UK: Financial & Tax Planning - A Briefing on Topical Issues

Last Updated: 30 August 2006

SIPPs – What’s All The Fuss About?

Since 6 April 2006 individuals who were previously only allowed to get tax relief on relatively small contributions into their pension plans will now be able to pay substantially more. Not surprisingly there is now far more interest in how pension schemes are invested. So what are the options and are SIPPs the answer?

Since the introduction of pensions simplification on 6 April 2006 individuals who were previously only allowed to get tax relief on relatively small contributions into their pension plans, can now pay, in some circumstances, up to £215,000, £129,000 net of tax relief, in the current tax year and similar amounts in future years.

We look below at how pension funds can be managed through a Self Invested Personal Pension (SIPP) and later in this issue we explain discretionary fund management within a SIPP.

So what is a SIPP? First, we need to understand the distinction between the wrapper in which the investments are held and the investments themselves. Once this differentiation is fully appreciated the rest is quite simple.

The wrapper

The pension scheme is the wrapper which affords a specific tax treatment to contributions going into it and the investment income and gains arising within it. The pension must be administered in accordance with HM Revenue & Customs (HMRC) rules which basically state that the funds can only be accessed post age 50 (or 55 as of 6 April 2010). Up to 25% can be taken in the form of a tax-free lump sum whilst the balance must be used to provide an income in one of several prescribed ways. If the pension scheme breaks these basic rules it will lose its valuable tax reliefs.

Managing the investments

Having understood the pension wrapper one now needs to understand that within it there are many different ways of managing the investments. These cater for all shapes and sizes of investments as well as the risk profiles of the investors.

Insurance companies, banks, unit trust providers and certain other bodies are allowed to establish pension schemes and whilst the wrapper is generally the same the investment options that each will offer can vary enormously.

At one end of the spectrum a basic insurance company pension plan might allow access to a small number of internally managed insurance company funds, whilst at the other end, a SIPP, which can be offered by the same providers, will allow access to any investment allowed for by the pension scheme investment regulations. SIPPs offer the most flexibility, allowing investors to take complete control of their pension funds, as they would over their personal assets. This allows them to manage the funds themselves, appoint a discretionary fund manager or use some form of halfway house using advice given by an investment manager.

Whilst care should always be taken over the investment of one’s assets more focus tends to be placed on them as they grow larger.

IHT Treatment of Trusts

Having stayed relatively unchanged for two decades, the inheritance tax (IHT) treatment of trusts was thrown into confusion when the Budget unexpectedly heralded sweeping changes – see our Spring newsletter.

This was followed by the Finance Bill in April, and the Finance Act in July, which provided details of the rule changes. Extensive lobbying led to some amendments to the original proposals, nevertheless, the new landscape for trusts is very different to the one in existence a few months ago and it is important for all affected parties to review existing and pending trusts to determine the best way forward.


So what are the key changes?

  • The inheritance tax regime previously in place for interest in possession (IIP) trusts and accumulation & maintenance (A&M) trusts has been significantly changed and most of these trusts will now be taxed under similar rules to those which have always applied to discretionary trusts.
  • Lifetime transfers to an IIP or A&M trust made on or after 22 March 2006 are no longer potentially exempt transfers (PETs) and as a result they will not escape IHT if the donor survives seven years. Instead, such transfers will be immediately chargeable to IHT to the extent that they exceed the Nil Rate Band, currently £285,000, at the lifetime rate of 20%.
  • Assets held in IIP trusts set up after the Budget are no longer deemed to be part of the estate of the life tenant. This could lead to an IHT charge every ten years based on the value of the trust assets, and an exit charge either when the trust comes to an end or when assets leave it.

There are a small number of ‘protected IIP trust interests’ which are not subject to the new rules, notably Immediate Post-Death Interests (IPDI), Transitional Serial Interests and Disabled Person’s Interests, of which more later. Furthermore some pre-existing A&M trusts can continue to benefit from the new rules although in many cases their terms will have to be changed. The good news is that the qualifying conditions for exemption are less harsh than those originally announced, which would have denied an IHT exemption on transfers into trusts for spouses in many cases.

These provisions create major problems, notably on divorce, for trusts holding life policies, but also in many other situations so it is imperative that careful reviews of trust terms are undertaken to help avoid penalties.

Interest in possession trusts

There are three types of trusts that are protected from the changes. The most common of these is likely to be the IPDI. This protection applies where the settlement is effected by Will or intestacy in favour of a spouse, ruling out IIPs created in their favour during the settlor’s lifetime.

Despite the relaxations, it will be important for all, notably the elderly or infirm, to review existing Wills to ensure that they still qualify for relief under these new rules. A Will Trust commences on death, not when it was drawn up, so even a Will drafted many years ago may create a problem under the new rules.

When a post-Budget IPDI for a spouse comes to an end on the spouse’s death, and is followed by a new IIP for children or other beneficiaries, there will not only be a charge on the spouse’s death, but also the new IIP will be taxed as a discretionary trust because it won’t have come into existence on the settlor’s death. This is another point to watch when reviewing Wills because it will not be the result which the Testator will have been advised to expect when the Will was drafted.

Transitional Serial Interests in trusts which existed on 22 March are exempt from the new rules. These apply where one life tenant succeeds another (whether or not on death and regardless of the relationship between them) before 6 April 2008, or after that date if the succession takes place on death and the successor is a surviving spouse or civil partner. In both cases the succeeding life interest will be taxed under the present rules. If the successive life interest comes into existence after 5 April 2008 the new rules will apply from that date unless the existing trust held a life policy only and the policy terms remain the same as they were on 22 March.

Disabled Person’s Interests are trusts where the beneficiary is disabled or it is clear they will become so, and these will continue to be taxed under the old rules.

A&M trusts

The only post-Budget A&M trusts which can maintain the old style tax advantages are those for Bereaved Minors, persons under the age of 18 who have lost at least one parent, which arise on that parent’s death.

Any pre-Budget A&M trust will continue to benefit from the old rules if before 5 April 2008, the terms of the trust allow, or are altered to allow, the beneficiaries title to capital outright at the age of 18. Since very few existing A&M trusts provide for assets to pass outright at or before 18, in practice this means that trusts will have to amend their terms by 5 April 2008 if they are to continue to qualify.

Many trustees and settlors will be uneasy about allowing young adults to have access to trust funds at the age of 18 so an alternative called the ‘18 to 25’ regime has been introduced. There will be no charge at age 18 if absolute entitlement is delayed until age 25 (at the latest), at which time there will be a tax charge at a rate of up to 4.2%. In many instances the tax rate will be lower than this so this option should be carefully considered.

What now?

Now that the Finance Bill has become the Finance Act, action can be considered with some certainty. The following must be considered and Smith & Williamson will be happy to help you with any planning.

  • Review your Will to determine whether your expectations can still be achieved without giving rise to any unexpected tax liabilities.
  • Consider particularly the IHT impact where there is no surviving spouse.
  • Consider whether to use ‘18-25’ trusts.
  • Consider whether any of the protected categories are applicable. Where death has already occurred, consider whether Deeds of Variations will assist.
  • Review A&M trusts and decide whether any steps need to be taken before 5 April 2008.
  • Can a bare trust help those nearing 18?
  • Watch capital gains tax issues with trusts for settlor’s children as no holdover relief is available when setting them up.
  • If lifetime giving is thought inappropriate because individual donees are not thought to be responsible enough, should you consider alternative forms of planning using, for example, AIM stocks, woodlands or farmland?
  • Is a more appropriate non-trust holding vehicle available?

The Future for Retirement Annuity Contracts under the Annual Allowance

The outlook is bleak for Retirement Annuity Contracts (RACs). Under pensions simplification the tax advantages they offered over other pension plans are no longer available. Old contracts should now be reviewed to assess their worth going forward.

Whilst they ceased to be available to new investors from 1 July 1988, many high earners who held RACs prior to this date found them invaluable subsequently as contributions were not limited by the earnings cap.

By way of background, the earnings cap rose to £105,000 by 2005/06. Since its introduction in 1989/90, it caught more and more individuals and as it was not linked to increases in national average earnings, it thereby inadvertently benefited those with RACs.

The ability to carry forward unused tax relief for up to six tax years and carry back pension contributions to the previous tax year added to the attraction of RACs but both have been swept away by the new rules and replaced by the annual contribution allowance.

The maximum tax efficient contribution an individual can make to a pension plan in the current tax year, 2006/07, is now limited to the lower of gross earned income and £215,000. Having said this, in some specific circumstances it will be possible to pay up to two annual allowances in one tax year and obtain tax relief on them both in that year. Furthermore, in the year that pension benefits vest, contributions are limited by earnings only, offering scope for some to delay pension planning until much later.

A non-earner will still be able to contribute up to £3,600 gross into a pension plan.

How does this affect retirement annuities?

RACs pre-dated the stakeholder regime, which introduced low-cost pension contracts, and as a result they generally have much higher charges – a 5% bidoffer spread (the difference between buying and selling price) on contributions and often much higher ongoing annual management fees. Many also have initial units which can carry annual management charges of up to 10% per annum. The fees can be particularly significant if nearing retirement as a 5% initial cost could erode the performance of a cautious fund in the years beforehand.

As well as punitive charges many RACs also offer limited fund choice. Some were restricted to old traditional with-profits funds whilst others offered access to a limited range of insurance companies’ funds. Newer personal pension contracts will generally offer access to a wide range of internal and external funds whilst the fund choices under a SIPP are unlimited.

Those individuals with RACs who are considering making contributions should seek advice on both the cost of the existing wrapper and the fund choices available within it. A new wrapper is likely to be much more cost effective as well as provide a much greater choice of investments.

Most new style personal pensions do not have any upfront entry charges or exit penalties and so can offer a very competitively priced alternative. If an individual is looking to take advantage of alternatively secured income rather than purchase an annuity, a SIPP may be more suitable.

Having identified the positive aspects of moving away from an RAC there are other issues which need attention such as guaranteed annuity rates, market value adjustments and transfer penalties.

All in all we strongly recommend that anyone who has an ‘old style’ RAC should have it reviewed by a good financial adviser who will highlight all factors that need to be considered when contemplating the future of an RAC.

Standard Life Post-Demutualisation Who’ll Get the Profits?

Standard Life finally demutualised in July, listing its shares on the London Stock Exchange and opening its doors to shareholder capital.

This was the culmination of much hard work by the management team, which followed many years of debate about the rights and wrongs of transferring ownership away from its members. The question shifted inexorably from ‘if’ to ‘when’ through the years as it became clear that the risks, rewards, costs and management requirements of a multi-faceted international savings and investment business did not sit well with shared passive ownership by a pool of historical UK-based with-profits policyholders.

All debates about ‘ifs’ and ‘whens’ are of course now irrelevant. What is relevant is the question of what, if anything, existing policyholders should now be doing with their Standard Life policies? In particular, will the with-profits policyholders continue to get their fair share of profits?

Non with-profits policyholders

Firstly let’s consider the position of the non with-profits policyholders. The answer here is a simple one. Such policies did not confer membership pre-demutualisation, and the position has not changed since. They received no shares in the new company in compensation for loss of ownership, and their investment returns are represented by movements in the value of the underlying assets of the funds in which their policy is invested.

Any policyholder concerned about their non with-profits policies should ask their financial adviser to review them. A review would be relatively straightforward and involves comparing the charges, contract terms and the value of any guaranteed benefits under the existing policy to the charges, contract terms and the value of any guaranteed benefits of an alternative policy. There may be other consequences of transferring or cancelling a policy that should be taken into consideration, such as financial penalties.

Little, if any, useful information can be gleaned from the past investment performance of one company’s funds compared to another, as this uses historic data and will not predict the future consequences of changing. However, the number and scope of investment funds under the current policy and the alternatives would usually be relevant. As a general comment, we are not aware of many Standard Life policies with wholly inappropriate charging structures, although terms can sometimes vary from contract to contract.

With-profits policyholders

Will the answer for with-profits policyholders be quite so simple? Those familiar with the complexities of with-profits funds will know that the answer is a firm ‘no’.

To briefly recap, the theory of with-profits funds is that some returns are held back in years of good investment performance (as reserves) whilst some are reflected immediately in the policy as annual bonuses. The eventual payout or transfer value should include an additional payment or final bonus paid from the reserves. This should reflect the investment returns of the policy over its entire term. In adverse short-term market conditions the payout or transfer value may be reduced by a market value adjustment (MVA) to reflect those conditions.

The theory – smoother returns

The idea of with-profits plans is to produce a smooth return over time. With-profits policies also confer ownership of the mutual company on policyholders, so that investment returns also reflect the fortunes of the business – hence the title of ‘with-profits’. In return, the fund’s reserves are used as the capital of the business and help to run it. In most cases, and of course for all Standard Life with-profits policyholders, going forward the with-profits fund will benefit from less of the firm’s profits as they will now have to be split with shareholders, as with the working capital risk.

The practice – reduced bonuses

So much for the theory. Recent practice has been to reduce annual bonuses whilst placing more emphasis on the final bonus, with the result that whilst returns continue to be smoothed, the graph will be flatter. As final bonuses are not guaranteed, whereas annual bonuses are supposed to be, subject to any MVAs, actuaries can exercise more control over payouts from policies, putting more emphasis than ever on the market timing of the encashment of the policy.

The move away from annual to terminal bonuses effectively removes one of the original intentions of with-profits – to provide a smoothed investment return over the period of the policy. As the other main benefit of with-profits – ownership of the company – has also been removed, it must be right to question whether with-profits funds are appropriate going forward.

Standard Life’s investment returns

Returning to Standard Life, the overall investment return of the with-profits funds was 16.1% for the calendar year to 31 December 2005. Based on this, most unitised with-profits pension policies will receive annual bonuses for the year to 31 January 2006 of 2.5%, whilst most unitised with-profits life policies received annual bonuses of 2%. The intention for the current year is to reduce these annual bonuses by 0.5%, to 2% and 1.5% respectively. This means that of the 16.1% of investment returns for 2005, policyholders who remain invested at the end of that year have had 2% or 2.5% locked in and must wait in hope for the remainder to be credited to their policies as part of their final bonus.

The complexities of with-profits

The reasons Standard Life and other life office actuaries have applied so little of the with-profits fund’s investment return to annual bonuses can be partly explained by the highly complex nature of the with-profits funds. As a starting point, we need to consider their liabilities as well as their assets. The reserves not only have to fund annual bonuses in years of negative investment returns and final bonuses, they must also meet promises previously made by the company.

These include, for example, the guaranteed annuity rates included in some pension policies, as well as annuities which have been in payment for a long time. Many of these exceed current market annuity rates and the reserves within the fund must meet the shortfall between the underlying value of the policy and the full cost of purchasing the annuity. Let’s take a simple recent example where the current open market annuity rate is 6.1%, whilst the guaranteed annuity rate on offer is 9.1%, and the fund value is £100,000. Here, £49,180 must be added to the policy value from the with-profits fund’s reserves in order to meet the annuity promised based on open market annuity yields. This represents an effective final bonus of nearly 50% for the policyholder, and of course reduces the reserves available to fund the annual and final bonuses for everybody else.

Guaranteed returns

Some insurance companies must also use their reserves to help fund the annual guaranteed returns included in a certain number of with-profits policies. In Standard Life’s case they are up to 4% for pensions and 3% for life policies. These guarantees have led to the segmentation of the Standard Life withprofits fund in order to group these policies in one sub-fund (there are six in total) so that each one can be managed to take account of the guarantees attaching to the policies in it. The segment with these guarantees is invested 63% in fixed interest securities, with only 19% in equities, in order to try to produce the returns required to meet the liabilities each year without taking too much risk. This must be viewed as a sensible approach, but intuitively it is difficult to envisage returns on these policies ever significantly exceeding the guarantees on offer, given the asset mix of the funds.

With all these issues in mind Standard Life with-profits policyholders should be weighing up their options fully armed with the relevant information. It is difficult to generalise given the differing nature of their contracts and the sub-funds that they are now invested in and whilst many holders of policies with guaranteed returns might be happy to receive 3% or 4% each year, some may prefer to take their chances in a slightly more aggressive fund. Of course, an additional factor that may have a significant impact on any decision to move away from the with-profit fund will be the possible application of a surrender or exit penalty on the plan. An experienced independent financial adviser will be able to guide you through this difficult area.

The Importance of Asset Allocation – and How to Get it Right

Research has demonstrated that asset allocation accounts for approximately 90% of the variation in investment returns. This means that asset allocation alone is nearly ten times as important as stock selection and market timing combined in determining the performance of a portfolio. So what is asset allocation and how can the optimum asset mix be achieved?

Asset allocation is the diversification of a portfolio across different asset classes and geographical regions with the aim of maximising investment returns whilst reducing the portfolio’s overall volatility, or risk, to below that of its individual components. This is achieved by mixing assets which are ideally negatively, or at least weakly, correlated – that is, unlikely to move in the same direction to the same extent under the same market conditions. This is the key principle of modern portfolio theory, that risk reduces as the assets held by a portfolio become more diversified.

Beyond diversification

However, the art of asset allocation goes beyond mere diversification. It looks to allocate the optimum proportion of a portfolio to each asset and geographical region. At any one time, the optimum asset mix will depend on the investor’s risk and return profile, as well as how the different asset classes are expected to respond to different economic drivers. As the investment environment is constantly changing, it is vital that any portfolio’s asset allocation is regularly rebalanced to take account of prevailing market conditions, as well as any changes to the investor’s objectives, attitude to investment risk and timeframe for investment.

Under present conditions, balanced investors are generally willing to hold up to 85% of their portfolio in equities with the aim of increasing the real value over the medium-to-long term. The remainder is normally invested in fixed interest securities and property, whose long-term returns have historically been lower than equities but also generally less volatile.

How to achieve the model asset mix

There are several ways that investors can incorporate asset allocation into their financial planning, although the level of flexibility and control varies significantly between each option. In summary, the following options are available.


Insurance company with-profits funds (see Smith & Williamson article on Standard Life post-demutualisation - who'll get the profits?) invest in a mix of equities, fixed interest securities and property with the aim of smoothing out the peaks and troughs associated with these asset classes individually.

Historically, investing in a with-profits fund was an ideal way for smaller investors to access professional asset allocation management. However, most with-profits fund reserves were severely depleted during the 2000-2003 bear market and almost all with-profits funds have now altered their asset allocation strategies.

Most with-profits funds now hold a higher than ideal proportion of their assets in fixed interest securities, property and cash, which has rendered the asset mix underlying them appropriate only for very cautious investors.

Managed funds

The advantage of using managed funds to achieve the model asset mix is that, like with-profits, the need for ongoing monitoring is reduced as each manager adjusts the fund’s overlying asset allocation as well as the underlying investments on a daily basis.

On the downside, managed funds are invested with the average investor in mind, with attempts to meet the optimum asset mix often restricted by the category of managed fund they belong to. For instance, a cautious managed fund is limited to holding a maximum 60% in equities at any time, irrespective of whether it might be preferable to hold a significantly higher proportion.

Such funds are not, therefore, appropriate for larger or more sophisticated investors who often require greater flexibility and control.

Collective sector funds

A more sophisticated option is to use an asset allocation model to manage a portfolio of collective sector funds. This gives the investor greater flexibility and control than with-profits or managed funds together with significant manager diversification, removing the reliance on the expertise of one fund manager, which is inherent in discretionary management.

The skill here is in blending the different management styles of the various collective sector funds available. The aim should not be to compile a portfolio of the current star managers but rather a blend of funds with complementary styles and strengths including income and growth funds, small cap and blue chip stocks as well as both topdown and bottom-up fund management.

Administratively it is easier if the portfolio is consolidated into a single contract with access to all collectives, not just those offered by the product provider, as this will enable the investor to select the strongest management team in each asset class and geographical region to meet the model asset mix. SIPPs for pension funds and fund supermarkets for personal portfolios are ideal for this purpose.

Fund of funds and manager of manager funds

As there are over 21,000 UK collective and offshore funds open to investment by UK individuals, selecting the optimum asset allocation as well as the best funds to achieve it can be a difficult and time consuming process. In recognition of this, many investment houses now offer fund of funds and manager of manager funds which make all asset allocation and fund selection decisions.

The fund of funds approach, which is similar to using collective sector funds, allows the overlying managers to invest in any FSA-recognised collective to meet their target asset mix. In comparison, manager of manager funds appoint external fund management groups to manage different parts of the portfolio. As manager of manager funds are not restricted to using FSA-recognised collectives they arguably have greater investment flexibility, however a lack of choice is clearly not an issue with the fund of funds approach.

Although both options mean that the investor has no control over the asset mix, fund of funds and manager of manager funds are clearly a cost-efficient way of accessing professional asset allocation management for smaller or inexperienced investors.

Discretionary management

Discretionary management is arguably the most sophisticated method of asset allocating and is appropriate for those with large portfolios who would prefer to have their assets invested directly into equities and fixed interest securities on a bespoke basis, rather than investing in collectives.

The key advantage is that the asset allocation of the portfolio is constructed and managed specifically according to the investor’s objectives, timeframe for investment and attitude to investment risk. We look at discretionary management in more detail in the article on the next page.

Over the next few issues of Financial & Tax Planning we will look at some of the other options mentioned above in more detail and consider which types of investor they might be suitable for. If you would like to consider how this or one of the other asset allocation models can be incorporated into your financial planning then please contact your usual contact at Smith & Williamson.

Discretionary Fund Management within a SIPP

The world of pensions and investment management is an area avoided by many savers whose pension contributions are paid directly into an insurance company’s pooled fund. Good news for the insurance company but not necessarily the best option for investors.

As discussed in the previous article there are several viable alternatives which grant the investor greater flexibility, visibility and control over the ongoing management of the fund. Appointing a fund manager to invest, with discretion, on your behalf but in line with your express wishes, is the most flexible of all. Discretionary fund management is designed to fit a specific investment strategy by meeting the individual requirements and objectives of investors. This forms the basis of a tailormade portfolio bearing in mind factors such as attitude to risk and time horizon, amongst other things.

A Self Invested Personal Pension (SIPP) is a pension wrapper within which investments are held and managed until the time that the investor needs to draw a pension income, and even then the flexibility it offers can continue unless the investor wants the certainty of an annuity income.

The SIPP was introduced in 1989 by the then Chancellor, Nigel Lawson, who said during his Budget speech, "I propose to make it easier for people with personal pensions to manage their own investments".

The range of permitted investments within the plan is wide and includes quoted securities worldwide, authorised unit trusts, OEICs and suitable commercial property in the UK.

Why discretionary management?

Management of investments can seem daunting and time consuming to some. Discretionary fund management is, therefore, of appeal to sophisticated investors, for those looking at their pension investments for the first time and investors looking for active management of their funds with the potential to add value. By appointing a dedicated fund manager a personal, relationship-driven service geared to the financial objectives of the investor can be established. This, together with a flexible approach and emphasis on getting to ‘know the client’, means that investment options can be directed by these objectives.

Tailored approach – the benefits

Understanding the needs of the investor and building a good relationship is important so that the pension portfolio can be managed efficiently and effectively. An initial meeting with the investor (and/or financial adviser) is essential so that the fund manager can fully understand their requirements and determine a suitable risk profile. As a result of this, an investment strategy can be agreed and work can then begin on the construction of a portfolio specifically designed for the investor. The fund manager can take over the responsibility for the day to day monitoring of the pension investments, responding to fluctuating investment market conditions and any change to the client’s own circumstances. By adopting a diversified approach within the investment portfolio, a degree of flexibility will be maintained which will make it easier to absorb any alterations as required.

Investment process

The investment process has three main elements which have a bearing on future investment performance.

Asset allocation

As discussed in the article earlier in this issue, asset allocation depends on the investor’s risk profile and to this end discretionary fund managers will usually use four models: capital growth, balanced, income and absolute return. These may be guided by benchmarks such as those set by the Association of Private Client Investment Managers and Stockbrokers (APCIMS) but do not have to be. Many managers will adjust these benchmarks based on their own house view of companies, markets and economic outlook in what can best be described as a constant process of review and adjustment. Such a strategy should assist performance in good times and protect capital when conditions are less favourable.

Stock selection

Discretionary fund managers will have sector specialists in the fixed income, UK equity, international equity and collective investment markets and should hold daily investment meetings to discuss market news as well as a weekly meeting in order to focus on specific areas of the market. In addition, they should conduct a large number of company meetings annually.

Fund selection

Many discretionary fund managers will use collective funds to gain access to specialised markets which are either expensive to enter on an individual share basis or require particular investment expertise.

As they do when selecting fixed interest stocks and equity investments, many discretionary managers, including Smith & Williamson, will call upon the expertise of in-house sector analysts, controlled by a selection committee, to produce recommendations for collective investments, including open-ended unit trusts, OEICs, close-ended (investment trusts) and offshore funds.

Discretionary investment management is not ideal for everyone, but is worth serious consideration for investors with £250,000 or more across their personal and pension assets. Should this service be of interest, please contact us to find out more.

The REIT Choice

As of 1 January 2007, investors will be able to invest in shares in UK Real Estate Investment Trusts (REITs). In reality it will take existing property companies some time to convert to a REIT so that initially the market will be small, but rapid growth is expected thereafter. So who should be interested and why?

After many years of lobbying and following the recommendations of the 2004 Barker Report on the supply of housing, the Government has finally legislated for UK REITs. The UK property industry felt they were at a disadvantage since many other countries such as the US and France had their own version of REITs. Additionally, UK listed property companies have traditionally traded at a substantial discount to net assets.

This was at least partly due to the double tax layer – the company would have to pay corporation tax on its rental income and on gains arising on the sale of its property. Only the net amount would be available to pay dividends to shareholders which would then be taxed in their hands.

The structure of UK REITs has been well trailed. The key areas, which have been honed following a considerable amount of consultation, are as follows.

  1. UK REITs will be established as UK resident quoted companies with special rules. They cannot be close companies or OEICs and their share capital can only be issued in the form of ordinary or non-participating fixed rate preference shares.
  2. Existing quoted companies and groups that carry on a qualifying property rental business can elect to be a UK REIT from 1 January 2007.
  3. The conditions for a qualifying property rental business are that:
    • at least 75% of the company’s assets must be property investments

    • at least 75% of the company’s income must derive from rental

    • gearing must be greater than 1.25. This ratio is calculated by dividing profits after adding back the interest charge, by the interest charge.

  4. The conversion charge which is payable to HMRC has been set at 2% of the value of the company’s investment properties.

Components of a UK REIT

The business of a UK REIT will be divided into a tax-exempt qualifying part and a nonqualifying part. The tax-exempt part will not pay corporation tax.

90% of the profits from the tax-exempt part must be distributed each year normally within 12 months of the end of the accounting period. These distributions will be paid net of basic rate tax. The recipient will treat them as Schedule A (rental) income.

Corporation tax will be payable on the profits of the non-qualifying part and distributions will be treated as normal dividends.

Various further conditions apply to the taxexempt business.

  • The company must own at least three single properties.
  • No single property must have a value exceeding 40% of all the properties in the tax-exempt business.
  • No property can be occupied by the UKREIT or its associates.
  • The company must derive 75% of its income from the tax-exempt business.
  • The value of the assets in the tax-exempt part must be at least 75% of the value of the assets in the whole.

Market for UK REITs

REITs will appeal to individuals who want to invest in property without the complications of owning it themselves. They will be able to select REITs that specialise in different types of property and location, including foreign property so that REITs may reduce the attraction of investing via LLPs. However it should be noted that REITs are not completely ‘look through’ – gains on the sale of property are distributed as income, not as gains and capital allowances are not available to the investor. Moreover, the income is treated as that of a separate property business so that losses made on direct holdings of property cannot be offset.

REITs may be of particular interest to non-taxpayers such as pension schemes and individuals who do not pay tax as, unlike the tax credit attaching to UK dividends, the tax deducted at source can be repaid.

Additionally, discretionary trusts receiving dividends suffer a high marginal tax rate if they wish to distribute all their income since the dividend tax credit does not form part of the tax that is needed to ‘frank’ payments to beneficiaries. This problem will not arise with REITs as the tax deducted at source will be available to ‘frank’ income distributions to beneficiaries.

Many of the larger quoted UK property investment companies have already signalled their intention to convert to REITs.

Owners of private property investment companies with high inherent gains on their properties may also be interested in REITs since the 2% conversion charge is relatively benign and property companies could amalgamate and float, with the original shareholders taking shares in the REIT.

Lobbying continues to make REITs more flexible. In particular, unquoted REITs would be welcome and the maximum permissible shareholding of 10% is restrictive.

All in all, REITs will be well worth a look for the investor and the property company considering converting and we look forward to providing investors with further information on the tax and investment opportunities available in due course. In the meantime if you would like further information at this stage please let us know.

How Safe is Your Pension?

It is estimated by the Pension Protection Fund (PPF) that the overall shortfall in UK final salary pension schemes exceeds £100bn. With many large companies’ final salary pension schemes currently under assessment by the PPF, many people are concerned about how secure the pension promise is from their current or former employers.

Many people took comfort from the Government’s launch of the PPF with effect from 6 April 2005. However some are realising too late that for those with long service or significant benefits the protection offered represents only a fraction of the pension they were expecting.

What protection is provided by the PPF?

PPF benefits depend upon whether you have reached the normal retirement date of the scheme and are in receipt of a pension or if you are still to draw your benefits. If the PPF accepts responsibility for a scheme, compensation will be paid as follows.

  • For those with pensions in payment after the scheme’s normal retirement age, 100% of the pension paid could be protected, however, future increases in pension may be affected.
  • For those members who took early retirement before the scheme’s normal retirement age and who have not yet attained the schemes normal retirement age the situation is more complex. The compensation will be restricted to 90% of their standard entitlement and the maximum pension will be limited by the PPF to £26,050. This may be further reduced by actuarial factors issued by the PPF even if early retirement without penalty had been offered by the main scheme.
  • For those members not yet in receipt of pension, compensation benefits are limited to 90% of the entitlement, subject to the current £26,050 limit. Further details concerning these benefits can be found on the PPF website

For people who have not yet taken pensions the 90% compensation limit has received a lot of publicity however we are not certain that the £26,050 cap on benefits paid has received the same amount of publicity.


Ivor is 56-years-old and has a deferred pension entitlement with his past employer of £74,088 at age 65. This pension would be subject to annual statutory increases in deferment until the scheme’s normal retirement age of 65.

Ivor could realistically expect a pension of £93,974 at age 65 as the scheme rules allow for the pension to increase in line with the Retail Price Index subject to amaximum of 5% per annum.

If, however, the scheme became subject to the PPF rules the likely pension at age 65 would reduce to £35,583 (90% of the limit of £26,050 revalued to age 65). Furthermore, only the pension earned post April 1997 would increase in payment.

Ivor would find that, rather than 90% of his pension entitlement being protected by the PPF, only 38% is covered by compensation. The loss of pension of over £58,000 per annum plus increases in payment would be actuarially capitalised at a value of over £1.3m.
Source: O&M Systems

HMRC’s New Compliance ‘Interventions’ What Can You Do?

HMRC has not long celebrated its first anniversary. It is now actively trying to move towards becoming a more ‘joined-up’ body rather than two separate departments thrust together. To this end it is reviewing its combined powers, ranging from simple enquiries to fullblown investigations.

If you have any doubts about the financial stability of the final salary scheme of a current or past employer, or doubts about the financial stability of the employer itself, you can request a review of your pension scheme benefits assessing the impact of the PPF. You can then make an informed decision about the security of your pension benefits and the relative benefits of transferring it elsewhere.

Remember not to leave the review too late. Once the PPF assessment period starts, benefits paid to individuals will be subject to the PPF limits even though the scheme is yet to be accepted by the PPF. Also, you will have no rights to transfer your benefits out of the scheme once it has entered the PPF assessment period, except if you had requested a transfer in writing prior to its start. You do not currently need to review your final salary pension scheme if the scheme is provided by a public sector employer. The PPF only applies to private sector schemes, as public sector schemes are secured by the taxpayer!

It has started a series of pilot programmes around the country called ‘interventions’ and it is important to be aware of them. There are six types of interventions being tested. Some involve visiting businesses and reviewing books and records whilst others include telephone calls or other forms of contact to alert taxpayers to potential problem areas.

The intervention list was first publicised in HMRC’s March 2006 consultation document ‘Modernising Powers, Deterrents and Safeguards’.

The aims of the new interventions and the trials are best summed up by HMRC.

  • "With these new approaches we aim to trial a lighter touch, providing help where needed, and freeing up resources to tackle serious and deliberate non-compliance.
  • We hope that the new approaches... will prove to be more flexible and less time consuming for businesses, tax agents and HMRC staff."

HMRC has confirmed that participation in trials of the interventions is voluntary. Indeed, at present it does not have formal powers which would enable it to carry out some of the interventions. Commentators have questioned whether taxpayers would welcome such intrusions into their business and if these interventions would provide appropriate information.

Nevertheless, the trials are to go ahead and will be carried out at selected locations around the country. The target sample of taxpayers has been selected on the basis of risks identified by HMRC. These risk criteria have not been published. The trials appear to place the emphasis on businesses and their records, but they will not be confined to such clients.

Where a tax adviser or agent, like Smith & Williamson, is acting for a client, HMRC should contact that adviser or agent to inform them that a taxpayer has been selected. Past experience suggests this may not always be the case. If you receive any communication about these pilots asking if you will participate, please contact your usual Smith & Williamson adviser immediately so that we can discuss how to take the issue forward.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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