When investors buy funds on investment platforms, part of the annual management charge they pay is often returned to them in the form of cash or unit ‘rebates’.
These rebates have become the subject of regulatory scrutiny with plans afoot to ban them by the end of next year.
In what represents a final nail in the coffin for fund charge rebates, HM Revenue & Customs has announced plans to tax them from 6th April 2013.
Because HMRC views these rebates as annual payments, they will become subject to income tax.
In practice, basic rate income tax at 20% will be deducted from cash or unit rebates from 6th April 2013. Higher rate taxpayers will have an additional tax liability to deal with through the self-assessment process.
It is worth noting that this tax will not apply to rebates within ISA or pension portfolios.
This move to tax rebates raises several important issues for investors.
Where investors hold retail fund share classes on platforms – which make provision for platform and advice charges within their charges (which are then rebated to the investor on the platform) – they might consider switching to clean share classes instead.
This will result in them paying for fund management only, with platform and advice fees charged explicitly from a separate cash account.
There are some factors to consider when moving from retail to clean share classes, including the possibility of capital gains tax triggered by the switch. Investors will also have to consider whether the cost of retail units (net of taxed rebates) are higher or lower than clean units.
Once clean funds become the norm rather than in the (rapidly growing) minority, we expect to see increased price competition resulting in lower fund management charges; a positive outcome for investors.
If investors choose to continue receiving rebates, will this taxation prove to be expensive?
Assuming a general investment account valued at £100,000 with rebates of 0.75% on half of the assets (which is typical based on the portfolios we recommend), a basic rate taxpayer will suffer income tax of £75 a year.
For a higher rate taxpayer, it would be £150 of income tax.
Probably more relevant than the tax charge is the added complexity of reporting this, for higher rate taxpayers, through the self-assessment process.
What we believe income tax on rebates will accelerate is the cleaning up of charging structures from execution-only investment platforms.
Rather than the current system of taking with one hand and giving back with the other, using perverse ‘loyalty bonuses’ which effectively give investors back their own money, we will soon see clarity around charges. This should result in greater price competition and a better deal for investors.
As we prepare to launch our own service for self-directed investors, our decision to only offer clean funds feels especially justified.
