B shares the reduction is equal to a quarter of the dividend distribution or 1.34p for the year to March 2010.
McNair says bolstering the revenue of A shares with the income foregone by B shares enhances his flexibility by lowering the yield requirement.
This may bolster capital growth by more than enough to compensate for the capital used to pay the distributions on the B shares.
"At the time of the reorganisation we consulted shareholders and decided a bit more of a capital hurdle in return for more flexibility in the investment profile was worthwhile," he says.
As proof that Investors Capital B shares are popular, they trade at a premium. The A shares are at a discount.
This article was originally published in Money Observer - Moneywise's sister publication - in May 2010
Net asset value
A company’s net asset value (NAV) is the total value of its assets minus the total value of its liabilities. NAV is most closely associated with investment trusts and is useful for valuing shares in investment trust companies where the value of the company comes from the assets it holds rather than the profit stream generated by the business. Frequently, the NAV is divided by the number of shares in issue to give the net asset value per share.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
Investors who borrow money they use for investment and use the securities they buy as collateral for the loan are said to be “gearing up” the portfolio (in the US, gearing is referred to as “leveraging”) and widely used by investment trusts. The greater the gearing as a proportion of the overall portfolio, the greater the potential for profit or loss. If markets rise in value, the investor can pay back the loan and retain the profit but if markets fall, the investor may not be able to cover the borrowing and interest costs, and will make a loss. Also used to describe the ratio of a company’s borrowing in relation to its market capitalisation and the gearing ratio measures the extent to which a company is funded by debt. A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are.